Presented To:

Sir Nazik Hussain

Group Members:

Syed Sajjad Haider

Roll No. 35
Farhan Sarwar
Roll No.07
Risk Management in Commercial
Banks

Guidelines by State Bank of Pakistan

 Defining Risk

“financial risk in a banking organization is

possibility that the outcome of an action or
event could bring up adverse impacts.”

Expected Losses:
Unexpected Losses
 Risks in the Bank

Credit Risk
Market Risk
Liquidity Risk
Operational Risk
Compliance Risk
Reputation Risks
 Risk Management
It involves identification, measurement, monitoring and
controlling risks to ensure that;

-The individuals who take or manage risks clearly

understand it.
-The organization’s Risk exposure is within the limits
established by Board of Directors.
-Risk taking Decisions are in line with the business strategy
and objectives set by BOD.
-The expected payoffs compensate for the risks taken
-Risk taking decisions are explicit and clear.
-Sufficient capital as a buffer is available to take risk

Optimize risk-rewards trade-offs

 Why Manage Risks?

It supports the achievement of objectives

It allows higher risks to be taken
It reduces the chance of serious errors
Risks exist at all levels: corporate/strategic, faculty,
departmental, functional, personal, project . . . . So we
all need to be risk managers in a way appropriate to
our own responsibilities
Benefits of risk management
Enhances
Supports strategic
com munication
and business
between faculties
planni ng
and departments

Quick grasp of new Supports effective

opportunities use of resources

Potential
benefits
Reassures Pr omotes conti nual
stakeholders impr ovem ent

Fewer shocks and Helps focus

unwelcome internal audit
sur pr ises programme
 Risk Management Activities

Strategic Level:
Senior management and BOD
Macro Level:
Business area or across business lines
Micro Level:
Front office and loan origination functions
 Risk Management Process

It Involves:

Identification of risk
Measurement of risk
Monitoring the risk
Controlling the risk
Risk Management in Banks
Board & senior management oversight
Risk Management framework
Integration of risk Management
Business line accountability
Risk Evaluation/Measurement
Independent review
Contingency planning
Credit Risk Management
 What is Credit Risk?

Credit risk arises from the potential that an

obligor is either unwilling to perform on an
obligation or its ability to perform such
obligation is impaired resulting in
economic loss to bank
 Sources of Credit Losses
Outright Default: due to inability or unwillingness of a
customer or counter party to meet commitments in relation to lending,
trading, settlement and other financial transactions.

Economic Exposure: This encompasses opportunity

costs, transaction costs and expenses associated with a non-
performing asset

Credit risk may arise liquidity problems

 Credit Risk Arises From;

Banks’ dealings with individuals, corporate,

financial institutions and sovereign.
Loans are the largest and obvious source of
credit risk
Components Of Credit Risk
Management:
 Components of Credit Risk
Management Frame work

1)Board and senior management’s

oversight.
2)Organigational Structure
3)Systems and procedures for identification,
acceptance, measurement, monitoring and
control risk
 Board and Management’s
Responsibilities

Their over responsibility is to approve

bank’s credit risk strategy and significant
policies relating to credit risk and its
management which should be based on
bank’s over all business strategy.
The overall strategy should be reviewed
annually.
Board’s Responsibility
 Board’s Responsibility
Delineate bank’s risk tolerance in relation
to credit risk.
Ensure that bank’s overall credit risk
exposure is maintained at prudent levels
and consistent with available capital.
Ensure that management and people
responsible for the function have sound
expertise and knowledge.
 Board’s Responsibility
Ensure that appropriate plans and
procedures for credit risk management are
in place.
Credit Risk Strategy Should Define

Institution’s plan to grant credit based on

various;
a) Client segments and products.
b) Economic sector
c) Geographic location
d) Currency and maturity
Credit Risk Strategy Should Define

Target market in each lending segment.

Level of concentration/diversification.
Pricing Strategy.
 Credit Strategy Should:
Provide continuity in approach.
Take into account cyclic aspect of
country's economy.
Consider Resulting shift in quality and
composition of credit portfolio.
Be reviewed periodically and amended so
it may be viable in long term and through
various economic cycles.
Senior Management
Responsibility:
Senior Management Should Develop

Credit Policy and Credit administration

Procedures.
Get them approved from board.
Such Policies should provide guidance to
staff on various types of lending.
 The Policy Should Include:
Detailed and Formulized credit evaluation
Process.
Credit approval authority at various
hierarchy levels including authority for
approving exceptions.
Risk identification, measurement,
monitoring and control.
Credit origination, credit administration,
and loan documentation procedures.
 Continued

Roles and responsibilities of staff.

Guidelines on management of problem
loans.
 For Policy to be Effective:

These should be;

Clear Communicated down the line
Any significant deviation should be
reported to top management.
Corrective Actions to be taken.
Organizational Structure:
A sound risk management structure is very
important to keep the bank’s overall risk
exposure within the parameters set by the
board.
Bank may choose different structures.
It should correspond with institution’s size,
complexity, and diversification of its
activities.
Components of Organizational
structure:

CRMC
Segregation of duties
CRMD
 CRMC
Stands for “Credit Risk Management
Committee.”
Comprises of;
a) Head of CRMD.
b) Credit department
c) Treasury.
Reports to bank’s risk management
committee.
Should be empowered to oversee credit
risk taking activities and overall credit risk
management functions.
 Segregation of Duties:
Loan origination function, credit policy
formulation, credit limit setting, monitoring
of credit exceptions, and documentation
functions should be separated.
 CRMD
Stands for “Credit Risk Management
Department.”
 Functions of Credit Risk
Management Deptt.

To ensure that risks remain within the

predetermined boundaries.
Establish systems and procedures relating
to risk identification, MIS, monitoring of
loans, investment portfolio quality, and
early warning.
 Systems and Procedures
Credit Origination
Limit Setting
Credit Administration
Measuring credit risk
Credit risk monitoring and control.
Risk review
Managing problem credits
 Credit Origination

a) Credit assessment of the borrower’s industry,

and macro economic factors.
b) The purpose of credit and source of repayment.
c) The track record / repayment history of
borrower.
d) Assess/evaluate the repayment capacity of the
borrower.
e) The Proposed terms and conditions and
covenants.
f) Adequacy and enforceability of collaterals.
g) Approval from appropriate authority
 Limit Setting

Limit Setting Depends on;

Credit strength of the obligor

Genuine requirement of credit
Economic conditions
Institution's risk tolerance
 Credit Administration
A credit administration unit performs
following functions:
a) Documentation
b) Credit disbursement
c) Credit monitoring
d) Loan repayments
e) Maintenance of credit files
f) Collateral and security documents.
 Measuring Credit Risk

Internal risk rating

Rating review
Assigned at the time of inception of loan
and reviewed at last annually.
Credit Risk Monitoring And Control

Checking credit quality and taking

remedial measure when deterioration
occurs.
Key indicators of Credit Quality of
Loans:

Financial Position an business position.

Conduct of accounts
Loan Covenants
Collateral valuation
 Risk Review
The purpose is to assess credit
administration process, and overall quality
of loans.
Must be performed on annual basis. More
frequent review can be conducted where
bank is not familiar with the customer.
For consumer loans it may not be needed
except for deterioration and exceptions.
 Managing Problem Credit

Problems should be identified ahead of time.

Problem Loan Management Process

Negotiations and follow up
Workout remedial strategies
Review of collateral and security document
Status report and review
Managing Market Risk
 Market Risk
It is the risk that the value of on and off – balance
sheet positions of a financial institution will be
adversely affected by movements in market rates
or prices.

Such as;
1. Interest rates
2. Foreign exchange rates
3. Equity prices
4. Credit spreads and/or commodity prices
Interest Rate Risk
Interest rate risk arises when there is a
mismatch between positions, which are
subject to interest rate adjustment.

 Assessment of Interest Rate Risk:

1. Earning perspective
2. Economic value perspective
 Foreign Exchange Risk

It is the current or prospective risk to

earnings and capital arising from adverse
movements in currency exchange rates.
Banks are exposed to risk;
Which arises from the maturity
mismatching of foreign currency positions
Default of the counter parties or settlement
risk
Time-zone risk
Equity Price Risk
It is the risk to earning or capital that
results from adverse changes in the
value of equity related portfolios of a
financial institution.

 Types of Equity Price risk:

1. Systematic Risk
2. Unsystematic Risk
Elements of Market Risk
Management
 Board and Senior Management
Oversight
Responsibilities of board of directors:
1. Overall risk tolerance
2. Consistency with existing capital
3. Sound expertise and knowledge
4. Devotion of adequate resources to risk
management function
 Elements of Risk Strategy
1. Determine the level of market risk
2. Develop a strategy for market risk-taking
3. Consider economic and market
conditions
4. Periodically review the strategy and
effectively communicate to relevant staff
 Organizational Structure

1. Risk Management Committee

2. Asset-Liability Management Committee
(ALCO)
3. The Middle Office
 Responsibilities of Risk
Management Committees
1. Devise policies for identification,
measurement, monitoring and control risk.
2. Adequate recourse allocation for risk
management.
3. Effective communication of all policies to
relevant staff.
4. Review & articulate funding policy.
5. MIS maintaining relating to risk reporting.
 Risk Measurement
The measurement system ideally should:
1. Assess all material risk factors
2. Utilize generally accepted financial
concepts and risk management
techniques
3. Have well documented assumptions and
parameters
 Value at Risk
A generally accepted tool for measuring
market risk inherent in trading portfolios.

VAR summarizes the predicted maximum

loss over a target horizon within a given
confidence level, using Variance
covariance approach or Historical
Simulation.
 Risk Control

Bank’s internal control structure ensures the

effectiveness of process relating to market risk
management.

Key elements of internal control process include:

1. Internal Audit & Review
2. Effective Risk Limits
3. Operational Limits
 Managing
Liquidity Risk
 Liquidity Risk Management
Definition:

Liquidity is the potential for loss to an

institution arising from either

Its inability to meet its obligation

To fund in assets as they fall due without
incurring unacceptable cost or loss
 Condition of funding through market
Liquidity is the major risk for banks
Banks often meet their liquidity Requirements form market

Condition of funding through market depends upon

Liquidity in the market

Borrowing institution’s liquidity

In short term institutions may bear heavy cost resulting loss of

Earning

In the long term the liquidity risk could result in bankruptcy of

the institution
 Causes of Arising Liquidity Risk
1. Banks with Large off _balance sheet
exposures Which rely heavily on large
corporate deposit have relatively high level
of liquidity risk

2. Because financial risk are not mutually

exclusive and liquidity risk often triggered
by result of these other financial risks such
as
Credit risk
Market risk etc
 Examples of Liquidity Risk
A bank increasing its credit through asset
concentration etc may be increasing its liquidity
risk as well

A large loan default or changes in the interest

rate can adversely impact on bank’s liquidity
position

Management misjudgment the impact on

liquidity of entering into a new business or
product line, the bank’s strategic risk would
increase
 Early Warning Indicators Of
Liquidity Risk
These are not always leads to liquidity problem but
these have potential to involve in such problem.

a) A negative trend or significantly increased risk in

any area or product line.
b) Concentrations in either assets or liabilities.
c) Weakening in quality of credit portfolio.
d) A decline in earnings performance or projections.
e) Rapid asset growth funded by volatile large
deposit.
f) A large size of off-balance sheet exposure.
g) Worsening third party evaluation about the bank
 Board and Senior Management
Oversight
For the effective liquidity Risk management it need staff having relevant
expertise and efficient system and procedures.

Duties of board of directors to,

Understand the liquidity risk profile of the bank

Tools used to manage liquidity risk.
To position bank’s strategic direction and tolerance level for liquidity risk.
To appoint senior managers who have ability to manage liquidity risk and
delegate them the required authority to accomplish the job.
To continuously monitors the bank's performance and overall liquidity risk
profile.
To ensure that liquidity risk is identified, measured, monitored, and
controlled.
Senior management is responsible:

Develop and implement procedures and practices

that translate the board's goals, objectives, and
risk tolerances into operating standards that are
well understood by bank personnel and consistent
with the board's intent.

Remain to the lines of authority and responsibility

that the board has established for managing
liquidity risk.
Senior management is responsible:

Oversee the implementation and

maintenance of management information
and other systems that identify, measure,
monitor, and control the bank's liquidity
risk.

Establish effective internal controls over

the liquidity risk management
process.
 Liquidity Risk Strategy
a. Composition of Assets and Liabilities:

Outline the mix of assets and liabilities to

maintain liquidity.
LRM and asset/liability management should
integrated to avoid steep costs.

b. Access to Inter-bank Market:

Important source of liquidity. strategies should

take into account the in crisis situation
 Liquidity Risk Strategy
c. Diversification& Stability of Liabilities:
The funding concentration exists when a single but significant factor has
potential to withdraw funds. So, in this withdraw funds. So in this
condition risk increase. Bank senior management make it ensure a
diversified stable source of funding.

Banks need to identify :

o Liabilities that would stay with the institution
under any circumstances;
o Liabilities that run-off gradually if problems arise;
o That run-off immediately at the first sign of
problems.
The liquidity strategy must be documented in a
liquidity policy
The institutions should formulate liquidity
policies, recommended by senior
management/ALCO and approved by the Board
of Directors
To be effective the liquidity policy must be
communicated down the line throughout in the
organization
Institutions should establish appropriate
procedures and processes to implement their
liquidity policies
The key elements of any liquidity
policy include:
General liquidity strategy (short- and long-term),
specific goals and objectives in relation to
liquidity risk management.
Roles and responsibilities of individuals
performing liquidity risk management functions.
Liquidity risk management structure.
Liquidity risk management tools.
Contingency plan for handling liquidity crises.
ALCO/Investment Committee

Asset Liability Committee (ALCO) comprised of senior management,

the treasury function or the risk management department.
Ideally, the ALCO should comprise of senior management from
each key area of the institution that manages liquidity risk.
members have clear authority over the units responsible for
executing liquidity-related transactions
The ALCO should meet monthly, if not on a more frequent basis.

Generally responsibilities of ALCO include Developing and

maintaining appropriate risk management policies and procedures,
MIS reporting, limits, and oversight programs. ALCO usually
delegates day-to-day operating responsibilities to the bank's
treasury department.
 Liquidity Risk Management
Process
An effective liquidity risk management
include systems to identify, measure,
monitor and control its liquidity exposures.
Be able to accurately identify and quantify
the primary sources of a bank's liquidity
risk in a timely manner.
Always be alert for new sources of liquidity
risk at both the transaction and portfolio
levels.
Management Information System
For effective liquidity management decisions MIS
is essential. Regular reports of the banks,
Internal Reporting, “Fund Flow Analysis Report”,
“Contingency Funding Plan Summary”, and
other bank reports are source of information for
a bank.

L.R. Measurement and Monitoring

An effective liquidity risk measurement and

monitoring system not only helps in managing
liquidity in times of crisis but also optimize return
through efficient utilization of available funds.
 Contingency Funding Plans

Is a set of policies and procedures that serves as a

basic plan for a bank to meet its funding needs
in a Managing liquidity risk

Use of CFP for Routine Liquidity Management:

A reasonable amount of liquid assets are
maintained.
Measurement and projection of funding
requirements during various scenarios.
Management of access to funding sources.
Contingency Funding Plans
Scope of CFP:

a) Analyzing and making quantitative

projections of all significant on- and off
balance-sheet funds flows and their
related effects.
b) Matching potential cash flow sources and
uses of funds.
c) Establishing indicators that alert
management to a predetermined level of
potential risks
 Liquidity Ratios and Limits
Banks may use a variety of ratios to quantify liquidity. Ratios should
always be used in combination with more qualitative information

Cash Flow Ratios and Limits

Cash flow ratios and limits attempt to measure and control the
volume of liabilities maturing during a specified period of time.

Liability Concentration Ratios and Limits

To prevent a bank from relying on too few providers or
funding sources.

Other Balance Sheet Ratios

Ratios used by financial institutions to monitor current and potential
funding levels.
Operational Risk
Management
 Operational Risk Management:
“Operational risk is the risk of loss resulting
from inadequate or failed internal
processes, people and system or from
external events.”
Reasons for operational risk
Importance of Operational risk
Examples
 Operational Risk Management
Principles of Operational Risk Management:
Ultimate accountability rests with the board ant transferred
from top to down

Ensure that there is an effective, integrated operational risk

management framework.

Board should recognize, understand and have defined all

categories of operational risk applicable to the institution

All aspects of operational risk are managed should be

documented and communicated

All business and support functions should be an integral part

of framework.

Established processes for the identification, assessment,

mitigation, monitoring and reporting of operational risk.
 Operational Risk Management:

Board and senior management’s oversight:

a)The strategy given by the board of the bank.

b) The systems and procedures to institute effective operational risk

management framework.

c) The structure of operational risk management function and the roles

and responsibilities of individuals involved.
 Operational Risk Management:
Risk Assessment and Quantification:

Operational Risk assess and identify by bank inherent

in all material products, activities, processes and
systems and vulnerability to these risks.

Risk Monitoring:
Regularly monitoring activities can offer the advantage of quality
detecting and correcting deficiencies in policies, procedures,
and processes for managing operational risk.
 Operational Risk Management:
Risk Reporting:
The reporting system should be appropriate and it provide help to
monitor and control of the business.

Establishing Control Mechanism:

The bank have formal framework that need to be reinforced through
strong culture. On the other hand the banks should have such
appropriate strategies to adjust their operational risks.

Contingency planning
 Operational Risk Management:

Contingency planning:

The bank should have contingency plan to minimize their losses and
also minimize business disruption.
Questions