RMB Introduction

Risk Management in Banks
Class 1
Presented by Jaswinder Singh
6/19/2013
What is Risk?
Risk is associated with Gods in the olden ages - Peter
Bernstein in celebrated book : Against the GodsThe Remarkable Story of Risk

Risk is inherent component of our life, be it business or personal life .
Risk may be different for different people.

Risk can be defined as any uncertainty about a future event that
threatens the organization's ability to accomplish its mission.

Presented by Jaswinder Singh 6/19/2013
Risk Explained
Risk is the probability that the realized return would be
different from investment.
the
anticipated/expected
return
on
Risk is a measure of likelihood of a bad financial outcome.

All other things being equal risk will be avoided. All other things are however not equal and that a reduction in
risk is accompanied by a reduction in expected return.
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Risk Explained Contd.

The uncertainties associated with risk elements impact the
net cash flow of any business or investment. Under the impact of uncertainties, variations in net cash flow take place. This could be favourable or un-favourable. The un-favourable impact is RISK of the business.
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What do you see?
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Sources of Risk
Prices
Technology
Sources of Risk
Market Share
Competition
Productivity
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Common Language: Profit from Risk

Do we understand risk to be: a) The probability of default and its consequences? b) Factors that influence volatility? c) What we cant define? d) An unacceptable degree of any of the above?
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About RISK in business

Risk is a cost of doing business, and an extremely
precious resource.
We need to be highly disciplined in managing risk.. When business development contemplates a deal, they should
incorporate the cost of risk into their profitability calculations.
With that as a prerequisite:

When examining deals, risk managers should maintain an integrated view, remembering that risk is but one component of profitability, and not eliminate revenue potential by mechanically insisting on eliminating all risk. By achieving that we can most effectively cooperate together to achieve our goal of profiting from risk
What do Banks do for their Customers ???

Intermediation
(Deposit & Lending function)
Payment Systems
(Retail, Corporates, Govt. business)
Other financial services

(Off-balance sheet activities, Insurance,Trust services)
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Banking Business
Business is broadly divided into on balance sheet and off balance sheet activities. On balance sheet activities are banking book (deposits & advances) and trading book(investments) Banking book has no market risk
Risks common to both books are credit, operational
Top 10 concerns of bankers*

1. Complex Financial Instruments
2. Credit risk
3. Macro economy 4. Insurance 5. Business continuation 6. International regulation 7. Equity markets 8. Corporate governance 9. Interest rates 10. Political shocks
* Banana Skins 2003 The CSFIs annual survey of the risks facing banks
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Bank Goals and Constraints

Maximise Shareholder Wealth
Amount of Cash Flow
Timing of Cash Flow Risk of Cash Flow
Credit Risk
Interest Rate Risk
Liqudity Risk
Operational
Risk
Fraud Risk
Constraints
Market Competition
Social
Legal / regulatory
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Risk Exposures Bank ABC

Liabilities Deposits from customers Deposits from Banks Total Deposits Borrowings Group balances payable Deferred Tax Liability Tax Payable Other Liabilities Subordinated Debentures Total Liabilities Shareholders Equity Share Capital Permanent Reserve Fund Reserves Total Equity Total Liabilities & Equity 31/12/2003 77312 188 77500 10923 397 0 26 4887 520 94253 1082 609 4056 5747 100000
Assets Cash & Short Term Funds Balances with Central Banks T Bills and other eligible securities Placement with and loans to other banks Bills of Exchange Loans & Advances Lease Rentals receivable within one year Lease Rentals receivable after One year Dealing Securities Equity & others Bonds Investment Securities Investment Properties Investments in Subsidiaries & Associates Accrued Intt Cheques Purchased Other Assets Other Assets Group balances receivable Property Plant & Equipment Total Assets 31/12/2003 1739 3305 5756 10987 2493 44222 96 72 587 916 17664 18580 804 1667 1073 2979 3331 7382 503 1807 100000
Credit Risk
Market Risk
Liquidity Risk
The bank runs asset liability mismatches due differing maturity profiles and lending and borrowing rates for credit, investments, deposits and subordinated debentures. Borrowing/ Lending/ Investing in Foreign Currency gives rise to foreign exchange risk Presented by Jaswinder Singh 6/19/2013
Why Manage Risks ??

Increasing competition and technical progress have fundamentally
changed the role of banks
Banks are exposed to strong competitive pressures in selling their
products and procuring capital, exposing them to risks which can significantly impact profitability. is important for its strategic positioning. It becomes a tool for offensive instead of defensive strategy. for generating profits and hence a critical determinant of banks profitability.
6/19/2013
A banks ability to measure, monitor and mitigate risks comprehensively
Risk Management is an important tool towards optimum use of capital
Process of Risk Management

Risk management is not Risk elimination, but to manage
risks at manageable levels not severely affecting the incomes.

It is about;
What can go wrong? What can be done in order to avoid or reduce such risk? How to pay for adverse happenings?
6/19/2013
Approaches to Risk Management ..

Avoidance:
Avoidance refers to not holding such as asset/liability as a means of avoiding
the risk. Exchange risk can be avoided by not holding assets/liabilities denominated in foreign currencies. Insurance for example is a loss control measure. location by distributing it to different locations
Loss Control:
The objective is either to prevent a loss or to reduce the probability of loss.
Separation:
The objective is to prevent loss due to concentration of an asset on a single
Combination:
Risk of default is less when the financial assets are distributed over a number
of issuers instead of locking them with a single issuer
Transfer:
By transferring the asset/liability or by swap or by insurance
Process of Risk Management

Risk Management
Identification of Risks Quantification of Risks Policy Formulation
Monitoring Risks
Strategy Formulation
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Identification of Risks
Risk can be anything that can hinder the bank from meeting
its targeted results

To know the hidden, economic and competitive exposures To know the nature and exposure of transactions Unbundling can help in pricing the risk
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Quantification of Risks
To quantify the decisions Depends on the availability of information Technology and Management Information System play a
crucial role
Should have an ongoing flow of information
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Policy formulation
Policy gives a long term frame work to tackle risk It depends on the objectives of the bank It depends on the tolerance levels of the bank Tolerance levels should not be too high or too low Should ensure profitability of the bank
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Strategy formulation
Strategy is tool to implement a Policy Strategy is relatively for a shorter period Strategy should focus on and meet the needs of exposures
and volatilities
Strategies differ depending upon; the nature of transaction,
nature of exposure, tenors and counterparties
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Monitoring of Risk
Risk is not static always, it is more dynamic Volatile circumstances may change the risk level of
investment, hence need to monitor

Ensure the target levels
To have a continuous vigil on risk profiles

Restore the levels into manageable levels
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RISKS in banking ..
Major risks are: CREDIT RISK MARKET RISK
INTEREST RISK LIQUIDITY RISK PRICE RISK
OPERATIONAL RISK STRATEGIC RISK REPUTATION RISK
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Anatomy of Bank Risk
Non-Financial Risk
Business Risk Strategic Risk
Financial Risk
Delivery (of Financial Services) Risk Balance Sheet Risk Balance
Operational Risk
Legal Risk
Reputational Risk
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Balance Sheet Risk
Credit Risk
Concentration Risk Intrinsic Risk
Market Risk
Interest Rate Risk
Liquidity Risk
Currency Risk
Commodity Risk
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Interest Rate Risk
Price Risk
Reinvestment Risk
Yield Curve Risk
Basis Risk
Gap Risk
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Risk in Banking Business

Banking business is broadly grouped under following major
heads from Risk Management point of view:

The Banking Book The Trading Book Off-Balance-sheet Exposures
6/19/2013
The Banking Book

All assets & liabilities in banking book have following
characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied
Since assets & liabilities are held till maturity, their mismatch
may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as Liquidity Risk.
6/19/2013
The Banking Book Contd.

Due to change in interest rates, assets and liabilities are
subjected to interest rate risk on their maturities/re-pricing.

Further, the assets side of the banking book generates credit
risk arising from defaults in payment of interest and or installments by the borrowers.
In addition to all these risk, banking book also suffers from
Operational Risk.
The Trading Book

The trading book includes all the assets that are held with
intention of trading that are marketable. They are normally held for a short duration and positions are liquidated in the market. Trading Book assets include investment held under Held for Trading category.
They are subjected to Market Risk and are marked to
market.
Off-Balance-Sheet Exposure
Off-balance
sheet exposure is contingent in nature-
Guarantees, LCs, Committed or back up credit lines etc.

A contingent exposure may become a fund-based exposure in
Banking book or Trading book. It is known as Call Risk

Therefore, Off-balance sheet exposures may have liquidity
risk, interest rate risk, market risk, credit or default risk and operational risk
Risks In Banking
Risk is inherent in Banking Banking is not avoiding risks but managing it Risks in banking can be of Broadly 3 types:
Credit Risk Market Risk Operational Risk
ALM addresses to Market Risks
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Risk Framework
Solvency Risk:
Risk of total financial failure of a bank due to its chronic inability to meet obligations Liquidity Risk: Risk arising out of a banks inability to meet the repayment requirements Credit Risk: Risk of loss to the bank as a result of default by an obligator Operating Risks: Risks arising from out of failures in operations, supporting systems, human error, omissions, design fault, business interruption, frauds, sabotage, natural disaster etc., Interest Rate Risk: Vulnerability of net interest income or the present values of a portfolio, to changes in interest rates Price Risks: Risk of loss/gain in the value of assets, liabilities or derivatives due to market price changes, notably volatility in exchange rate and share price movements
6/19/2013
Pure and Speculative Risks

Pure Risk: It is also called a Static Risk Or One-way risk
All One-Way Risks are
Speculative Risk: It is also called a Dynamic Risk Or Two-way Risk

All Two-way Risks are possible
Downside outcomes
Solvency Risk (one way and
down side) Liquidity Risk (one way and down side) Operating Risks (mainly oneway)
upside and well as downside outcomes

Credit Risk (Hybrid)
Interest Rate Risk (Two-way) Price Risk (Two-way)
6/19/2013
Credit Risk
Credit risk means default of the borrower or deterioration of
borrowers credit quality.
Credit risk is also called Counter party risk It is the risk to each party of a contract that the other will not
live up to its contractual obligation. In most financial contracts, this risk is known as default risk. It can also be an Issuer risk that could arise on default in payment of interest or in repayment of principal by the issuer. There can be Pre-Settlement Risk which is the bankruptcy of the counterparty. There can also be Settlement Risk that arises with respect to the settlement of a transaction
Credit Risk defaults take various forms

Direct Lending: Loan amount (Principal as well as interest) will
not be paid Guarantees/ Letter of Credit etc.: Funds will not be forthcoming upon crystallization of liability Treasury Products payment due from the counter parties either stops or not forthcoming
Securities Trading Settlement will not be effected
Cross border exposure: free transfer of currency is restricted
or comes to an end.
6/19/2013
Credit Risk, consists Of Three Risks

Default risk Exposure risk Recovery risk
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Exposure risk
Uncertainty associated with future amounts Credit lines- repayment schedule- exposure risk small Other lines of credit -OD, project financing , guarantees etc-
risk cannot be predicted accurately
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Recovery risk:
Recoveries in the event of default not predictable Depend upon type of default Availability of collaterals, third party guarantees Circumstances surrounding the default.
6/19/2013
Expected Losses & Unexpected Losses

EL depends upon default probability(PD), Loss given default
(LGD)& exposure at risk (EAD)

EL = PD x LGD x EAD Unexpected losses (UL) is the uncertainty around EL and it
is Standard deviation of EL.
6/19/2013
Market Risk
Arising from movement in market prices
Interest Rate Risk, Exchange Rate Risk,
Commodities Price risk

Equity Price Risk.
Market risk takes the form of interest rate risk, exchange rate risk, commodity price risk and equity price risk , major risk presently faced by banks in India are interest rate ,exchange rate and liquidity risk.
Liquidity Risk
Liquidity risk is of two types:
Funding Risk is the inability to raise funds at normal cost Asset liquidity risk is the lack of trading depth in the market
for a security or class of assets

Liquidity Risks tend to aggravate other risks It is difficult to isolate liquidity risk
6/19/2013
Interest Rate Risk

Interest rate risk is the risk (variability in value) borne by an interestbearing asset, such as a loan or a bond, due to variability of interest rates.
Banks face four types of interest rate risk: Basis risk Yield curve risk Repricing risk Option risk
6/19/2013
Interest rate risks Contd.

Basis risk :The risk presented when yields on assets and costs on liabilities are based on different bases, such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses. Yield curve risk: The risk presented by differences between short-term and long-term interest rates. Short-term rates are normally lower than long-term rates, and banks earn profits by borrowing short-term money (at lower rates) and investing in long-term assets (at higher rates). But the relationship between short-term and long-term rates can shift quickly and dramatically, which can cause erratic changes in revenues and expenses. Repricing risk :The risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate. Option risk: It is presented by optionality that is embedded in some assets and liabilities. For instance, mortgage loans present significant option risk due to prepayment speeds that change dramatically when interest rates rise and fall. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with relatively more loans based on prior, lower interest rates. Option risk is difficult to measure and control.
6/19/2013
Foreign Exchange Risk

Risk arising due to price fluctuations of currencies Demand and Supply of currencies International and domestic Political statements Expectations Speculations
Can be categorized into;

Transaction Exposure
Translation Exposure Economic Exposure
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Operational Risk
Loss resulting from inadequate or failed Internal processes People Systems or External events.
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Solvency Risk
The risk of being unable to cover the losses generated by all
types of risks, with the available capital. Solvency risk can thus be the risk of default of the bank It can be termed as the credit risk incurred by the counterparties of the bank
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Country Risk
Country risk arises due to cross border transactions They include; Transfer risk Sovereign risk Political risk Cross border risk Currency risk
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Technical Risks
Technical are specific risks that include; the errors in the recording
process of transaction, deficiencies of information system and absence of adequate tools for measuring risks
Environmental Risks
Related to delivery channels, customer service, innovation of new
products etc.,
Contingency Risk
Contingency risks are the off-shoots of off-balance sheet items
such as guarantees, letters of credit, underwriting commitments etc.,

What can happen when a bank strengthens control to reduce risk but separately insists on growing assets and Profit ?
Slow decisions Less business Still have losses

Bank Failures
6/19/2013
Emergence of Risk Management function

Aligned to business drivers
1980s 1990s
Focus on link to performance & capital efficiency E.g.. RAROC
Focus on stakeholder profitability
Focus on alignment to objectives
Integrated Performance Management
Integrated Risk & Value Management
Objectivesoriented Risk Management Focus on governance & reporting

Focus on risk quantification
Institution-Wide Risk Management
Focus on loss prevention Risk Control Frameworks
Value-at-Risk
Risk Monitoring & Reporting
Integrated across risks / businesses
6/19/2013

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RMB Introduction

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Risk Management in Banks

Presented by Jaswinder Singh

Bernstein in celebrated book : Against the GodsThe Remarkable Story of Risk

Risk may be different for different people.

threatens the organization's ability to accomplish its mission.

different from investment.

Risk is a measure of likelihood of a bad financial outcome.

risk is accompanied by a reduction in expected return.

Presented by Jaswinder Singh

Risk Explained Contd.

Presented by Jaswinder Singh

What do you see?

Presented by Jaswinder Singh

Presented by Jaswinder Singh

Common Language: Profit from Risk

Presented by Jaswinder Singh

About RISK in business

incorporate the cost of risk into their profitability calculations.

With that as a prerequisite:

What do Banks do for their Customers ???

Other financial services

Presented by Jaswinder Singh

Top 10 concerns of bankers*

Presented by Jaswinder Singh

Bank Goals and Constraints

Timing of Cash Flow Risk of Cash Flow

Interest Rate Risk

Risk Exposures Bank ABC

Why Manage Risks ??

changed the role of banks

Banks are exposed to strong competitive pressures in selling their

A banks ability to measure, monitor and mitigate risks comprehensively

Risk Management is an important tool towards optimum use of capital

Presented by Jaswinder Singh

Process of Risk Management

risks at manageable levels not severely affecting the incomes.

Presented by Jaswinder Singh

Approaches to Risk Management ..

of issuers instead of locking them with a single issuer

Process of Risk Management

Identification of Risks Quantification of Risks Policy Formulation

Presented by Jaswinder Singh

its targeted results

Presented by Jaswinder Singh

Presented by Jaswinder Singh

Presented by Jaswinder Singh

nature of exposure, tenors and counterparties

Presented by Jaswinder Singh

investment, hence need to monitor

To have a continuous vigil on risk profiles

OPERATIONAL RISK STRATEGIC RISK REPUTATION RISK

Presented by Jaswinder Singh

Anatomy of Bank Risk

Balance Sheet Risk

Interest Rate Risk

Presented by Jaswinder Singh

Interest Rate Risk

Yield Curve Risk

Presented by Jaswinder Singh

Risk in Banking Business

heads from Risk Management point of view:

Presented by Jaswinder Singh

The Banking Book

Presented by Jaswinder Singh