Risk management in banking

1. MARKET RISK Market risk is that risk that changes in financial market prices and rates will reduce the value of the banks positions. Market risk for a fund is often measured relative to a benchmark index or portfolio, is referred to as a risk of tracking error market risk also includes basis risk, a term used in risk management industry to describe the chance of a breakdown in the relationship between price of a product, on the one hand, and the price of the instrument used to hedge that price exposure on the other. The market-Var methodology attempts to capture multiple component of market such as directional risk, convexity risk, volatility risk, basis risk, etc.

MARKET RISK What is Market Risk? Market Risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices". Thus, Market Risk is the risk to the bank's earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due. In other words, it should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on the management of Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. An effective market risk management framework in a bank comprises risk identification, setting up of limits and triggers, risk monitoring, models of analysis that value positions or measure market risk, risk reporting, etc.

Types of market risk

Interest rate risk:

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank's networth since the economic value of a bank's assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as 'earnings perspective' and 'economic value' perspective, respectively. Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective. Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the total interest income and the total interest expense. Economic Value perspective involves analyzing the changes of impact on interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long-term interest rate gaps. The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating assets or liabilities), expose bank's NII or NIM to variations. The earning of assets and the cost of liabilities are now closely related to market interest rate volatility Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly

position their balance sheet into Trading and Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

Equity price risk: The price risk associated with equities also has two components General market risk

refers to the sensitivity of an instrument / portfolio value to the change in the level of broad stock market indices. Specific / Idiosyncratic risk refers to that portion of the stocks price volatility that is determined by characteristics specific to the firm, such as its line of business, the quality of its management, or a breakdown in its production process. The general market risk cannot be eliminated through portfolio diversification while specific risk can be diversified away.

Foreign exchange risk: Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a result

of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned. In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallization does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one center and the settlement of another currency in another timezone. The forex transactions with counterparties from another country also trigger sovereign or country risk (dealt with in details in the guidance note on credit risk).

The three important issues that need to be addressed in this regard are: 1. Nature and magnitude of exchange risk 2. Exchange managing or hedging for adopted be to strategy> 3. The tools of managing exchange risk

Commodity price risk: The price of the commodities differs considerably from its interest rate risk and foreign

exchange risk, since most commodities are traded in the market in which the concentration of supply can magnify price volatility. Moreover, fluctuations in the depth of trading in the market (i.e., market liquidity) often accompany and exacerbate high levels of price volatility. Therefore, commodity prices generally have higher volatilities and larger price discontinuities.

Treatment of Market Risk in the Proposed Basel Capital Accord The Basle Committee on Banking Supervision (BCBS) had issued comprehensive guidelines to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The banks have been given flexibility to use in-house models based on VaR for measuring market risk as an alternative to a standardized measurement framework suggested by Basle Committee. The internal models should, however, comply with quantitative and qualitative criteria prescribed by Basle Committee. Reserve Bank of India has accepted the general framework suggested by the Basle Committee. RBI has also initiated various steps in moving towards prescribing capital for market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in Government and other approved securities, besides a risk weight each of 100% on the open position limits in forex and gold. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. As the ability of banks to identify and measure market risk improves, it would be necessary to assign explicit capital charge for market risk. While the small banks operating predominantly in India could adopt the standardized methodology, large banks

and those banks operating in international markets should develop expertise in evolving internal models for measurement of market risk. The Basle Committee on Banking Supervision proposes to develop capital charge for interest rate risk in the banking book as well for banks where the interest rate risks are significantly above average ('outliers'). The Committee is now exploring various methodologies for identifying 'outliers' and how best to apply and calibrate a capital charge for interest rate risk for banks. Once the Committee finalizes the modalities, it may be necessary, at least for banks operating in the international markets to comply with the explicit capital charge requirements for interest rate risk in the banking book. As the valuation norms on banks' investment portfolio have already been put in place and aligned with the international best practices, it is appropriate to adopt the Basel norms on capital for market risk. In view of this, banks should study the Basel framework on capital for market risk as envisaged in Amendment to the Capital Accord to incorporate market risks published in January 1996 by BCBS and prepare themselves to follow the international practices in this regard at a suitable date to be announced by RBI.

The Proposed New Capital Adequacy Framework The Basel Committee on Banking Supervision has released a Second Consultative Document, which contains refined proposals for the three pillars of the New Accord - Minimum Capital Requirements, Supervisory Review and Market Discipline. It may be recalled that the Basel Committee had released in June 1999 the first Consultative Paper on a New Capital Adequacy Framework for comments. However, the proposal to provide explicit capital charge for market risk in the banking book which was included in the Pillar I of the June 1999 Document has been shifted to Pillar II in the second Consultative Paper issued in January 2001. The Committee has also provided a technical paper on evaluation of interest rate risk management techniques. The Document has defined the criteria for identifying outlier banks. According to the proposal, a bank may be defined as an outlier whose economic value declined

by more than 20% of the sum of Tier 1 and Tier 2 capital as a result of a standardized interest rate shock (200 bps.) The second Consultative Paper on the New Capital Adequacy framework issued in January, 2001 has laid down 13 principles intended to be of general application for the management of interest rate risk, independent of whether the positions are part of the trading book or reflect banks' non-trading activities. They refer to an interest rate risk management process, which includes the development of a business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. In particular, they address the need for effective interest rate risk measurement, monitoring and control functions within the interest rate risk management process. The principles are intended to be of general application, based as they are on practices currently used by many international banks, even though their specific application will depend to some extent on the complexity and range of activities undertaken by individual banks. Under the New Basel Capital Accord, they form minimum standards expected of internationally active banks. The principles are given in Annexure II.

Riskmanagementin bankingsector 2.3.2 MARKET RISK

It is defined as the possibility of loss caused by changes in the market variables such as interest rate, foreign exchange rate, equity price and commodity price. It is the risk of losses in, various balance sheet positions arising from movements in market prices. RBI has defined market risk as the possibility of loss to a bank caused by changes in the market rates/ prices. RBI Guidance Note focus on the management of liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity price risk and equity price risk. Market risk includes the risk of the degree of volatility of market prices of bonds, securities, equities, commodities, foreign exchange rate etc., which will change daily profit and loss over time; its the risk of unexpected changes in prices or rates. It also addresses the issues of Banks ability to meets its obligation as and when due, in other words, liquidity risk.

2.9.2 MARKET RISK APPROACHES

Market Risk

Standardized Approach

Internal Model Based approach

Maturity Based

Duration Based

RBI has issued detailed guidelines for computation of capital charge on Market Risk in June 2004. The guidelines seek to address the issues involved in computing capital charge for interest

rate related instruments in the trading book, equities in the trading book and foreign exchange risk (including gold and precious metals) in both trading and banking book. Trading book will include: Securities included under the Held for trading category Securities included under the Available for Sale category Open gold position limits Open foreign exchange position limits

Trading position in derivatives and derivatives entered into for hedging trading book exposures.

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ii) Market Risk Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the banks earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. The following are types of market risks; a) Liquidity Risk: Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk. b) Interest Rate Risk Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institutions financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and cash flow. Earnings perspective involves analyzing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense. c) Forex Risk Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies

are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one center and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the maturity mismatch of foreign currency position. d) Country Risk This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time. It comprises of Transfer Risk arising on account of possibility of losses due to restrictions on external remittances; Sovereign Risk associated with lending to government of a sovereign nation or taking government guarantees; Political Risk when political environment or legislative process of country leads to government taking over the assets of the financial entity (like nationalization, etc) and preventing discharge of liabilities in a manner that had been agreed to earlier; Cross border risk arising on account of the borrower being a resident of a country other than the country where the cross border asset is booked; Currency Risk, a possibility that exchange rate change, will alter the expected amount of principal and return on the lending or investment.

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B. Interest Rate Management Procedures The area of interest rate risk is the second area of major concern and on-going risk monitoring and management. Here, however, the tradition has been for the banking industry to diverge somewhat from other parts of the financial sector in their treatment of interest rate risk. Most commercial banks make a clear distinction between their trading activity and their balance sheet interest rate exposure. Investment banks generally have viewed interest rate risk as a classic part of market risk, and have developed elaborate trading risk management systems to measure and monitor exposure. For large commercial banks and European-type universal banks that have an active trading business, such systems have become a required part of the infrastructure. But, in fact, these trading risk management systems vary substantially from bank to bank and generally are less real than imagined. In many firms, fancy value-at-risk models, now known by the acronym VaR, are up and running. But, in many more cases, they are still in the implementation phase. In the interim, simple ad hoc limits and close monitoring substitute for elaborate realtime systems. While this may be completely satisfactory for institutions that have little trading activity and work primarily on behalf of clients, the absence of adequate trading systems elsewhere in the industry is a bit distressing. For institutions that do have active trading businesses, value-at-risk has become the standard approach. This procedure has recently been publicly displayed with the release of Riskmetrics by J. P. Morgan, but

similar systems are in place at other firms. In that much exists in the public record about these systems12, there is little value to reviewing this technique here. Suffice it to say that the daily, weekly, or monthly volatility of the market value of fixed-rate assets are incorporated into a measure of total portfolio risk analysis along with equity's market risk, and that of foreign-denominated assets. For balance sheet exposure to interest rate risk, commercial banking firms follow a different drummer -- or is it accountant? Given the generally accepted accounting procedures (GAAP) established for bank assets, as well as the close correspondence of asset and liability structures, commercial banks tend not to use market value reports, guidelines or limits. Rather, their approach relies on cash flow and book values, at the expense of market values. Asset cash flows are reported in various repricing schedules along the line of Table 6. This system has been labelled traditionally a "gap reporting system", as the asymmetry of the repricing of assets and liabilities results in a gap. This has classically been measured in ratio or percentage mismatch terms over a standardized interval such as a 30-day or one-year period. This is sometimes supplemented with a duration analysis of the portfolio, as seen in Table 7. However, many assumptions are necessary to move from cash flows to duration. Asset categories that do not have fixed maturities, such as prime rate loans, must be assigned a duration measure based upon actual repricing flexibility. A similar problem exists for core liabilities, such as retail demand and savings balances. Nonetheless, the industry attempts to measure these estimates accurately, and include both on- and offbalance sheet exposures in this type of reporting procedure. The result of this exercise is a rather crude approximation of the duration gap.13 Most banks, however, have attempted to move beyond this gap methodology. They recognize that the gap and duration reports are static, and do not fit well with the dynamic nature of the banking market, where assets and liabilities change over time and spreads fluctuate. In fact, the variability of spreads is largely responsible for the highly profitable performance of the industry over the last two years. Accordingly, the industry has added the next level of analysis to their balance sheet interest rate risk management procedures.

Currently, many banks are using balance sheet simulation models to investigate the effect of interest rate variation on reported earnings over one-, three- and five-year horizons. These simulations, of course, are a bit of science and a bit of art. They require relatively informed repricing schedules, as well as estimates of prepayments and cash flows. In terms of the first issue, such an analysis requires an assumed response function on the part of the bank to rate movement, in which bank pricing decisions in both their local and national franchises are simulated for each rate environment. In terms of the second area, the simulations require precise prepayment models for proprietary products, such as middle market loans, as well as standard products such as residential mortgages or traditional consumer debt. In addition, these simulations require yield

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curve simulation over a presumed relevant range of rate movements and yield curve shifts. Once completed, the simulation reports the resultant deviations in earnings associated with the rate scenarios considered. Whether or not this is acceptable depends upon the limits imposed by management, which are usually couched in terms of deviations of earnings from the expected or most likely outcome. This notion of Earnings At Risk, EaR, is emerging as a common benchmark for interest rate risk. However, it is of limited value as it presumes that the range of rates considered is correct, and/or the bank's response mechanism contained in the simulation is accurate and feasible. Nonetheless, the results are viewed as indicative of the effect of underlying interest rate mismatch contained in the balance sheet. Reports of these simulations, such as contained in Table 8, are now commonplace in the industry. Because of concerns over the potential earnings outcomes of the simulations, treasury officials often make use of the cash, futures and swap markets to reduce the implied earnings risk contained in the bank's embedded rate exposure. However, as has become increasingly evident, such markets contain their own set of risks. Accordingly, every institution has an investment policy in place which defines the set of allowable assets and limits to the bank's participation in any one area; see, for example, Table 9. All institutions restrict the activity of the treasury to some extent by defining the set of activities it can employ to change the bank's interest rate position in both the cash and forward markets. Some are willing to accept derivative activity, but all restrict their positions in the swap caps and floors market to some degree to prevent unfortunate surprises. As reported losses by some institutions mount in this area, however, investment guidelines are becoming increasingly circumspect concerning allowable investment and hedging alternatives.

C. Foreign Exchange Risk Mananagement Procedures In this area there is considerable difference in current practice. This can be explained by the different franchises that coexist in the banking industry. Most banking institutions view activity in the foreign exchange market beyond their franchise, while others are active participants. The former will take virtually no principal risk, no forward open positions, and have no expectations of trading volume. Within the latter group, there is a clear distinction between those that restrict themselves to acting as agents for corporate and/or retail clients and those that have active trading positions. The most active banks in this area have large trading accounts and multiple trading locations. And, for these, reporting is rather straightforward. Currencies are kept in real time, with spot and forward positions marked-to-market. As is well known, however, reporting positions is easier than measuring and limiting risk. Here, the latter is more common than the former. Limits are set by desk and by individual trader, with monitoring occurring in real time by some banks, and daily closing at other institutions. As a general

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characterization, those banks with more active trading positions tend to have invested in the real-time VaR systems discussed above, but there are exceptions.

Limits are the key elements of the risk management systems in foreign exchange trading as they are for all trading businesses. As Table 10 illustrates by example, it is fairly standard for limits to be set by currency for both the spot and forward positions in the set of trading currencies. At many institutions, the derivation of exposure limits has tended to be an imprecise and inexact science. For these institutions, risk limits are set currency-by-currency by subjective variance tolerance. Others, however, do attempt to derive the limits using a method that is analytically similar to the approach used in the area of interest rate risk. Even for banks without a VaR system in place, stress tests are done to evaluate the potential loss associated with changes in the exchange rate. This is done for small deviations in exchange rates as shown in Table 10, but it also may be investigated for historical maximum movements. The latter is investigated in two ways. Either historical events are captured, and worse-case scenario simulated, or the historical events are used to estimate a distribution from which the disturbances are drawn. In the latter case, a one or two standard deviation change in the exchange rate is considered. While some use these methods to estimate volatility, until recently most did not use covariability in setting individual currency limits, or in the aggregating exposure across multiple correlated currencies.

Incentive systems for foreign exchange traders are another area of significant differences between the average commercial bank and its investment banking counterpart. While, in the investment banking community trader performance is directly linked to compensation, this is less true in the banking industry. While some admit to significant correlation between trader income and trading profits, many argue that there is absolutely none. This latter group tends to see such linkages leading to excess risk taking by traders who gain from successes but do not suffer from losses. Accordingly, to their way of thinking, risk is reduced by separating foreign exchange profitability and trader compensation. D. Liquidity Risk Management Procedures Two different notions of liquidity risk have evolved in the banking sector. Each has some validity. The first, and the easiest in most regards, is a notion of liquidity risk as a need for continued funding. The counterpart of standard cash management, this liquidity need is forecastable and easily analyzed. Yet, the result is not worth much. In today's capital market banks of the sort considered here have ample resources for growth and recourse to additional liabilities for unexpectedly high asset growth. Accordingly, attempts to analyze liquidity risk as a need for resources to facilitate growth, or honor outstanding credit lines are of little relevance to the risk management agenda pursued here. The liquidity risk that does present a real challenge is the need for funding when and if a sudden crisis arises. In this case, the issues are very different from those addressed above. Standard reports on liquid assets

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and open lines of credit, which are germane to the first type of liquidity need, are substantially less relevant to the second. Rather, what is required is an analysis of funding demands under a series of "worst case" scenarios. These include the liquidity needs associated with a bank-specific shock, such as a severe loss, and a crisis that is system-wide. In each case, the bank examines the extent to which it can be selfsupporting in the event of a crisis, and tries to estimate the speed with which the shock will result in a funding crisis. Reports center on both features of the crisis with Table 11 illustrating one bank's attempt to estimate the immediate funding shortfall associated with a downgrade. Other institutions attempt to measure the speed with which assets can be liquidated to respond to the situation using a report that indicates the speed with which the bank can acquire needed liquidity in a crisis. Response strategies considered include the extent to which the bank can accomplish substantial balance sheet shrinkage and estimates are made of the sources of funds that will remain available to the institution in a time of crisis. Results of such simulated crises are usually expressed in days of exposure, or days to funding crisis. Such studies are, by their nature, imprecise but essential to efficient operation in the event of a substantial change in the financial conditions of the firm. As a result, regulatory authorities have increasingly mandated that a liquidity risk plan be developed by members of the industry. Yet, there is a clear distinction among institutions, as to the value of this type of exercise. Some attempt to develop careful funding plans and estimate their vulnerability to the crisis with considerable precision. They contend that, either from prior experience or attempts at verification, they could and would use the proposed plan in a time of crisis. Others view this planning document as little more than a regulatory hurdle. While some actually invest in backup lines without "material adverse conditions" clauses, others have little faith in their ability to access them in a time of need.

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