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Topics
y Risk Management Philosophy
y Types of Risks
y Identification of Risk
y Tools for Risk Management
y Basel
 6isk Management Philosophy
× It is more than Compliance- It is about building value by optimizing
rather than avoiding Risk.



 
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× Risk Management is not Avoiding Risk. It helps you to be aware of the

Risks Inherent in your business and take advantage of this knowledge to
gain competitive advantage and enhance shareholder value.
 Types of 6isk
y Interest Rate Risk

y Credit Risk/Default Risk

y Liquidity Risk

y Foreign Exchange Risk

y Market Risk

y Sovereign (Country) Risk

y Insolvency Risk

y Technology Risk

y Off Balance Sheet Risk

 {nterest 6ate 6isk
y Banks and FIǯs create loan assets and investments and at the same time
create deposit or other borrowing liabilities.

y Earn interest on assets and pay interest on liabilities.

y The mismatches of the maturities of assets and liabilities expose the

FIǯs to interest rate risk.

y The interest rate is higher on the assets than liabilities and the net
difference is margin which changes several times a year.
 {mpact of {nterest 6ate {ncrease and Decrease
on F{ s Profitability
y Suppose a bank borrows Rs. 100 from the market for 2 years @ 10% p.a.
and creates an asset of the same amount for 5 years period @ 12% p.a.
The mismatch between the two is quite visible. In such a case, the
profitability of bank for the year would be Rs. 2 (.02*100).

y In case, there is an upward trend of interest rate after 2 years and the
cost of liability goes up to 13% p.a., the bank will post a loss of Rs. 1 (-
.01*100).

y If the movement in interest rate is downward and comes down to 8%

p.a. for liability, bankǯs profit will increase from Rs. 2 to Rs. 4 (.04*100)
in a year.
 redit 6isk
y Credit risk is the risk due to uncertainty in a counterpartyǯs ability to
meet its obligations.

y In most financial contracts, this risk is known as default risk.

y The credit risk is linked to the various factors such as performance of the
borrowerǯs business, performance of the economy, industry, and
management of the specific business.

y Sometimes credit risk follows chain reaction and this situation may pose
settlement problem in the whole financial system.

y To minimize the chances of default, FIǯs need to monitor and collect

information about borrowers on a continued basis. The managerial
monitoring efficiency and credit risk management strategies affect risk
and return of loan portfolio.
Failure of obligation by counterparty leads to redit 6isk
y A famous German Herstatt Bank failed to honor its obligation to
counterparty. The bank had received all its foreign currency receipts
in Europe in the same business day, but did not honor any of its US
Dollar obligation/payments and the situation continued till the end
of the business day. Due to this, German banking regulators closed
the bank due to insolvency. As a result the counterparties were left
holding unsecured claims against the bankrupt bankǯs assets.
 îiquidity 6isk
y Liquidity risk is the potential inability to meet the bankǯs liabilities as
they become due.

y It originated from the mismatches in the maturity pattern of assets

and liabilities.

y An FI may face liquidity crises if its credit rating is downgraded and

experiences sudden, unexpected cash outflows.

y Liquidity risk may lead to other risks like market risk or credit risk.

y A simple way to manage liquidity risk is to look at future net cash

flows on a daily basis. If in a day there is a sizeable negative net cash
flow, it deserves attention.
 ow liquidity 6isk arises?
y ©hen liability holders of any FI immediately demands money, FI has
to meet its obligation either by selling of assets or additional
borrowing from the market.

y Maintaining a high cash balance is not a profitable option to meet

sudden demand of cash as cash does not earn any interest on it.

y FI either sell its assets at a discounted price or raise money from

market at higher rates to meet its sudden obligation.

y This in turn reduces FIǯs profitability and if the situation persists for a
longer duration, FIǯs may be exposed to solvency risk.
 Forwards
y Forward contract is an agreement between two parties in which one party, the
buyer, agrees to buy from the other party, the seller, an Underlying asset at a
future date at a price established at the start.

y 

‰ muppose say the spot rate for a commodity is 1100 6s and Mr. X wants to buy it
in 3 months time. At the same time suppose Mr. Y currently owns that
commodity worth 1100 rs at present that he wishes to sell in 3 months time.
muppose that they both agree on the sale price in 3 months time of $1500.

‰ Then Mr. X and Mr. Y have entered into a forward contract. muppose that they
both agree on the sale price in 3 months time of $1500 .

‰ At the end of 3 months, suppose that the current market valuation of Mr. Y s
commodity is $1800. Then, because Mr. Y is obliged to sell to Mr.X for only
$1500, Mr. X will make a profit of $300. {n contrast, Mr. Y has made a potential
loss of $300.
 ’ptions
y 

‰ muppose an investor buys 3-month 100 call option contracts (one call contract
consists of 100 equity shares) of Tm with strike price of 6s 125 and call option
premium 6s 5 per share. Therefore the total sum invested is 6s 50000.
‰ After 3 months, if the market price of Tm turns out to be 6s 150 the investor
gains 6s 25 per share. is gross profit would be 250000 and his net profit
would be 200000 (250000 - option premium). An investment of 6s 50000
would yield him a profit of 6s 200000.
‰ {n case Tm price turns out to be 100 the seller would not exercise the contract
restricting his loss to option premium (i.e. 6s 50000)
y 


‰ {n the above example investor protects himself against adverse price
movements in the future while still allowing him to benefit from favorable
price movements.
 Futures
îet's say an American car exporter is due to export Um$1,000,000 worth of
cars to {ndian customer in 6 months time. As the {ndian customer is going to
pay for the goods in Um Dollars, it would hurt the exporter if the Um dollar
appreciated against the {ndian 6upee. mo a currency future could be used to
offset this risk.
 Swaps

y Swaps are private agreements between two parties to exchange cash

flows in the future according to a prearranged formula. They can be
regarded as portfolios of forward contracts.

y The two commonly used swaps are :

‰ {   These entail swapping only the interest
related cash flows between the parties in the same currency.
‰    These entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a
different currency than those in the opposite direction.
 {nsurance
y {nsurance is defined as the equitable transfer of the risk of a loss, from one
entity to another, in exchange for payment.

y {nsurance is a form of risk management used for hedging any uncertainty.

 xample
y WAMU has given housing loan of $4 billion. After their certain calculation
based on past experience and loan default ratios, they found that there is a
probability of 2% default by loan holder.

y To mitigate this risk WAMU is approaching to Allstate insurance company.

y Now Allstate is considering this offer and has calculated certain premium
on the basis WAMU s loan holder s portfolio.

y The premium charged by Allstate to WAMU is $160 million.

y Now if in case there is any default by the loan holders Allstate will repay
the default amount to WAMU.

y mo this is how WAMU has taken care of their risk through ͚{nsurance .
 „Amî Accord
Managing risk is increasingly becoming the single most important issue for the
regulators and financial institutions. These institutions have over the years
recognized the cost of ignoring risk.

Basel II is an international business standard that requires financial institutions

to maintain enough cash reserves to cover risks incurred by operations.

The Basel accords are a series of recommendations on banking laws and

regulations issued by the Basel Committee on Banking Supervision (BCBS).The
name for the accords is derived from Basel, Switzerland, where the committee
that maintains the accords meets.

The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the
capital adequacy of financial institutions. The capital adequacy risk, (the risk that
a financial institution will be hurt by an unexpected loss)

The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It
focuses on three main areas, including minimum capital requirements,
supervisory review and market discipline, which are known as the three pillars.
 The „asel { Accord

y Focused on credit risk but formula based

y Partially amended in 1996 to include market risk

y Operational risk not addressed

y Simple in its application

y Produced an easily comparable and verifiable measure of bankǯs

soundness
 „Amî {{ Accord
y Broadly speaking, the objectives of Basel II are to encourage better and
more systematic risk management practices, especially in the area of
credit risk, and to provide improved measures of capital adequacy for
the benefit of supervisors and the marketplace more generally.

y The introduction of Basel II has incentivized many of the best

practices banks, both internationally and in the Indian economy to
adopt better risk management techniques and to reconsider the
analyses that must be carried out to evaluate their performance relative
to market expectations and relative to competitors.

y Ensure that Regulatory Capital requirements are more in line with

Economic Capital requirements of banks and by this, make capital
allocation of banks more risk sensitive
 „asel {{ ʹ The 3 pillars


 


      


 

 

   


 

   
 
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