rmb introduction
TRANSCRIPT
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Risk Management in Banks
6/19/2013Presented by Jaswinder Singh
Class 1
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What is Risk?
“Risk is associated with Gods in the olden ages” - Peter
Bernstein in celebrated book : ‘ Against the Gods – The 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.
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Risk Explained
Risk is the probability that the realized return would bedifferent from the anticipated/expected return oninvestment.
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 inrisk is accompanied by a reduction in expected return.
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Risk Explained Contd.
The uncertainties associated with risk elements impact thenet 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
Sourcesof Risk
Prices
MarketShare
ProductivityCompetition
Technology
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Do we understand risk to be:
a) The probability of default and its consequences?
b) Factors that influence volatility?
c) What we can’t define?d) An unacceptable degree of any of the above?
Common Language:
Profit from “Risk”
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Risk is a cost of doing business, and an extremelyprecious 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 anintegrated view, remembering that risk is but one component
of profitability, and not eliminate revenue potential bymechanically insisting on eliminating all risk.
By achieving that we can most effectively cooperate together toachieve our goal of “profiting from risk”
About ‘RISK’ in business
6/19/2013Presented by Jaswinder Singh
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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
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Top 10 concerns of bankers*
1. Complex Financial Instruments2. Credit risk
3. Macro economy
4. Insurance
5. Business continuation
6. International regulation
7. Equity markets
8. Corporate governance9. Interest rates
10. Political shocks
6/19/2013Presented by Jaswinder Singh
* Banana Skins 2003 – The CSFI’s 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
Market Competition Social Legal / regulatory
Credit
Risk
Interest Rate
Risk
Liqudity
Risk
Operational
Risk
Fraud
Risk
Constraints
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Assets
31/12/2003
Cash & Short Term Funds 1739
Balances with Central Banks 3305
T Bills and other eligible securities 5756
Placement with and loans to other banks 10987
Bills of Exchange 2493
Loans & Advances 44222
Lease Rentals receivable within one year 96
Lease Rentals receivable after One year 72
Dealing Securities 587
Equity & others 916
Bonds 17664
Investment Securities 18580
Investment Properties 804
Investments in Subsidiaries & Associates 1667
Accrued Intt 1073
Cheques Purchased 2979
Other Assets 3331
Other Assets 7382
Group balances receivable 503
Property Plant & Equipment 1807Total Assets 100000
Liabilities31/12/2003
Deposits from customers 77312
Deposits from Banks 188
Total Deposits 77500
Borrowings 10923
Group balances payable 397
Deferred Tax Liability 0
Tax Payable 26
Other Liabilities 4887
Subordinated Debentures 520
Total Liabilities 94253
Shareholders Equity
Share Capital 1082
Permanent Reserve Fund 609
Reserves 4056
Total Equity 5747
Total Liabilities & Equity 100000
Market Risk Credit 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
Risk Exposures – Bank ABC
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Why Manage Risks ??
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Increasing competition and technical progress have fundamentallychanged the role of banks
Banks are exposed to strong competitive pressures in selling theirproducts and procuring capital, exposing them to risks which can
significantly impact profitability.
A bank’s ability to measure, monitor and mitigate risks comprehensivelyis important for its strategic positioning. It becomes a tool for offensiveinstead of defensive strategy.
Risk Management is an important tool towards optimum use of capitalfor generating profits and hence a critical determinant of bank’s profitability.
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Process of Risk Management
6/19/2013Presented by Jaswinder Singh
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?
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Approaches to Risk Management ..
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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/liabilitiesdenominated in foreign currencies.
Loss Control: The objective is either to prevent a loss or to reduce the probability of loss.
Insurance for example is a loss control measure. Separation:
The objective is to prevent loss due to concentration of an asset on a singlelocation by distributing it to different locations
Combination:
Risk of default is less when the financial assets are distributed over a numberof issuers instead of locking them with a single issuer
Transfer: By transferring the asset/liability or by swap or by insurance
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Ident i f icat ion
of Risks
Quant i f icat ion
of Risks
Pol icy
Formulat ion
Moni tor ing
Risks
Risk Management
Strategy Formulat ion
Process of Risk Management
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Identification of Risks
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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
6/19/2013Presented by Jaswinder Singh
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
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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
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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
6/19/2013Presented by Jaswinder Singh
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 ..
6/19/2013Presented by Jaswinder Singh
Major risks are:
CREDIT RISK
MARKET RISK
INTEREST RISK
LIQUIDITY RISK
PRICE RISK
OPERATIONAL RISK
STRATEGIC RISK REPUTATION RISK
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Operational Risk
Presented by Jaswinder Singh
Anatomy of Bank Risk
Financial Risk
Strategic
Risk
Delivery (of Financial
Services) Risk Balance
Legal Risk Reputational
Risk
Non-Financial Risk
Business
Risk
Balance
Sheet Risk
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6/19/2013Presented by Jaswinder Singh
Balance Sheet Risk
Credit Risk
Concentration
Risk
Intrinsic Risk
Interest Rate
Risk
Liquidity Risk Currency Risk Commodity
Risk
Market Risk
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Interest Rate Risk
Reinvestment
Risk
Yield Curve
Risk
Basis Risk
Gap Risk
Price Risk
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Risk in Banking Business
6/19/2013Presented by Jaswinder Singh
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
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The Banking Book
6/19/2013Presented by Jaswinder Singh
All assets & liabilities in ‘banking book’ have followingcharacteristics:
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 ‘LiquidityRisk’.
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The Banking Book Contd.
6/19/2013Presented by Jaswinder Singh
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 creditrisk 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’.
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The Trading Book
6/19/2013Presented by Jaswinder Singh
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 forTrading’ category.
They are subjected to Market Risk and are marked to
market.
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Off-Balance-Sheet Exposure
6/19/2013Presented by Jaswinder Singh
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 inBanking 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
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Risks In Banking
6/19/2013Presented by Jaswinder Singh
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
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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 bank’s 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 ininterest rates
Price Risks:
Risk of loss/gain in the value of assets, liabilities or derivatives due to market pricechanges, notably volatility in exchange rate and share price movements
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‘Pure’ and ‘Speculative’ Risks
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Pure Risk: It is also called a ‘Static Risk’
Or ‘One-way risk’
All One-Way Risks areDownside outcomes
Solvency Risk (one way anddown side)
Liquidity Risk (one way and
down side) Operating Risks (mainly one-
way)
Speculative Risk:It is also called a ‘Dynamic
Risk’ Or ‘Two-way Risk’
All Two-way Risks are possibleupside and well as downside
outcomes
Credit Risk (Hybrid)
Interest Rate Risk (Two-way)
Price Risk (Two-way)
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Credit Risk
6/19/2013Presented by Jaswinder Singh
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 inpayment 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
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Credit Risk defaults take various forms
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Direct Lending: Loan amount (Principal as well as interest) willnot be paid
Guarantees/ Letter of Credit etc.: Funds will not be
forthcoming upon crystallization of liability
Treasury Products payment due from the counter parties eitherstops or not forthcoming
Securities Trading Settlement will not be effected
Cross border exposure: free transfer of currency is restricted
or comes to an end.
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Credit Risk, consists Of Three Risks
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Default risk
Exposure risk
Recovery risk
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Exposure risk
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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:
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Recoveries in the event of default not predictable
Depend upon type of default
Availability of collaterals, third party guarantees
Circumstances surrounding the default.
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Expected Losses & Unexpected Losses
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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.
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Market Risk
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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 riskpresently faced by banks in India are interest rate ,exchangerate and liquidity risk.
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Liquidity Risk
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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 marketfor a security or class of assets
Liquidity Risks tend to aggravate other risks
It is difficult to isolate liquidity risk
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Interest Rate Risk
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Interest rate risk is the risk (variability in value) borne by an interest- bearing 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
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Interest rate risks Contd.
6/19/2013Presented by Jaswinder Singh
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 somecircumstances different bases will move at different rates or in different directions, which can causeerratic changes in revenues and expenses.
Yield curve risk: The risk presented by differences between short-term and long-term interestrates. 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 riseand less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank'sinterest margin will fluctuate.
Option risk: It is presented by optionality that is embedded in some assets and liabilities. Forinstance, mortgage loans present significant option risk due to prepayment speeds that changedramatically 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 havedeclined. 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 tomeasure and control.
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Foreign Exchange Risk
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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
6/19/2013Presented by Jaswinder Singh
Loss resulting from inadequate or failed Internal processes
People
Systems or
External events.
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Solvency Risk
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The risk of being unable to cover the losses generated by alltypes 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
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Country risk arises due to cross border transactionsThey include;
Transfer risk
Sovereign risk
Political risk
Cross border risk
Currency risk
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Technical Risks
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Technical are specific risks that include; the errors in the recordingprocess 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.,
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What can happen when a bank strengthens control to
reduce risk but separately insists on growing assets and
Profit ?
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Slow decisions
Less business
Still have losses
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Bank Failures
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E g f Ri k M g t
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Emergence of Risk Management
function
A l i g n e d
t o b
u s i n e s s d r i v e r s
Integrated across risks / businesses
1980s 1990s
Value-at-Risk
Objectives-
oriented Risk
Management
Institution-Wide
Risk
Management
Integrated
Risk & Value
Management
Integrated
Performance
Management
Risk Control
Frameworks
Risk Monitoring
& Reporting
Focus on
loss
prevention
Focus on r isk
quant i f icat ion Focus on
governance
& report ing
Focus on
al ignment to object ives
Focus on l ink to per formance & capital eff iciency
E.g.. RAROC
Focus on
stakeholder
profi tabi l i ty
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Presented by Jaswinder Singh