PROJECT SYNOPSIS ON RISK MANAGEMENT IN BANKS

1. INTRODUCTION

Risk is inherent and absolutely unavoidable in baking. Risk is the potential loss, an asset or a portfolio is likely to suffer due to a variety of reasons. As a financial intermediary, bank assumes or restructures risks for its clients. A bank while operating on behalf of the customers as well as on its own behalf, has to face various types of risks associated with those transactions. Risk in financial terms is the possibility of adverse impact of certain developments in business and operations of the banks/financial institutions on their profit and loss account situation. The various risks include operational, fiduciary, transactional, competitive, managerial, legal, disaster concentration and documentation. 2. NEED FORS STUDY

During post nationalization period of Indian Banking Industry different concepts have attained significance over different times. Initially, it was social banking in the seventies, followed by IRDP upto mid-eighties ending with rationalization/computerization by late eighties. Liberalization and deregulation of interest rates, prudential norms, capital adequacy, asset liability management as also RISK MANAGEMENT have become the buzzwords of the nineties. With happenings like BCCI, BARINGS and DAIWA, consciousness about the Risk factor is gaining prime importance. In the context of Indian Banks, asset classification norms pronounced by Narasimham committee have brought the risk into sharper focus. with the globalisation of financial sector operations, the contours of risk have also broadened multifold. When the thrust of operations is on profit, i.e., reward, the emphasis on risk is bound to go up. The uncertainty of future, impact of past and instability of present, all give risk to risk. Prudent banking lies in identifying, assessing and minimizing these risks, In a competitive market environment, a banks rate or return will be greatly influenced by its risk management skills. An attempt is made to have an overview of Bank Risk Management. with the collapse of Barings Bank, the inquiry team has stated as under: A number of industry studies have strongly advocated the establishment within a financial institution of an independent risk management function overseeing all activities including trading activities and covering all aspects of risk. A primary objective of the risk management function is to ensure that limits are set for each business. These limits should reflect the risks being run and the level of risk that management is willing to take. The function should also serve as an independent check to ensure that traders operate within their limits.

3.

OBJECTIVES OF THE STUDY

The objectives of RISK MANAGEMENT for any organization can be summarized as under : a. b. c. d. e. f. g. Survival of the organization Efficiency in operation Identifying and achieving acceptable levels of worry Earnings stability Uninterrupted operations Continued growth and Preservation of reputations.

Having extensively quoted as above, there is very little that could be further emphasized regarding the need for risk management. Suffice it to say that BETTER WE MANAGE RISK OR ELSE RISK WILL MANAGE US. Risks in banking are many. These risks can be broadly classified into three categories viz., a. Balance Sheet Risks/ Financial Risk] b. Transaction Risks and c. Operating and Liquidity Risks. The Balance Sheet Risks generally arise out of the mis-match between the currency, maturity and interest rate structure of Assets and Liabilities resulting in : a. Interest Rate mis-match risk b. Liquidity risk and

c. Foreign Exchange risk Financial Risks Types : The types of financial risks are as under : a. Credit Risk b. Interest Rate Risk c. Liquidity Risk d. Market Risk e. Capital Risk

Transaction Risks essentially involve two types of risks. They are : a. Credit Risk which is the risk of loss on lending investment etc., due to counter party default. b. Price risks which include the risks of loss due to change in value of assets and liabilities.

The factors contributing to price risks are : i. ii. iii. iv. Market Liquidity Risk Issuer Risk Instrument Risk and Changes in commodity prices etc.,

The Operating and Liquidity Risks encompasses two types of risks viz., a. b. Risk of loss due to technical failure to execute or settle a transaction and Risk of loss due to adverse changes in the cash flows of transactions

The components of Operational Risk are : a. Equipment risk, b. Product risk and c. People risk The risk contributors interest with each other in both direct and indirect pathways as explained in the following diagram. EQUIPMENT PRODUCTION

RISK

PEOPLE

MAJOR CONTRIBUTORS TO OPERATIONAL RISK

The objectives of the study are a. b. 4. To understand the concept of risk management Analyse the impact of the different types of risks on the profitability of the banks. SCOPE OF THE STUDY

Banking industry in general and Indian Banking in particular. The scope of the study, methodology and database, period of the study is confined to Risk Profile of Indian Banks. Risk Profile Indian Banks : The risks faced by the Indian Banks, particularly in the past five years have been described below: a. Currency risk b. Currency fluctuations c. Interlinkages in domestic pricing of money and forex position as reflected in simultaneous occurrence of falling rupee value. d. Concentration of credit to particular single or group borrowers. e. Risks involved in already financed sunset industries. f. Uncertainty associated with lending to weaker sections in the absence of backward and forward linkages. g. Likely competition from private and foreign banks. h. Regulatory guidelines. i. Partial and ad-hoc interest rates deregulation j. Social issues etc., The whole gamut of risk factors gives rise to the need of a solution Risk Management. It is all a question of risk management and size is not necessary and advantage. What needs

to be seen is the quality of assets. Mergers of bank was a recent trend, several countries like Japan and the United States have seen the successful survival of smaller banks. There have cases of very big Japanese banks going bust and what a banker needs to see is the quality of assets. It is all a question of risk management and size is not necessarily an advantage. The problem that banks have been facing now is one of lending or deploying funds at a profit. Banks corporate mission is to provide the threshold of banking service, both retail and corporate. In order to achieve this, the areas to look after by the banks are : a. Risk b. Corporate c. Finance d. HRD and administration e. Information technology and f. Audit The treasury systems in the banks were geared to meet the challenges of capital account convertibility. 5. METHODOLOGY

Asset classification norms as suggested by Narasimham Committee for the study purposes 6. PERIOD OF STUDY 1992 98

Banking industry in general and Indian Banks in particular. 7. CHAPTERISATION

The plan of study in the context of Indian Banks is as follows : a. Concept of risk and its components b. Risk situation in Indian Banks c. Possible option to manage risks

d. Prerequisites for risk management.

( K. MALLIKARJUNA RAO)

CONTENTS
Details Chapter No. I Title Conceptual Framework for Risk Management Page No.

Chapter No. II

Risk Management in Banks

Chapter No. III

Bank Risk Management : A Risk Pricing Model

Chapter No. IV

Trends in Risk Management in Banks

Chapter No. V

Summary, Conclusions and Suggestions

Reference:

CHAPTER I

CONCEPTUAL FRAMEWORK FOR RISK MANAGEMENT With the globalization of economies world-over, the concepts like capital adequacy, asset classification and income recognition have pride of place in the glossaries of financial sector. Post Daiwa/ Barings episodes, the focus of supervisory concern has shifted from Asset Quality to RISK MANAGEMENT. Instead of merely addressing the credit quality issues, financial sector in general and banks in particular are laying emphasis on overall risk profile. Variety of risks are created and are required to be managed to encompass credit/ interest rate/pricing/environmental/legal/systemic/currency/reputation risks. Risk is the volatility of future income and net present value of equity that results from changing environmental conditions. This write up endeavors to provide a conceptual framework for risk management in banks. Defining risk management concept with its components is followed by the description of pre-requisites to be complied with for managing risks. Generation of a banks risk profile and process involved in commencement of risk management function have been discussed thereafter. Survey on corporate Risk Management published by the Economists makes the following observations: a. Risk Management must be regarded as a core skill by every firm b. Risk Management is not an ivory tower for arcane specialists c. Increased disclosure of risk assessments and responses is the best course of action, not increased regulation or aversion of employing financial instruments that can reduce risk if used properly. d. Risk Management must be a senior managements strategic responsibility, not solely assigned to finance department. The primary message of this survey is that firms need to understand all the main risks to which their future cash flows are exposed, not just the narrowly defined financial ones. Over focus on one type of risk or another simply perpetuates the outmoded fragmented approach to the management of risk. The aforesaid clearly brings out the need to have proper understanding of framework for risk management including the concept, generating of risk profile and the process.

Risk Management Concept: -- Risk Management is the continuous process of identifying and capitalizing on appropriate opportunities while avoiding inappropriate exposures in such a way to maximize the value of the enterprise. Exposures in the aggregate result from diverse activities, executed from many locations by numerous people. Identifying exposureits worthiness or otherwise, is the greatest challenge in the risk management. Ultimately how exposures and risks are managed, depends on organizational culture, goals and risk tolerance. Risk Management is the primary duty of line managers. It is based on separation of responsibilities. It is fundamentally a managerial process, reflective of organizations risk characteristics. There is a mistaken belief that risk management is window dressing for regulators. Risk Management is neither an added layer of bureaucracy nor an impediment to quick execution and superior customer service. Risk Management is critical to the conduct of safe and sound banking activities. New technologies, new products and size and speed of financial transactions have added impetus to the risk management issues. Along with financial performance of an institution equal importance is given to risk management practices. Under the ROC-A(R: Risk Management, O: Operations, C: Compliance and A: Asset Quality) rating system for reflecting safety and soundness of US based foreign banks, Federal Reserve has accorded top most weight age to R factor. R has been made the major determinant of composite rating. The risk management procedures need to address the following issues namely (a) ability to manage risk inherent in lending, trading and other transactions, (b) soundness of implicit and explicit assumptions both qualitative and quantitative in the risk management system, (c) consistency of policies/ guidelines with lending/trading activities, managements experience level and overall financial strength, (d) appropriateness of MIS and communication network viz-a- viz level of business activity and (e) managerial capacity to identify and accommodate new risks. A fully integrated risk management system that effectively identifies and controls all major types of risks including those from new products and changing environment would facilitate or assure best R rating under the ROC-A system. Risk is a multidimensional concept and risk management is a continuous activity. As such, practically everyone throughout the organization is concerned with identifying and managing risk. What is required is anticipating and preventing risk at the source and the continuous monitoring of the risk controls and ineffective processes which are the primary source of risk. Hence, risk management encompasses three activities viz., risk identification, risk measurement and risk control. Risk identification, as the starting point consists of naming and defining each of the risks associated with a type of transaction or a product or a service. When the transactions are many and the chain of communication is long a formal risk identification system is necessary. The second component is risk measurement. It is the estimation of size, probability and timing of potential loss under various scenarios. This is a difficult component due to variety of available methods, degree of sophistication and costs involved. For example, assets/liability analysis is considered as a measure of estimating impact of changed interest on portfolio value. Various interest rate scenarios could be developed for appreciation of risk involved. Risk control has two sub-categories. The first relates to policy administrative control, while the second is risk mitigating activity. Having proper policies/procedures, helps to define each persons role, limit to which he can take risk,

reporting mechanism and the like. The goal of each such policy is to keep the outcome within risk tolerance ranges. Uniformity of language is useful while defining each risk precisely from department to department. The other aspect of risk control is risk mitigating Activity. The available options could be risk transfer(insurance or hedging), elimination or avoidance(staying out of risky business), reduction( specification and adherence to limit ) and risk retention. THE PRE-REQUISITES Establishment of a sound risk management system pre supposes specification of and adherence to certain qualitative and quantitative criteria. The quantitative requirements provide a level of consistency necessary for a capital standard, while the qualitative requirements include aspects which may take the shape of (a) having risk control unit independent of the operating unit, (b) implementing a regular programme for validation, (c) laying down procedures for periodic stress testing to evaluate the impact of unusual transactions, (d) adopting internal policies/procedures/controls which are documented and (e) conducting independent review of risk management system to meet these quantitative and qualitative criteria, each organization has to address to certain pre-requisites. They are (a) adequate risk management policies and limits, (c) appropriate risk management and reporting systems and (d) comprehensive internal control system. Board and Senior Management Oversight: Board of Directors have the ultimate responsibility to determine the level of risk undertaken by the organization. Board need to approve overall business strategies/policies including managing and undertaking risks. Ensuring capability of senior management to conduct the risk management task is also the Boards responsibility. Board, therefore needs to have clear understanding of the types of risks, the institution is exposed to. They should receive in meaningful terms reports identifying the size and significance of risks. It may be useful to have briefing from outside experts so that the Board is capable to guide its institution on the level of acceptable risk. This would also facilitate ensuring that the senior management implements the procedures and controls necessary to comply with adopted polices. Senior Management is responsible for implementing strategies that limit risk associated with each strategy and ensures compliance with laws and regulations. Adopting policies, devising control mechanisms and risk monitoring systems, delineating accountability and lines of authority creating and communicating awareness of internal controls as also ethical standards are all the tasks of senior management. The adequacy or other wise of board and senior management oversight can be assessed through the following tests : (a) identification, understanding and working knowledge of inherent risks, as also the efforts made to remain informed of these risks, (b) adoption and review of appropriate policies to limit risks relevant to activities like lending, investing, trading and other products, (c) familiarity with and reliance on records and reporting systems to monitor/measure the major sources of risk, (d) review of strategies, risk exposure limits as also possible reaction of market conditions,

(e) management ensuring that business lines are started by personnel of required knowledge, experience and expertise, (f) provision of adequate supervisory mechanism at all levels on a day-to-day basis and (g) responsiveness to changes in environment or from market innovations. Adequate policies/procedures: There can be nothing like proto-type policies or procedures for risk management. The size of operations, sophistication, level of technology, managerial capacity and ability to undertake risks are some of the determinants while documenting policies and procedures. The policies and procedures are tailored according to the types of risks that arise from the activities of the organization. They provide detailed to protect the organization from excessive and imprudent risks. The core of these policies is to address to the material areas of risk and their necessary modification to respond to significant changes in the banks activities or business environment. These policies/procedures provide risk management framework based on management experience level, goals, objectives and overall financial strength of the banking organization. Delineating accountability and lines of authority across the organizational activities and review of activities new to the bank are also facilitated through such policies. Monitoring and Management Information System (MIS): Risk Management related activities i.e., identification , measurement and monitoring/control need to be supported by a proper Management Information System(MIS). Such MIS provides reports on financial condition, operating performance and risk exposures. Line Managers can expect to obtain more detailed feedback on day-to-day operating activitities. Complexity and diversity of institutions financial transactions would dictate sophistication of MIS. MIS, for example, could include daily financial including profit/loss details, a watch list for potential troubled loans, interest risk reports, past due loans, etc. Whenever trading activities are on a larger scale, more detailed activity reports across the whole organization may be necessary. The purpose is ultimately to ensure that polices/procedures address to material risk areas and that they are modified to respond to the changes in activities, business conditions and environment. The following tests are generally applied to assess the adequacy of MIS, (a) risk monitoring practices/reports address to all material risks, (b) assumptions, data sources and procedures used are appropriate, adequately documented and tested for validity on a continuous and are structured not only to monitor exposure but to facilitate compliance with laid down exposure limits by having variance analysis, (d) reports are accurate and timely containing sufficient information for decisionmakers. This should lead to probing adverse trends and evaluating level of risk faced by the institution. Internal Control: Internal Control structure is critical for safely and soundness of any organization. As the instances of Daiwa/Barings have proved, failure to implement/maintain separation of duties can result in serious financial and reputation losses. A properly placed internal control system aims at (a) promoting effective operations and reliable reporting , (b) safeguarding assets and (c) ensuring regulatory/policy compliance. Effective internal controls need to be

looked into by internal auditors, who would report directly to the top management. The internal controls primarily check the policies/procedures in terms of their adequacy and effectiveness. The prescriptions for proper policies and procedures do equally hold good for internal controls. The description of the pre-conditions is followed by the discussion on determination of risk profile and management thereof. RISK PROFILE In a banking situation, the business risk is inherent, arising out of probability of loss of earning or reputation as a result of a banking or non-banking activity. It is a cost of doing business. What risk management does is to reduce the inherent business risk by ensuring adequacy of managerial controls and making risk mitigation efforts. What is normally endeavored to be controlled is the impact of risk in terms of losses. Elimination of risk in business is a utopia and nearly impossible proposition. The risk management involves two separate but simultaneous processes, first is determining risk profile and second relates to organizing the risk management process itself. Deciding risk profile is synonymous to drawing a risk picture of and organization and involves the following steps: 1. Identifying and prioritizing the inherent risk-this would involve conducting a sort of risk audit checking product by product and area by area exposures undertaken by the bank, Larger transactions could be the matter of focus in the initial stages. Having listed all risk areas, sorting of critical ones on a probabilistic basis is another task. The risk audit will involve (a) holding discussions with managers having different portfolio responsibilities. (b) analysis of historical trends in relation to business cycle, competition and regulatory requirements. While prioritiing the risks, consideration should be given to their materiality/quantification, highly expected losses, very volatile losses and accidental/one time losses. Examples thereof could be, (a) high volatility/low expected losses associated with trading or natural disaster, (b) high volatility/high expected losses like commercial real estate or bank wide operational failure, (c) low volatility/high expected losses like losses from credit cards and (d) low volatility/low expected losses like teller loses or crimes 2. Suring and scoring inherent risks-this part involves study/analysis of industry outlook and trends. A view on the industry by national and international rating agencies will also be useful. The composition of earnings and the fluctuations therein shall provide some clues about the historical aspects. The level of economic activity and stage of business cycle can standards for evaluation may be simple and normative on a grade of 1 to can standards for evaluation may be simple and normative on a grade of 1 to 5, where 1 represents the lowest risk and 5 the highest. Grade 1 may signify small potential for a significantly adverse impact on earnings, capital, stability or

reputation. Under grade 2 and 3, the impact would be considered modest. Grade 4 & 5 would denote serious and substantial impact. Refinements could be made as the risk management system goes along. 3. Establishing standards for each risk component the framework for establishing standards is provided by prudent banking practices based on current environment, industrys best practices and regulatory expectations. The components and their examples are (a) organization/staffing(separation of responsibilities, reporting relationships and approved checks and balances, (b) policies/procedures (currency comprehensiveness, exactness, user-friendly and applicability), (c) process controls (well defined, standardized controls and practices matching policies, (d) measurement/monitoring (specific/quantitative performance measures, appropriate methodology and identified risk factors ), (e) MIS/ reporting (reliability/ timeliness/accuracy of data and appropriate distribution thereof), (f) communications (formal process, common understanding and reciprocity and (g) performance (results meeting set standards). Evaluating and scoring the quality of managerial controls-the first step would be to specify the standards of control. Having extensive controls would mean that the organization has significant resources and well-defined policies/procedures/control and that they are properly implemented. Average standard would reflect modest level of policies/procedures/controls. While minimal standard would indicate that the organization has limited resources and few controls in the area of risk management. The various risk components are tabulated to provide a chart of current practices vis-vis standards, showing relevant strengths/weaknesses. The tabulation can be supplemented according to numerical score or a grade to reflect extensiveness or otherwise of the standards. Scoring of managerial controls involves survey of the controls, consultation with the external/internal audit reports and regulatory examination with the external/internal audit reports and regulatory examination reports 5. Developing risk tolerance levels-the exposure matrix provides the indications on adequacy or otherwise of the of the managerial controls in terms of the risk involved. The options are to increase control or to reduce exposure or both. A view on historical performance/information is use full. This can be supplemented with a view on expected changes for the future. The contribution of risk mitigants and their impact on risk profile could also be analyzed. It may be useful to have risk with mitigants and control, rather than taking risk at all. Based on all aforesaid, the risk strategies are to be developed and finalized. The determination or risk profile is undertaken as a part or organizing for risk management function. This involves: Establishing scope of the risk management process-this entails creation of a separate organization, positioning proper executive at managerial level, initiating the process of risk thinking and awareness, redefining role of chief executives as the top

4.

most risk manger, delineating specific jobs/responsibilities and clarifying relationship with other departments. Defining and communication implications-this involves the determination of specific role and responsibilities. For CEO, the tasks may be setting risk strategy/budget and enforcing the same. The risk managers activities may includes confirming measurements guiding line mangers, ensuring consistency in reporting, co-ordinating relevant operations and above all, maintaining independence. Similar tasks could be assigned to audit and loan review, as also risk management committee. Organizing support the last stage in the process involves establishing clear cut responsibilities, determining/ providing technological support, arranging training programmes and the like. INDIAN CONTEXT A question can now be posed whether such an elaborate risk management process is relevant in Indian context. The answer has to be an affirmative for a variety of reasons. The process would facilitate better understanding of risks and their management by comparison on risk return matrix. Acceptance of such an internationally recognized procedure 5 may be the demand of the next phase of financial sector reforms. Thirdly, proper risk management cannot only put income steam on good stead, but also can serve as useful manpower development strategy. Risk management goes much beyond routine audits. It is a managerial function-post facto operation but pro-active to avoid future losses. More than the auditors, cadres of system specialists with finance background could be developed through introduction of the process. Assessing and documenting risks as a part of appraisal memos in credit and alike decisions will not only develop processing skills, but would facilitate to separate willful negligence from erroneous business judgment. Baste committee norms on capital adequency are hereto stay so also the practices like risk management. Hence, better prepare to internalize them. BENEFITS TO THE BANK The risk assignment will result in significant benefits to the banks in the form of development and operationlisation of an integrated and comprehensive risk management system. The establishment of a sound risk management system would help the bank in: - Improved risk management practices - Improved business perspective - Improved progitability - Better management control -Increases compliance with established policies and standards.

-Inproved morale of employees -Healthy growth MID-TERM REVIEW OF MONETARY AND CREDIT POLICY FOR 1998-99 Risk management systems are designed to incorporate all the provisions and statutory requirements of the RBI, proposed by the Narsihmam committee on Banking Sector reforms, which were announced by the RBI Governer Dr. Bimal Jalan on 30th October, 1998 in the mid-term review of the monetary and credit policy for 1998-99. They also have the in-built flexibility of enabling the bank to adopt to any changes or additions made in the future policies and guideline of the Reserve Bank of India. The RBI has announced guidelines on comprehensive Asset-Liability Management practices on credit risk, market risk, interest rate risk, operational risk, etc., to be followed by all banks with effect from April 1, 1999. It has also specified the risk weights to be attached to the various categories of assets, including the weights to be attached to government advances and government guaranteed advances. This will help the banks to comply with the regulatory environment as stipulated by the Reserve Bank or India. Risk such as credit risk, market risk, liquidity risk, operational and system risk is a fundamental aspect of financial institution management. Thus, as a financial institution our goal to maximize corporate value can be realized through controlling those risks in a satisfactory level and range. By effectively managing the individual risk according to its character, we are able to achieve financial soundness and increase business profitability, which enables us to meet stockholders demands for maximizing corporate value.

CHAPTER II
RISK MANAGEMENT IN BANKS (i). INTEREST RISK MANAGEMENT The deregulation of the financial system in Indian has put in place a lot of operational freedom to the financial institutions. The entry of new players and product has rapidly transformed the financial market and most of the rigid regulations are on the way out. The deregulation of forex and domestic resources base of banks has brought in various types of liabilities, free from reserve requirements, interest rate regime and other types of regulatory restrictions to the balance sheet of banks. The pricing of these liabilities has also been left to the commercial judgment of banks. The earnings and costs of these liabilities are closely related to interest rate volatility. Thus, the interest rate risk, a term totally unknown to the banking industry in Indian has suddenly became relevant. Most of the banks identified interest rate risk as a drain on their profitability and have started assessing the magnitude of interest rate risk embedded in their balance sheets.

Interest rare risk refers to volatility in net interest margin or variations in net interest income due to changes in interest rate. In other words, where assets and liabilities are contracted on a floating rate basis, a banks exposure to interest rate risk arises from fluctuations in the interest rate on repricing maturity dates i.e., roll over rate. Interest rate risks are broadly classified into. Mismatched or gap risk, basis risk, net interest position risk, embedded option risk, yield curve risk, price risk and reinvestment risk. 1. GAP OR MISMATCH RISK A gap or mismatch arises from holding assets and liabilities with a different principal mount, maturity dates or repricing dates, thereby creating exposure to changes in the level on interest rates. The gap is the difference between the amount of assets and liabilities on which the interest rates are rest during a given period. In other words, when assets and liabilities fall due for repricing in different periods, then they can create a mismatch. Such a mismatch or gap may lead to gain or loss depending upon how interest rates in the market tend to move. For example, if a bank has invested 90 days 8 per cent and maturing on the same day as the deposit, the bank will have matched gap. As defined by gap there would be no interest rate risk. If the interest rate rise by 100 basis points during the 90 days term of the deposit, the deposit will be renewed at 9 per cent and the fixed rare loan will also mature and can be repriced at 11per cent. This the 2 percent net interest margin will be preserved. If the proceeds of the 90 days while the deposit are reinvested in a floating rate loan (repricing at every 30 days) with an initial rate of 10 per cent, the interest earned on the loan will change twice during 90 days while the deposit rate remains unchanged. Since the asset is repricing much more rapidly than the liability during this period, the bank is asset sensitive. The asset sensitive bank can produce a large net interest margin if the interest rate rise because interest rate on floating rate loan move higher during the 90 days period while the interest rate being paid on the deposited remains at 8 per cet. Conversely asset sensitive gap position would cause compression in the net interest margin as interest rate declines. If a bank uses the 8% 90 days term deposit to find a 30 year fixed rate mortgaged loan at 10%, the loan will continue to earn 10% while the deposit reprises at every 90 days interval. The bank is now liability sensitive because the interest rate paid on its deposits is reset more rapidly than the rate being received on the loan. A rise or fall in interest rate in a liability sensitive situation has the opposite effect on the net interest margin an asset sensitive bank. Any increases in interest rate will cause an erosion of the liability sensitive banks net interest margin. Mismatched repricing periods of assets and liabilities in only one form of interest rate risk. There are other forms of interest rate risks inherent in every banks balance sheet that can severely affect their earnings. 2. BASIS RISK

In a perfectly matched gap position there is no timing difference between the reset dates; the magnitude of change in the deposit rate would be exactly matched by the magnitude of change in the loan rate. However, interest rates of two different instruments will seldom change by the same degree during the same period of time. In the example of a bank with a matched gap position, in case the 90 days deposit rate changes from 8 per cent

to 9 per cent, the rate earned on 90 days fixed rate loan can also be changed from 10 per cent to 11 per cent and preserve the 2 per cent net interest margin. If the risk premium in lending rate remains constant at 25 per cent of the 90 days deposite, as the 90 days deposit rate move from 10 per cent (8 1.25) to 11.25% (9 1.25), which will produce as 25 basis point increase in net interest margin. Risk premium, however, changes over time, as the perception of risk changes in the market place. If the existing 25 per cent risk premium shrinks to 19.4% per cent, a 100 basis point increase in the deposit rate produces only a 75 basis point increase in the loan ( 9 1.94 = 10.75), the net interest margin contracts by 25 basis points The fact that bank gap remains perfectly matched while changes in the level of interest rates cause wide swings in the banks profits clearly indicates another form of interest rate risk in the balance sheet of banks When the variation in the rate causes the net interest rate margin to expand, the bank has experienced a favorable basis shifts and if the interest rate movement causes the interest margin to contract, the basis has moved against the bank. 3. NET INTEREST POSITION RISK

The banks net interest position also exposes the bank to additional interest rate risk. If a bank has more assets on which it earns interest than it has liabilities on which it pays interest, interest rate risk arises when interest rate earned on assets changes while the cost of funding of the liabilities remains unchanged at zero per cent. Thus, a bank with a positive net interest position will experience a reduction in its net interest margin as interest rate decline and an expansion in its net interest, margin as interest rate rises. A large positive net interest position accounts for most of the profits generated at many financial institutions. 4. EMBEDDED OPTION RISK

Large changes in the general level of interest rates create another source of risk to banks profit by encouraging per-payment of loans and bonds and/or withdrawal of the deposits for prepayments of loans, the borrowers have a natural tendency to pay off their loans when a decline interest rate occurs. In such cases, the bank will receive only a lower net interest margin. Take the case of a bank disbursed a 90 days loan at a rate of 10 per cent and rate of interest declines to 9 per cent after 30 days and the borrower pays off his loan immediately, the bank will receive only 200 basis points interest margin for 30 days rather than the anticipated 90 days. In the remaining 60 days of the 90 days term, the net interest margin will be only 100 basis points When the interest rate rises, the net interest margin becomes exposed to the same embedded option risk on the liability side of the balance sheet as well. If there are no substantial penalties for early withdrawal, the depositor will withdraw the term deposit before maturity, so the funds can be redeposited in a new deposit account at a higher rate of interest. For example, if a 100 basis points rise in rate occurs 30 days after the deposite is fixed, the depositor would close 8 per cent 90 days deposit and open a new 90 days term deposit at 9 per cent. This action of the depositor will cause the bank net interest margin to decline 100 basis points during the last 60 days of the originally 90 days term.

As interest rate rise and fall, the banks are exposed to some degree of risk as customers exercise the embedded options inherent in their loans and deposit contracts. The faster the changes in rates and higher the magnitude of the changes the greater will be embedded option risks to the banks net interest margin. Most of the banks protect themselves from these risks by imposing penalties for prepayment of loans and early withdrawal of deposits. However, most banks have found customers resist paying large penalties and must reduce the penalties to more modest levels as a competitive strategy to attract additional business. 5. YIELD CURVE RISK

An yield curve is a line on a graph connecting the yields of all the maturities of a particular bond. As the economy moves through the business cycle, the yield curve changes rather frequently. During most of the business cycles, the yield curve has a positive slope i.e., short term rates are lower than longer term rates at the intervention of Government of India/Reserve Bank, the yield curve can be twisted to negatively slopped i.e., short term interest rates are higher than long term interest rate. A negatively slopped yield curve is frequently referred to a inverted yield curve. Yield curve risk occurs with the variation in yield curves between securities of different maturities. Positive and negative yield curve on different dates are shown below:

To illustrate how a change in the shape of the yield curve affects the bank net interest margin, let us assume that Bharat Bank Ltd has deliberately placed itself in a liability sensitive gap position on 30th June 1993 by using 90 days certificate of deposit to fund one year floating rate loans. If the bank pays 100 basis points above the 6.60 per cent 91 days treasury bills rate on its 90 days C.D. and charges 250 basis points above the one year T. B. rate climbing to 9 per cent and one year T. B. rate of 8% on its loans, a net interest margin

of 290 basis points is produced if the yield curve becomes inverted on 1 st January 1994 with 91 days T. B rate climbing to 9 per cent and one T. B. remaining at 8 per cent and the spread relationship of the deposits and loans to treasury bills rates remain constant, the net interest margin will be reduced to 50 basis points. 6. PRICE RISK

Price risk occurs when assets are sold before their maturity dates. For example, the price of 10 years 10 per cent government of India loan will receive only lower price than originally paid for when interest rates on bonds of 10 year Government of India loan have gone up to 13.5% per cent. 7. REINVESTMENT RISK

The difference in the timing of interest cash flows between various assets and liabilities create reinvestment risk. Measuring interest rate risk Before risk can be managed, they must be identified and quantified. Unless the quantum of risk inherent in a banks balance sheet is measured, it is impossible to measure the degree risk to which the bank is exposed. It is also equally impossible to develop effective risk management strategies without being able to understand the current risk position of the bank. The interest rate risk is measured by calculating gaps over different time intervals based on aggregate balance sheet data at a fixed point of time. Gap analysis measures mismatches between rate sensitive assets and rate sensitive liabilities. The gap values provide an indication of the effects of movement of interest rated on met interest margin. An institutions interest rate position is the cumulative result of thousands of individual deposits, loans, investments etc., comprising the balance sheet date. Each deposits, advances etc., has its own cahs flow characteristics. In order to fully comprehend the risks inherent in banks balance sheet, each loan, deposit etc, should be related to their flows and repricing to a change in the general level of interest rates. The gap report is generated by grouping assets and liabilities into buckets according to maturity or time until the fast possible repricing. The principal portion of an asset and liability that can be priced is classified as rate sensitive. The gap then equals the rupee difference between Rate Sensitive Assets (RAS) and Rate Sensitive Liabilities (RSL) for each time interval. Any number of periods can be used while constructing gap report. Most mangers focus their attention on the near term periods viz, monthly, quarterly, half yearly or one year. The gas reports indicates whether it is in a position to benefit from rising interest rates by having a positive gap position (RAS > RSL) or whether it is in a position to benefit from declining interest rate by its negative gap (RSL > RSA). The size of the gap indicates the degree to which an institution will benefit from favourable movement in interest rates. The negative gap indicates that the bank has more RSLS than RSAS. When interest rates rises during a specified time period, the bank

pay higher rates on all repriciable liabilities and earns higher yield on the reprice able assets. If all rates rise by equal amounts at a time, interest expenses rises more than interest income because more liabilities are repriced and the spread declines. When interest rate fall during the interval, more liabilities than assets are repriced at lower rates, the average yield widens. A positive gap indicates that the bank has more RSAS than RSLS. When short term interest rate rises, interest income increases more than interest expenses because more assets are repriced. The spread and net interest margin similarly. Any fall in short term interest rate has the opposite effect. The change in net interest rate margin rises because amount or rate sensitive assets defers from the amount of rate sensitive liabilities. It is also linked to yield curves. A positive gap is desirable when the yield curve is shifting from a flat position to a negative or humped shape. In a negative gap sloping yield curve is profitable.

The impact of interest rate movement on different gap situation is illustrated in the following table:

GAP SUMMARY Gap position Change in Interest Change in Interest Income POSITIVE POSITIVE NEGATIVE NEGATIVE ZERO ZERO Increase Decrease Increase Decrease Increases Decrease Change in Interest Expansion Change in Net interest Margin Increases Decreases Decreases Increase Increases Decreases

Increase > Increase Decrease > Decreases Increase < Increases Decrease < Decrease Increases = Decrease = Increases Decreases

Although the gap report has been used as a primary measure of interest rate risk, it failed to provide all the information necessary to measure total interest rate exposure. Gap report quantifies only the time difference between repricing of assets and liabilities but fails to measure impact of basis, embedded etc., risks. The gap report also fails to measure the entire impact of a change in interest rate on net interest margin or the effect of a change in interest rate on the market value of banks assets and liabilities. The most accurate estimate of the impact of interest rate change at banks market value can be assessed by conducting a net present value analysis. This analysis determines the net present value of all the cash flows which are induced either by assets or liabilities.

STRATEGIES FOR CONTROLLING INTEREST RATE RISK Interest rate risk management process should begin with strategies that change the banks interest rate sensitivity by altering various components of the balance sheet. The actual management of banks assets and liabilities focuses on cont rolling the gap between RSA and RSL. Some banks pursue a strategy of mismatching assets and liabilities maturity as closely as possible to reduce the gap to zero and reduce the volatility of net interest margin. Aggressive bankers, however, vary the gap in line with their interest rate forecasts. If they expect interest rat to increase, they widen the gap by repricing the assets more frequently than their liabilities. The banks have been following various balance sheets etc., strategies to limit the stocks of interest rate volatility. The basic strategy of the banks is focused on bridging the gap position. The strategies for reducing assets and liabilities sensitivity are: Reducing asset sensitivity Extend investment portfolio maturities Increase floating rate deposit Increase short term deposit Increase fixed rate lending Sell adjustable rate loans Increase short term borrowings Increase floating rate long term debt

Reducing liability sensititvity reduce investment portfolio maturities increase longer term deposits sell fixed rate loans increase fixed rate long term debt

The basic balance sheet strategy to alter banks interest rate exposure is to effect changes in the portfolio composition. A variation in portfolio mix potentially alters net interest income. The assets sensitivity situation can be tackled by pricing more loans on floating rate basis or shortening maturities of investment securities. The banks can also consider selling fixed income securities and reinvesting the proceeds in securities with a different maturity.

High level of interest rate risk in several banks is the direct off-shoot of aggressive pricing policies on loans and deposits. To address these problems, banks may have too develop floating rate loans with interest rates that can be reset at a near term intervals. The base rate that can be used an index on adjustable rate loan may be treasury bills rate with same maturity as the reset period. For example, the rate on floating one-year loan may be based on a fixed spread above the prevailing one year treasury bill rate at the time of resetting. The impact of an asset sensitivity situation can be managed by securitisation of various loans portfolio backed by cash flow. IT greatly increases the liquidity and eliminate the interest rate risk embedded in the balance sheet. The other options available to the banks are : i. match long term assets with non- interest bearing liabilities.

ii. match repriceable assets with a similar repriceable liabilities. iii. Swaps, options and financial futures to construct synthetic securities and thus hedge against any exposure to interest rate risk; and iv. Maturity mismatch is accentuated by Non-Performing Assets (NPA) and loan renegotiations. Sound loaning policies and effective post sanction monitoring and recovery steps can contain the volume of NPA. Risk averse banks management would always endeavor for a matched book. Full match in repricing assets and liabilities is neither feasible nor expedient. The adverse impact on net interest margin due to mis-matches can be minimized by fixing appropriate tolerance limits should be relatively lower in the shorter ends or proximate time bands. Thus the bank should constantly review finances with a view to protecting interest rate margins. (ii) CREDIT RISK MANAGEMENT

Credit risk is a contingent risk which arises when the counterparty in a foreign exchange transaction fails to honour the commitment. Credit risk can be classified into:

Contract Bank

Credit Riks Clean Risk

Contract Risk: where the failure of the counterparty is known prior to the performance of banks commitment in the contract; the contract has to be treated as cancelled and the risk is to the extent of loss resulting from an adverse movement in exchange rates while covering the transaction on going market rates. Clean Risk at Settlement: Through currencies are exchanged at settlement on the same value date, the time zone differences between different centers would result in one currency being paid before the other is received. If the failure of the counterparty occurs after you have settled your portion of the commitment, it would result in the loss of the entire value of the contract. The case of Bank Herstatt in Germany, which failed in 1974 in the afternoon after receiving Deutschemark funds but before delivering counter value dollar funds, is a classic example of the clean risk at settlement of funds. Control over credit risk is exercised by fixing limits on aggregate value of outstanding commitments for merchants as also inter bank counterparties. The limits are constantly monitored and the dealing room suitably advised if the limits are close to being breached. Limits are fixed on the aggregate outstanding commitments and separately for the amount of funds to be settled on a single day. The letter limit would be smaller and is intended to control the clean risk at settlement. In the Indian context, prior to computerization of the foreign exchange operations not much attention was paid to credit risk and its control. This was perhaps due to the difficulty in monitoring the limits by a manual system and also a complacency that the possibility of any participant in the Indian forex market failing is rather remote. In the interest of developing comprehensive control and also computerization of dealing operations on on-line basis such complacency is not warranted. Sovereign Risk: Sovereign risk is the political side of the credit risk when a country suspends or imposes restrictions on payments. Thus, even if the counterparty is willing and able to honour commitments, sovereign action could frustrate the contract. This risk is present not merely in dealing room activity but also the entire volume of assets is prone to such a risk. The exposure limits for different countries should take into consideration factors such as political stability health of the economy, possibility of state interference, availability of infrastructure for legal recourse, etc., MISMATCHED MATURITIES OR GAP RISK Guided by asset liability management principles, we are inclined to know and find that the assets and liabilities constituting the exchange position would generally have different maturites and mismatches in cash flows would also result. If uncorrected this would translate in cash flows would also result. If uncorrected this would translates into problems of overdrafts or idle surpluses not only in quantum but also in maturity, Deposit these efforts it does not materialize because: (a) Uncertainty attendant with merchant transactions. Option periods availability under forward contracts as also early/delayed receipt of export payments. (b) Non- availability of matching forward cover in the market.

(c) Even in interbank contracts the buyer bank has option of pick-up within the period of the contract. (d) Deliberate attempt to hold gaps and to cover them subsequently to minimize swap costs or to earn swap gains. The risk the bank runs in carrying the gaps is that when the gap has to be covered by a suitable swap the forward differentials could do against the bank and costs more than provided for, could result. The Indian derivative market handles mainly forwards, swaps and for options, it is quite thin and can move very sharply. In the overseas market forex as well as money markets are integrated and the swap differentials reflect interest rate differentials. Uniquely in the Indian context banks are not allowed to lend or borrow forward currencies, thus forward margins are driven purely by demand and supply for forward cover which could change quite dramatically as observed recently annualized 6 months premium for USD/Rupee went up approximately by 26 percent.This enhances the risks of maintaining mismatches. RBI has thus placed restrictions on banks maintaining mismatches. Segregating assets and liabilities maturity wise and quantifying the net inflow or outflow for each period exercise control of gap at monthly intervals. Banks thereafter take the cumulative effect of these period-wise mismatches to quantify the cumulative inflow and outflow, on the quantum of which limits are placed. This is the way the net outflow or inflow is measured and subject to an individual mismatch or gap limit. For all the periods, instead of the concept of cumulative outflow of inflow, the individual gaps are grossed without set off and subject to an aggregate limit. RBI has also prescribed that the aggregate of aggregate limits of all currencies should be within us$100 million or 6 times the owned funds of the bank whichever is less. The rationale behind computing the aggregate gap limit in the manner suggested in the guidelines is often questioned, since what is really relevant is cumulative effect of inflows and outflows. However, RBIs intent in fixing the aggregate limit as above seems to be not only risk control but also to avoid excessive trading in the ambiguous forward market. The Sodhani Committee is of the view that AGL in its present form represents only the sum of the monthly mismatches and does not adequately take into account the period of the exposure and attendant interest rate risk and the committee has recommended that authorized dealers interest rate exposure should be reviewed with a view to extending limits also to rupee transactions as a part of general banking supervision. However the committee for the present want the gap discipline may only apply to foreign currency only and the top management of banks may be permitted to fix the AGL and IGL in relations to their forex operations, risk taking capacity etc.,

REVISED BIS ADEQUACY

PROPOSALS

ABOUT

MARKET

RISKS

AND

CAPITAL

The 1988 Balse Committee on Banking Supervision has considered mainly the credit risk, for capital requirements. Now the Basle committee has set out to develop a framework for integrating into the 1988 Accord an approach to assessing explicit capital charges for market risk. Under the shorthand method, the nominal amount or net present value of the net position in each foreign currency and in gold is converted at spot into the reporting currency. The overall net open position is measured by aggregating: the sum of net short positions or the sum of the net long positions, whichever is the greater plus net position short or long in gold, regardless or sign. The capital charges will be 8 per cent of the overall net open position. In banks own internal models methodology, price and position data arising from the banks trading activities are entered into a computer model that generates a measure of the banks market risk exposure, typically expressed in terms of value-at-risk. This method calculates the maximum loss during a holding period of say ten days, with a given confidence level for either stimulated or historical position changes, and 8 per cent of the maximum loss is assigned for capital charges. OPERATIONAL RISKS Operational risks arise out a wide variety of situations ranging from humor errors to administrative inadequacies, provisions flaws in systems and procedures etc., It is essential that we recognize them early and ensure that they are controlled and corrected. We can identify some major areas of operations and the probable nature of operational errors that could occur. Segregation of dealing and accounting functions: It is essential that the dealing decision and its execution be separated and performed by different functionaries. This ensures that a check is maintained on the dealers activities and the dealer of course cannot execute a dealing decision without involving the accounts section. In some cases in Indian and abroad huge dealing losses emanated from concealed exchange position, the situation largely arose because of the lack of functional segregation. Follow-up of deal slips and contract confirmations; A dealing decision is taken orally by telephone, or through unauthenticated messages. It is essential to have this follow-up by written/authenticated confirmations. This requires the follow-up of the deal slip, the brokers note and contract confirmations. In several cases mistakes in understanding of nay essential detail of the contract came to light so much later that there correction become very painful. The duidelines do require banks to follow up unconfirmed outstanding contracts. This aspect has been taken care of largely where dealing operations are put on the dealing screen. Control over settlement of local and foreign funds: A dealing decision can be totally frustrating if the funds are not settled appropriately and marginal profits on exchange are likely to be more than loss by way of interest on delayed settlement of funds. While execution of funds transfer instructions are to be prompt, the bank requires to be equally vigilant and quick in locating and rectifying and delays in settlement of funds. Brach reports and pipeline transactions: One of the major areas of operational difficulties is managing of exchange cover for forex transactions affect the banks position immediately notwithstanding the fact that they are advised by the branch much later. Such

an exposure has to be maintained under control and any significant delay in a branch reporting a transaction has to be followed-up. Overdoes bills and contracts: Export bills and forward contracts have to be monitored to ensure that they are delivered as per their tenor. Failing this the bank is likely to incur considerable swap costs in maintaining these items in position. Nostro reconciliation: The Nostro Account is the logical end of any forex transaction. When a transaction is ultimately transferred to the mirror account in the books of the bank, it must find a corresponding entry in the statement of account sent by the correspondent bank. Reconciliation of the entries and balance has to be done periodically to identify and follow-up the outstanding items. Keeping in mind A, B, C control reconciliation is required to be taken up by staff other than those who operate the accounts to avoid possibilities of any cover up of errors or fraudulent transactions. The problem often lies in situations considering the exercise complete on reconciling the balance. The fact is that the job begins with identification of the unrecognized which have to be followed-up with the concerned branches, counter parties or the correspondents. Managements are often lulled into complacency by considerations like: Un reconciled debits and credits are in aggregate more or less equal and their reconciliation process will not result in net outflows. Only unreconciled debits have to be follow-up. It is obvious that such reasoning is shallow. Efforts towards improving reconciliation include: a. Where there is a large branch network allocation of separate nostro accounts for specific groups of branches, convenience on reconciliation obtaining from a limited number of branches operating on an account should of course be weighed against the cost of maintaining several nostro accounts. More than one account maintained with the same correspondent often results in misdirection of transactions by the correspondent and can be avoided. Responding entries remaining unreconciled signal an error and while following up the unreconciled entries priority therefore has to be given to such entries. Bank changes debited to the account has to be promptly responded to. The problem often arises when the customer on whose account the charges arose is not making payment or is not available. Where the charges have been levied entry has to responded promptly and where the customer is not available the bank absorbs the charge. Set-offs of unreconciled debits and unreconciled credits has to be totally avoided since while apparently reducing the unreconciled items they will render future reconciliation into further disarray. The RBI has required banks to have a vigorous follow up of reconciliation and submit periodical statements on the volume of unreconciled items. While follow-up

b. c. d.

e.

of unreconciled item could be quite laborious, it must be borne in mind that what is now difficult is only likely to become impossible, if postponed further . Control over operational errors and failures would be exercised through a system of record and follow up of such errors supported by concurrent or periodic audits. Periodic reports need to be submitted to the management who could then review the system in operation. SKILL AND EXPERTISE It has been observed that the Indian banks as of now, do not generally, deal in a big way in a number of sophisticated activities, particularly forex and money markets. It is mainly due to the hesitations arising out of lack of appreciation of operation of the products and skills to handle them. Efforts have already been initiated to break this vicious circle to be able to expand our range of services and augment fee income. It will facilitate and enable Indian Banks to handle derivative products beyond forwards and swaps to futures, options and FRAS within the ambit of forex dealing/trading operations and also to ensure that the activity is in consonance with the frame work at the international level. Conclusion: The progressive globalization of the economy has exposed the Indian forex market to the volatility in international markets. In order to appreciate the issues relating to products available for hedging forex risk, scope for further development of the market and introduction of new derivative products and other related matters let us take stock of the situation, analyze and accept tested devices, regulate efforts facilitating the process to mange risk in the given situations. As the market develops the cost of note taking an in depth approach increases but the benefits of an intelligent and well informed approach to the system increases faster. In the name of volatile forex market and believing in SURVIVAL OF THE FITTEST market players find and anticipate further challenging task before. Surely it is high time to harness the potential Indian forex market promise and to book advantage of available latent talent in activating the forex market. The implementation of the Sodhani Committee Recommendtions on Foreign Exchange Markets in India is expected to deepen and broaden the forex market and provide an opportunity to integrate ultimately with the global activity still further in the days ahead. OPERATIONAL RISK MEASUREMENT Time, money and people do not always lend themselves to so comprehensive a program. In these situations, Operational Risk Management (ORM) provides an alternative approach that requires less time and fewer human resources. Reliability of risk-centered maintenance are functional risk measurements that consider what can happen, that in they take an in-depth look at all possible failure modes and incorporate them all into maintenance planning. There is no question that such functional risk measurements are beneficial, especially for developing a complete maintenance plan and for managing low-frequency. High consequence events. However, when there is a need for quick, low-cost reductions in risk,

operational risk measurement is an excellent alternative. Operational risk measurement is performed only on process critical equipment. It involves a reorientation of data normally collected in plan operation and used that data to identify areas of high risk and just as important areas of low risk. Its principles are applicable to the e consider only events that have already occurred, here we also limit our scope to identifying and quantifying only risk contributors that are within the plant boundaries. For example, companies that have plants on foreign soil in volatile areas of the world may find social instabilities a factor in risk management. With this method, however, we restrict ourselves to within the plant itself and deal with risk solely from a plant operational point of view, regardless of its location in the world. Our discussions of computing operational risk measurement will include its data requirements. There are three fundamental characteristics that are common to all applications: (1) the time/date of failures; (2) the nature of the failures, and (3) the costs associated with the failures Accurate recording of the time of failure may appear to be an obvious and routine activity. Unfortunately, it is nor always. In many cases, people will use the date the work repair order was opened as the failure occurrence time. Depending on what else is happening in the plant, this could be on the same day or could be several days later. The time of day information is usually not recorded at all. This information is very useful for analyzing the potential for subtle, synergistic effects, on is usually not recorded at all. This information is very useful for analyzing the potential for subtle, synergistic effects, such as circadian influences, and is relatively simple to capture. Capture of the failure time is common with automated control systems like those involved in process control. For these systems, it is a simple matter of computer programming to record failure times. The nature of the failure simply identifies what failed and how. A good way to uniformly and systematically record this information is with the use of failure codes. This minimizes the time required to record the event either in a computer management system or paper-oriented system. To some extent, it relieves the personnel demands in writing descriptions and also standardizes reporting responses. You want the codes to be as accurate as possible to capture the valuable failure cause or effect information. I use the word accurate here with deliberate intent. The personnel deciding on what code or codes to apply should be able to select the appropriate codes by scanning a list. You want to minimize the number of failure with the miscellaneous or other codes, I have seen upto 33% of all failures of one plant in the miscellaneous category. In this case, it meant that without interviewing the personnel directly who did the repairs, no information was available on the failure cause. Thus, from a practical point of view, no improvement could be made on 33% of the plants failures (this has been corrected since the observation was made). Now work orders cannot be closed unless at least one failure code has been assigned. The failure code is a simple piece of information that is obvious to personnel at the time of repair. Unfortunately, it rapidly fades from memory as new problems continuously arise. That is why recording this information at the time when it is fresh in peoples memory is invaluable for risk reduction.

The cost of failure is the most complex of the date items required for operational risk measurement. Cost cannot be readily entered at the time of the failure occurrence because it includes many factors. These range from tangible items, such as cost of parts and labour, to those which are less obvious, including lost production, insurance increases resulting from the failure, workers compensation and litigation costs. Costs of failure is the fundamental measure of operational risk. Components of Operational Risk: Before we can measure operational risk, we must first identify its primary components, which are (1) equipment risk, (2) product risk, and (3) people risk. The risk contributors interacts with each other in both direct and indirect pathways. Every plant has unique factors that compose its specific risk components. Operational risk measurement begins with data gathering and summarizing. The data for this process are normally collected during plant operations. Here is an overview of the steps involved: 1. Look at the frequency and costs attributable to equipment failures. This involves gathering the numbers that tell you how money left the company to pay for costs incurred as a result of equipment failures and how often. Costs will include equipment replacement, purchase of parts, and both company and contract labour fees. These expenses should be accrued over a fixed time period, which is generally one year. Gather information about the frequency and costs incurred because of production failures. This actually means summarizing information about how much money did not come into the company because of production failures and how often these losses of income occurred. RISK MANAGEMENT IN BANK GUARANTEES Broadly, risk is the volatility of potential outcomes. For banks, engaged in the business of managing risk, that means the volatility of future income. But by estimating the likelihood of risk, banks have a better change or making sensible decisions. Those who best define, anticipate and manage risk will have a competitive advantage and should stand to profit. Banks, in the ordinary course of business are required to issue a variety of guarantees on behalf of the customers. Issuing guarantees is a non-fund based business and so long as the business continues to be non-fund based it is remunerative with no attendant risk. But it is very important to bear in mind the associate risk inherent in different types of guarantees as perforce may be required to fund borrowers activates. Bank guarantees may be classified according to the period, as short term and deferred payment guarantees; short term may extend even upto 3 years. They may also be classified according to purpose as performance and financial guarantees.

2.

(iii)

Short term guarantees, could either be performance or financial performance guarantees assure the beneficiary that the customer will perform a contract in accordance with the terms. Financial guarantees relate to the payment of certain sum of money advanced by the beneficiary to the customer, i.e., guarantees covering advance payments under a contract. The degree and nature of risks inherent in different types of guarantees are given in the following TABLE:

Types of Guarantees

Degrees & nature of risk

Performance guarantees

HIGH RISK Performance over a period of time Likely to be affected by cost overruns. Uncertainties due to market condition.

Financial guarantees (Guarantees for advance payments )

HIGH RISK May result in indirect funding of un derlying contract. It is generally followed by performance guarantee.

Guarantees of release of retention money/ delivery of goods. Guarantees for supply of Material on credit Deferred Payment Guarantee

LOW RISK Liability may crystallize only when, There is a serious irregularity of dishonesty on the part of the client.

To be treated as part of funded working Capital facility and appropriate security to be obtained.

To be treated on par with/part of term loans.

Projects to be appraised fully and debt service coverage ratios should be found adequate for meeting installment payments. Misc. Guarantees Risk depends on specific purpose and nature of underlying contracts.

No guarantee should be issued without fully appreciating the underlying contractual obligations.

RISK MANAGEMENT:- In order to contain risk in bank guarantees, the following aspects should be taken into consideration: i. Customer: Verification of antecedents of customers in terms of integrity, experience and capacity to perform a contract is crucial. As a matter of rule, the guarantees should not be issued to strangers or to customers who do not have credit facilities. In case of customers maintaining only current account, it should be ensured that they do not enjoy credit facilities with any other bank before acceding to their request. In case of good business opportunity, such request from the client who have credit facilities elsewhere may be considered only with prior permission from competent authorities in corporate/ Head Office. ii. Security: While security is an important consideration for issue of guarantee, it should be appreciated that the degree of underlying risk does not vary with the quality of security. The best security remains to be an ability of the customer to discharge obligation under the guarantee promptly. To this extent, security is not a substitute for credit judgment. Security is to be negotiated with reference to specific cases. General principles may be stated as under: a. In cases of all corporate clients, charge on current assets should be extended to cover the guarantee facilities too.

b. As a rule, all deferred guarantees or all guarantees for suppliers credit should be secured by the underlying assets i.e., mortgage of fixed assets or hypothecation of current assets in the same manner as security for a term loan/working capital facility is obtained. RISK RIDDEN GUARANTEES:generally avoid. These are: There are certain guarantees which banks should

a. b.

For unlimited amount or for long period. In respect of contracts which are likely to lead to dispute about their actual performance.

c. d. e. f. g. h.

Which are anomalous in their nature and content and create unknown and undefined responsibilities and liabilities to the bank. Which are transferable and assignable by the beneficiaries On account of payment of income-tax. Which may restrict the rights of the bank to pay the amount guaranteed. Of an unusual natural or with onerous clause For amount exceeding prudential norms.

GURANTEES AND THIR RISK WEIGHT:- Balance-sheet assets, non-funded items and other off-balance sheet exposures are assigned weights according to the prescribed risk weights. Banks are required to maintain minimum unimpaired capital funds of 8% on the aggregate risk weighted assets on an ongoing basis. Non-funded items such as bank guarantees are first multiplied by Credit Conversion Factor (CCF) and the derived value is thereafter multiplied by the weights attributable to the relevant funded risk assets. In the case of financial guarantees, the CCF is 100% and for performance guarantees 50%. Depending upon, whether these bank guarantees are counter-guaranteed by Government etc., relevant risk weights (0-100) of funded assets are applied. In order to meet the capital adequacy norm, the following points should be kept in mind while entertaining guarantee business. Whenever possible endeavor should be made to obtain: a. b. Government guarantees/counter guarantees so that the advance will attract zero risk weight and Higher cash margin/deposits so that the amount can be netted off before applying the risk weight. Banks must embrace risk if they are to make profits.

So the hazards of errors and omissions are always present. But with better risk management banks can take risks consciously, plan for the consequence and can make the mistakes less costly. (iv) FOREX OPERATIONS AND RISK MANAGEMENT Forex Market in India:- The forex market in India is developed principally to facilitate forex services to the customers. The RBI has allowed 96 banks(Ads) to deal in forex, to trade among themselves in foreign currencies directly or through forex brokers. The market operates from major centers viz., Mumbai, Calcutta, Delhi, Chennai, Bangalore and Kochi. Besides banks, financial institutions such as IFCI, IDBI, ICICI, etc., have also been given licenses to undertake forex business incidental to their main business activities. The forex market trades in spot and forward exchange contracts in USD/ Rupee and cross currencies. The turnover is estimated to be around USD 3BN per day. The Indian forex market is a skewed one with around 30 percent of merchant business emanating form SBI and foreign banks account for 55 percent turnover of interbank transactions. Business turnover has been showing an increasing trend over the years. The interbank segment of the forex market is the biggest one in India as its is elsewhere. The arbitrage opportunities arise, within the constraints of given regulations between call money markets and the foreign exchange markets. Also often, a demand arises for forward dollar from banks who are rolling over the FCNR deposits. In India the link between call money rate and not to have a proper rupee yield curve and a very dep and liquid money market and whatever may be the form, its lack of integration with the forex markets. RISKS IN FOREX In view of the volume, volatility in currencies, market structure, liberalization in trade and exchange control, integration of the Indian forex market to global market, sophistication of mechanism and skill to handle dealing operations, we are to remember that a risk does not vanish one just prefers to ignore it. It is better to face, quantify and manage risk exposure. Forex business, however, places risks; the management of which requires understanding and appreciation of controls separate from those applicable to domestic operations. As these risks arise as a consequence of certain unique features forex business has given birth to various aspects: Operations are transnational-obviously subject to controls restrictions, monetary and fiscal policies. Involve dealing in currencies whose value is volatile due to a variety of factors Operations are integrated with a vast global market spread in all time zones.

Quick decentralized decision taking involving large values without losing sight of the main theme of profit earnings at acceptable risk levels Requirement of compliance with exchange control in India

It is pertinent to note that forex trading by the authorized dealers is not seen freely as a source of foreign exchange innings. RBI restrictions also exist on dealings in overseas markets. It is neither desirable nor even possible to totally restrict access to overseas markets to cover merchant transactions. The RBI has evolved a set of guidelines are in no way unique to banks in India. While the RBI has, through its circulars and inspections, endeavoured to ensure compliance with these guidelines. It is imperative that the banks appreciate and understand the purpose behind the control and observe them truly as internal controls rather than transform them into Reserve Bank requirements. The risk in forex business can be broadly classified as: Position or Rate Risk: There are inherent risks involved in forex business. Dealings in forex involves acquisition of assets and liabilities denominated in foreign currencies whose values against the domestic currency change, the bank is exposed to a rate risk. A total quantitative match between assets and liabilities denominated in one currency is normally not practicable because of the following facts Merchant sales and purchases are not likely to match and the consequent cover in the market may not be immediately taken up. Market participants deal in standard lots and it may not be worthwhile going for cover of small amounts. Transactions entered into by the branches effect the exchange position but may come to the notice of the dealing room later. Open positions may be built up and held deliberately to the advantage of prospective rate movements. Control over position risk generally is through currency wise limit on the size of the exposure (i.e., the mismatch between assets and liabilities in that currency). The limit would generally be fixed on the following considerations:

Exposure Limits

++ Volume of business ++ Branches network being covered ++ Volatility of rate movement

++ Loss bearing capacity of the bank While no empirical relationship is fixed, it is obvious that the first two deal with merchant generated exposure while the last two deal with the potential loss on exposure and the banks ability to bear it. Separate limits are generally fixed for the exposure during the trading hours- the DAYLIGHT LIMIT and the exposure left at the closure of the day the OVVERNIGHT LIMIT. The overnight limit should necessarily be smaller, since the exposure allowed is prone to a greater risk as it remains unattended till the next trading day. RBI has permitted individual banks to have an open position at the close of the day subject to a maximum of Rs. 15 crores. With the implementation of the Sodhani Committee, it is to be decided by the banks individually. Consequently overnight limits should be conservatively set. While fixing the overnight limit it is advisable to consider the impact of small value transactions though individually small cold collectively direct the closing position of the bank. It is hence suggested that banks periodically estimate the volume of such small value transactions and their impact on the exchange position. This would not only enable banks to review the limits set for he branches to report transactions by telex/fax/phone but also given the dealer an indication of the extent of possible distortion so that the overnight exposure could be so managed to offset such distortion. Daylight limit should allow for greater exposure since the bank can monitor its exposure constantly and undertake market operations to maximize its returns on the exchange position. Generally the exposure limit is fixed currency wise. Banks also fix an overall exposure limit expressed in terms of a single currency, say us in Indian perspectives. This limit functions as an override to ensure that the exposure is lower than the sum of all the currency wise limits when cross currency positions are built, arguments are often advanced, that in monitoring limits complementary position should be measured as an exposure only in currency, since the correction of the position in the currency automatically squares the complementary position. While there is substance in the argument, it is preferable for easy monitoring, to have individual currency exposure measured and limited. Complementary positions can be identified and used to substantiate any excess in the position beyond the limits. After all limits are not absolute bans on their transgression but are only meant to identify such transgression for supervisory scrutiny. CUT LOSS LIMIT The limit serves to restrict the quantum of loss a bank is willing to risk on its open position during the day. The limit operates within the exposure limit, i.e., the daylight limit, and is a function of the exposure of the exposure size as also the extent to which rates have moved adversely. The moment the rates moves adversely to translate into a loss equivalent to the limit, the position has to be liquidated and the loss booked. This serves to avoid holding on to a position in anticipation of reversal of movement of rates. While the quantum of loss should be explicit, for easy monitoring it is better to translate is into the number of points on the exchange rate before an adverse movement can be accepted. When so translating it, it is also essential to relate is to the size of the exposure. For instance, if a permissible amount of loss translates to a 50 points movement on the rate on a position of USD 1 million

the cut loss should operate when 25 point movement affects a position of USD 2 million. Banks generally have the practice of consolidating the balance in the different position accounts and tallying the net position with the closing position of the dealer. This is an operational procedure to ensure no transaction has been omitted either by the dealer or the accounting section. An attempt is also sometimes made to convert this operation in all the accounts and of all currencies into a single exposure against the local currency. This does not serve any purpose as an exposure control device and only is an expression of the banks exposure to the home currency. CHAPTER III BANK RISK MANAGEMENT A RISK PRICING MODEL Risk is inherent and absolutely unavoidable in banking. Risk is the potential loss an asset or portfolio is likely to suffer due to a variety of reasons. As a financial intermediary, bank assumes or restructures risks for its clients. A simple example for this would be acceptance of deposits. A bank while operating on behalf of the customers as well as on its own behalf or the customers as well as on its own behalf, has to face various types of risks in identifying, assessing and minimizing these risks, Ina competitive market environment, a banks rate of return will be greatly influenced by its risk management skills. An attempt us mode in his article to have an overview of Bank risk management and to suggest a model for pricing the products is based on credit risk assessment of the borrower. RISKS IN BANKING Risks in banking are many. These risks can be broadly classified into three categories. They are (i) (ii) (iii) Balance sheets risks Transaction Risks, and Operating and Liquidity risks

The balance sheet risks generally arise out of the mismatch between the currency, maturity and interest rate structure of assets and liabilities resulting in

(1) (2) (3)

Interest Rate mismatch risk Liquidity Risk and Foreign Exchange Risk

The Transaction Risks essentially involves two types of risks

They are (i) (ii) (a) CREDIT RISK which is the risk of loss lending investment, etc., due to counter party default. PRICE RISKS which include the risks of loss due to change in value of Assets and Liabilities. The factors contributing to price risks are: Market liquidity Risk: This is the risk of lack of liquidity of an instrument or asset or the loss one is likely in incur while liquidating the assets in the market due to the fluctuations in prices. Issuer Risk: The financial strength and standing of the institution/sovereign that has issued the instrument can affect its price as well as reliability. The risk involved with the instruments issued by corporate bodies would be an ideal example in this context. Instrument Risk: The nature of instrument creates risks for the investor. With many hybrid instruments in the market, and with fluctuations in market conditions, the prices of various instruments may react differently from one another Changes in commodity prices, interest rates and exchange rate may affect the realizable value of yield of many assets when transactions take place.

(b)

(c)

(d)

THE OPERATING AND LIQUIDITY RISK encompasses two types of risks viz. (1) (2) Risk of loss due to technical failure to execute or settle a transaction and Risk of loss due to adverse changes in the cash flows of transactions

RISK MANAGEMENT: OBJECTIVES The objectives of risk management for any organization can be summarized as under: (a) (b) (c) (d) (e) (f) (g) Survival of the organization Efficiency in operations Identifying and achieving acceptable levels of worry Earnings stability Uniterrupted operations Continued growth and Preservation of reputations.

RISK MANAGEMENT: COMPONENTS Risk management may be defined as the process of identifying and controlling risk. It is also described at times as the responsibility of the management to identify, measure, monitor and control various items of risks associated with the banks position and transactions. The process of risk management has three clearly identifiable steps, viz. Risk identification, Risk measurement and Risk Control. (A) Risk Identification Risk identification, in the banking context, consists of naming and defining each of the risks associated with a transaction or a type of bank product or service. Risk identification can be stated as an art of combining intuition with such formal information gathering tools such as check lists, reports, personal inspections and interviews to locate the risk associated with a product or position. In the case of banks of very small size, a formal risk identification machinery may not be essential. However, in the case of big banks with long chain of communication, a formal risk identification system of constituting Risk Management Committee Composing of senior officials of the bank to manage risks in the key areas of their operations. The risk management committee define risk as a probable loss to the organization in terms of quantum of money or as percentage of institutional assets. Potential risk scenario is also measured in terms of maximum possible loss or maximum probable loss, there by attempting to quantify the risk. A proper risk identification network is necessary and the process must be an ongoing one to ensure that a risk is discovered before it develops into a loss. Adequate information regarding risk offers the possibility of identifying pools of risk within the institution. Pools of Risk is a concept originated by Ed Williams and is defined as a series of transactions that have common risk characteristics. An example of pool of risk is funding risk and interest risk which affect the loan and investment port folios of an institution (B) RISK MEASUREMENT The second step in risk management process is the risk measurement of risk assessment. Risk assessment is the insemination of the size probability and timing of a potential loss under various scenarios. This is the most difficult step in the risk management process and the methods, degree of sophistication and costs can vary greatly. The potential loss is generally defined in terms of FREQUENCY and SEVERITY. Here FREQUENCY can be further divided into four broad divisions of probability, vis, none or almost nil, slight, moderate and definite. Severity is measured in three categories, vis. Slight substantial and severe. This can be diagrammatically shown as under: These classifications could be helpful in assessing the ranges of loss of various portfolios

Asset- Liability management is a good example of risk measurement, Asset-Liability analysis can provide an estimate of the potential effect of an assumed change in interest rates on the income from or value of a portfolio. By analyzing a variety of scenarios, one can develop an appreciation for the degree of risk inherent in the portfolio. While many risk management instruments are available for certain risks such risks in foreign exchange transactions, interest rate risks, etc. (e.g. Futures, Options, Swaps ) designing instruments for managing risks associated with credit portfolio is a Herculean task due to the complexity of this portfolio. However, credit portfolio being the major asset portfolio of the bank, identification and measurement of risks associated with large corporate borrowers becomes essential. Two broad factors which can affect the performance of a portfolio involving large borrowers will be the industry related volatility and the company related volatility in their operations. Industry related volatility is to be assessed on he basis of characteristics of the industry such as variability of cash flow and sales growth as well as the levels of leverage in the industry. On the other hand. Company related volatility is based on such characteristics as years in business, years with current management/ownership growth rate and consistency in companys performance, etc. Other factors such as deviation from industrial financial norms and strategies and policies also determine company related volatility. While both the items should be seen together efforts should be made to reduce the risks associated with company related volatility by evaluating the risks related to the borrowers operations. BORROWER ANALYSIS FOR RISK ASSESSMENT Borrowers risk analysis is the most important part of analyzing risk in lending. To identify the risk in credit, the lender needs to understand the risk inherent in borrowers business. Credit risk has functional relationships with various risks associated with a borrower and it can be expressed as below: CREDIT RISK (CR) = f (BR, FR, DR, CBR, FR) Where, BR is Business Risk FR is Financial Risk DR is Default Risk CBR is Cost Base Risk and FR is Fiduciary Risk A brief account of each of these risks is given below: (A) BUSINESS RISK involves

(a) (b) (c) (d) (e) (B) (C) (D)

Critical input risk (e.g. Raw Material Supply) Operational risk (e.g. Coordination of various organizational functions) Production Process Risk (e.g. Lack of coordination of Technical Factors) Marketing and Selling Risk (e.g. Fluctuation in the market) Labour Risk (e.g. Labour unrest/disputes, etc)

FINANCIAL RISK- is the risk relating to financial performance of the borrower, viz, profitability, liquidity and solvency. DEFAULT RISK- is the risk relating to the potential loss on the asset due to nonpayment of the dues by the borrower FIDUCIARY RISK- is the risk arising from contingent liabilities of the unit. Indicators of fiduciary risk could be the correlation between Fund bases and Nonfund based facilities and also the total borrowing (including non-fund based facilities) and its impact on capital structure. The above mentioned items of risk can be identified and measured only through proper appraisal and analysis. While Business Risks and Financial Risks can be identified and assessed through general appraisal with special reference to technical and financial aspects, special in depth analysis may be required (such as sensitivity analysis, turnover ratio analysis etc) to assess the cost base risk. Acquisition of collateral may cover. Default Risk and Fiduciary Risk to a great extent. However, all these will depend on the depth and accuracy of the borrower analysis done by the banker. Certain dimensions of the borrower analysis required could be as under: (1) (2) (3) (4) Evaluation of Management Industry Strategic Risk Assessment and Operational Risk Assessment

The components of the above items can be diagrammatically represented as given below: The borrower analysis will enable the bank to assess the risks BORROWER RISK ANALYSIS Evaluation of Industry Risk Strategic Operational

Management

Assessment

Risk Assessment

Risk AssessMent

Qualifications

Historical Attraciveness

Competitive advantages market policies

Sourcing Risk

Planning Skills Management Information System

Key Drives

Production Distribution risk Sales Risk

Major changes etc Operational strategies Corporate Positioning Etc.,

And develop strategic initiatives for risk control RISK CONTROL After identification and assessment for risk factors, the next step involved is risk control. The major alternatives available in risk control are: (i) (ii) (iii) (iv) (v) Avoid the exposure Reduce the impact by reducing frequency or severity Avoid concentration in risky area Transfer the risk to another party Employ risk management instruments to cover the risks

Avoidance of the exposure will mean the withdrawal from transactions/business, which is highly risky from the banks point of view. However this would be a difficult proposition for any bank since banking business is risky in nature. Reducing frequency and severity will involve reduction in the number of cases where exposure is involved and also obtaining collateral or cove to reduce the impact of risk if something happens. Financial instruments are available for risk management and the same may be deployed to obtain cover wherever possible. One of the major strategies of risk control is to avoid Risk Concentration or Pools of risk in the institutions Asset or Liability portfolio. One of the options in these contexts assesses what is termed as Loan Loss Estimation. This refers to the assessment of probabilities of various levels of losses that may occur in loan portfolio

and provides an important basis for understanding individual loan risk and portfolio concentration risk. Loan loss stems from the value depletion from such credit loss events such as default., bankruptcy or restructuring of the counter party. The loss estimation, therefore, involves the assessment of the difference between the value of assets if it is treated as default free and the estimated value presuming a loss. RISK RELATED PRICING OR PRODUCTS Functioning in a risk scenario, it is essential for banks to appropriately price their products to ensure that the borrower bears the cost of the risk the bank is taking by financing him. Therefore, it is imperative that every institution should establish the mechanism of pricing loans. If a loan can improve portfolio diversification, i.e, decrease overall risk, it should be priced at a lower contract rate. On the other hand, the rates offered to the borrower could be proportionately increased in view of the risk perception and the higher risk assessment mode about him. This will necessitate a system for categorizing borrowers under various risk groups so that clients belonging to higher risk groups can be charged higher rates. A possible model for risk categorization could involve identification of various risks and assessing whether they exist in a particular proposal. For this, the types of risks could be listed vertically and they may be classified horizontally under the following categories and assigned weight age to each of the categories in a scale of 0 15 (1) N/A - If the risk is not pertinent or is negligible in probability and value. This category may be assigned 0 (Zero) weightage/marks (2) L (3) M If the magnitude of the potential loss is low or the probability of loss due to this risk is very small If the magnitude of the potential loss is medium/ probability of loss due to this risk is medium. This category may be assigned a weightage/marks of 10 (Ten) If the magnitude of the potential loss is very high probability of loss due to this risk is high. This category may be assigned a weightage/marks of 15 (Fifteen)

(4) H

A borrower may be classified under this system and the total score may be worked out. For example, if X company is analyzed under business risk, Financial Risk, Default Risk, Cost Base Risk and Fiduciary Risk it may look as:

X COMPANY LTD. This score may be as Risk Index of the borrower presuming that only five risk factors are to be analysed, this model can have a highest score of 75 (i.e, all H) and lowest of 0 (Zero is all N/A). This will help to create a scale for categorizing the

borrower under various-risk groups to enable the lender to price the produce offered to them accordingly. A scale for risk categorization could be as: RISK CATEGORY 1 2 3 4 5 RISK INDEX RANGE 0 15 16 30 31 45 46 60 61 75 (PROPOSED PRICING) (Prime) (Prime + X) (Prime + X1) (Prime + X2) (Prime + X3)

Once the borrowers are categorized based on their Risk Index, the bank can price the product offered to them accordingly. For example, a borrower in Category 1 could be financed at prime lending rate whereas from category two onwards, it will be prime +X, Prime +X1, Prime+X2 and Prime +X3, where X, X1, X2 and X3 denotes the additional price charged on the borrower for being in higher risk category, in the ascending order (as shown in the chart above). The value of X, X1, X2 and X3 could be even adjusted according to the exposure proposed for the borrower, i.e., higher quantum of loan or lower. A typical risk related pricing chart based on Risk Index categorization mentioned above could appear as:

PRICING MODEL BASED ON RISK RATING

Exposure 25 6 10 11 25 26 50 51 100 Above 100 Risk Category Risk Pricing 1 PRIME PRIME PRIME PRIME PRIME PRIME 2 PRIME + 1 PRIME + PRIME + PRIME + PRIME + PRIME 3 4 5

The above model is only illustrative. It presumes that the bank chooses to vary interest rates of even 0.25% from borrower to borrower in a highly competitive market. Further, it is also presumed that the bank is ready to give larger quantum of advances of lower rates since such advances will be given only to reputed clients and income earned is proportionately high. While financing large borrowers it is presumed that bank will be obtaining adequate collateral to cover the potential loss if any. These presumptions are hypothetical in nature and will not hold good for all institutions. Each institution while categorizing borrowers and also while designing the pricing model it would like to adopt, should first identify and list out the premises under which it will be done taking into account organizational strengths and weaknesses positioning in the market, competitive etc. For example one institution would like to have a range of 1- 4 for X, X1, X2 and X3 while another would like to have a range of 2-8. This would be purely a policy decision taken by the institution for pricing their products.

Good risk management is good banking. And good banking is essential for profitable survival of the institution. A professional approach to identification, measurement and control of risk will safeguard the interests of the banking institution in the long run.

CHAPTER IV TRENDS IN RISK MANAGEMENT IN BANKS The concept of risk management as it is universally understood has so far remained somewhat alien to the Indian financial sector comprising both commercial banks and the development banking institutions. It is not that the basic concept of risk management are not familiar to the financial community in India. The deficiency relates mainly to real life applications of risk management techniques in the banking institutions. One need not have to struggle much to find out the main reason why even the elementary risk management practices have not been integrated into the functioning of the banks. Excessive state intervention in all aspects of the banks functioning has led to total neglect of risk management strategies With the taking over of the then imperial Bank by the Reserve Bank of India and using it as an important agent of economic change, especially for the development of the so called priority sectors, the banking industry of the country entered a new era. Thereafter many major banks were nationalized in two installments and with that well over 95% of the India Banking sector came under public sector ownership. Public sector ownership has no doubt brought about significant improvements in the services provided by the banks, both in their geographical spread as also the range of facilities. But in the process it also led to sharp neglect of the profitability considerations among banks. A feeling developed among the banking personnel that both risk management and profitability were more of frills which the banks could sacrifice for meeting their lending targets to different sections of industry and category of borrowers. Social banking became the overriding goal. Until 1991, before the launch of the real economic liberalization polices in the country, the banking policy of the country was primarily influenced by the economic planning strategy as adopted under the various five years plans. Although the process of economic planning itself got significantly diluted over time, especially during the 1980s, the banking policy as framed by the RBI did not reflect corresponding changes at the same speed. During the current decade many more significant changes have taken place. Government has almost abolished industrial licensing. Both the central and the state governments are slowly withdrawing from many industrial and infrastructure activities.

The process of policy liberalization as incorporated in various directives or guidelines issued by RBI during the 1980s did not reflect the same degree of Lack of faith in the process of economic planning as formulated by the Planning Commission or implementation of planned projects by the state and central governments

Since the beginning of this decade, however, the process of policy liberalization initiated by RBI gathered momentum. The SLR levels have been brought down significantly. The CRR has also been reduced but not to the same extent as reduction in the SLR level. The CAS system which has taken away the powers of credit sanction from the banks has been totally withdrawn by RBI. Almost the entire range of detailed controls on lending and deposit rates; have been discontinued. Branch licensing by RBI has also been given up. Thus in most of the operational area the regulatory controls have been diluted substantially. Now the banks will have to take charge of the major area of risk management. Banks can no longer on the buck and argue that they do not have the operational free dom that impinges on their risk management activities. For example, when the banks had to lend as per the details interest rates prescribed by RBI for all their lending as also adopt deposit rates for various maturities of deposits they could hardly do anything to protect themselves against the risks arising from asset liability mismatches. Similarly, when detailed guidelines were issued to the banks in regard to their advances to priority sectors like agriculture, small scale industry, small road transport operators, exports etch, the banks did not have the required degree of freedom to protect themselves from the credit risks as they were obliged to meet the credit targets irrespective of the attendant risks. It is not that the priority sector guidelines have now been significantly modified. But, with the lowering of the SLR and CRR the amount of loan able funds that banks have to deploy to other areas are proportionately more and the banks have now to give much greater of attention to containing credit risks. Another major paradigm shift affecting the banks is the guidelines issued by RBI in regard to income recognition, asset classification and provisioning. These guidelines have forced banks to be more careful in regard to their lending activities. Now banks have to worry much more than in the past about the health of their balance sheets because of these income recognition and provisioning guidelines. The high level of comfort they enjoyed in the past by adopting an accrual accounting policy for income recognition has been snatched away from them. New Risk Management Paradigm It needs to be noted that the habit of even unconsciously adopting risk management policies and strategies among and banking personnel needs to be systematically encouraged and developed. This has to be done at the Board level as also at all management levels of these entities. Risk management has also to become a conscious policy objective at the regulators level. A major outcome of the discussions of the BIS committee on Banking Supervision at Basle in September 1997 has been a set of core principles of banking supervision which all the central banking institutions are expected to adopt vis--vis the institutions they regulate. Thus risk management is as much a responsibility of the institutions who are the direct beneficiaries of its implementation as also the regulatory bodies of the respective countries. The responsibility of the regulatory authorities in a country like India is particularly crucial when it comes to adoption of risk management by banks and institutions. The long post-Independence history of the country has been characterized by a paternalistic regulatory regime, the planned economy concept has dominated every field of economic

activity including the financial sector. Under a system of centralized planning the regulated entities over time lost initiatives even internal management including risk management. The regulatory supervision of banks in Indian has been so much detailed that banks have, over time, lost considerable degree of initiative and proactive approach. Hence, during the next several years RBI will have to integrate into its over all regulatory and supervisory frame work the risk management policies and practices that the regulated entities need to internalize. RBI needs to accord top priority to persuading banks and institutions to adopt the basic risk management strategies in all their operational areas. It is only when the banks and institutions realize that RBI accords very high priority to risk management they will adopt the appropriate risk management practices enthusiastically. Unpreparedness of Indian Banks: The whole area of risk management has been neglected by the Indian banking system for too long. Traditionally, the risk management in Indian has often been equated with proper house keeping and protecting the institution from the risks arising out of possible employees infidelity. For long the emphasis of banks was on recruiting staff that is literate as defined by educational qualification (irrespective of the subject of study at the college or university level) and honest (as assessed by the family background and/or the absence of known negative personal fidelity traits). Many of the internal controls that have been developed over time are not sufficiently tight to prevent possible frauds or falsification of accounts due to employee infidelity. It is for this reason that the menacingly growing and unresolved problems like the unreconciled inter-branch accounts have not been taken up seriously. Cases like lending to non-existent assets or borrowers do come to light. The banking institutions have not taken risk management as a serious proposition all these years. Some of the newly set up banks are giving great deal of serious attention to this area. But one gets an impression that they are also yet to take this area with the required degree of seriousness. They enjoy, however, several initial advantages as hey have laid great deal of emphasis on information of technology. Most of them have networked their branches with the head office. The older banks have just started automating their operations and some of them have started networking at least their major offices. Automation together with intensive application of information technology in all business area got delayed in the Indian banks for long because of the opposition from labour unions. Unfortunately, the application of information technology in banks was not projected properly as a management tool and for significantly improving the information base of the banks. It got misunderstood by the bank unions as labour saving tool. Some agreements have been reached recently with staff unions in this area but the banks do not appear to be approaching this area with well conceived detailed planning. Many bank managements are shy of even seeking the right of type of advice from professional consultants. The new banks that are being set up are giving full attention to these aspects. Right from the beginning they are laying emphasis on required degree of automation through computerization and effective means of communication among the branches. Even in a country like the US which has achieved a very high level of computerization in banks, banks spend every year on an average $20 billion on automation and computerization.

The new banks in India are scoring in one more way over the other banks. They offer attractive compensation packages to their staff depending on the relative scarcity of skills in the market. They are therefore able to steal good and competent staff from other banks. The existing nationalized banks which are not offering attractive compensation packages and are also denying job-satisfaction-cum-rightful-promotional opportunities to their competent staff. But, all along Indian banks have totally neglected this area. The neglect is an outcome of two illusions. Firstly, we do not recognize that banking is a specialized type of activity. Since banks have to handle large amount of other peoples money and earn profits they should know how to assess credit risks and how to keep accounts. But the people which banks recruit for these jobs often do not know both. There is a mistaken belief that universal franchise bestows fundamental right to all citizens at some appropriate chronological age to get jobs in banks irrespective of the type of their education. In the process, a management graduate or a chartered accountant is though to be as good as a student of Sanskrit or pali so long as he has memorized some general knowledge questions and answers from some trash book or magazine. Even after such a gross neglect at the recruitment level, no attempt is made to give the new appointees requisite training due to universal inadequacies of training facilities in the banking industry. After the introduction of the Tandon Committee norms in banks Mr. Tandon found to his horror that most of his staff did not know how to read a balance sheet. Not that things have improved significantly in this area. But we still refuse to recognize that just as a doctor is needed to treat patients are an engineer is needed to construct a bridge, banks also need people trained in some relevant disciplines. The second illusion under which we suffer is that all bank staff have the fundamental right to handle all types of operations so that they can eventually rise to the post of an ED if not Chairman. There is no recognition of the fact that different jobs in banks require certain expertise often gained through on-the-job training. A person handling foreign exchange in say New York office is mercilessly transferred to a rural branch after he or she completes some given number of years at that particular desk. Such an approach to handling valuable human resources is again influenced efficiency. Promotional activities of banks should not be interpreted merely in terms of creating promotional avenues for all staff. Moreover, there is nothing basically wrong if a senior executive cannot understand all the intricacies of the jobs his subordinates are handling. We should always try to distinguish between general management and technical job specifications. The banks which continue to suffer under these two illusions would face a rapid decline in a competitive situation. Appropriate education skills at the recruitment stage and job specialization through learning by- doing or long training at the relevant desks should be given due importance in the banks that are eager to keep their heads above water.

Organization specific strategy.

No two institutions are alike when it comes to devising business risk management strategies. Despite the fact that most of the nationalized banks were guided by the same business goals and the guidelines issued either by the RBI or the GOI all of them do not seem to be alike. The composition of business is not the same as they carry separate historical legacies which of course over time have got substantially changed. Part of the reason why their business mix differs is the geographical area specially covered by them as part of this historical legacy. Equally interestingly, a major feature which often distinguishes one nationalized bank from the other is the staff culture and the detailed work practices. The differing work cultures have a great deal to do with the background of the original promoters and the geographical area from which they recruited bulk of their senior staff during the prenationalization years. Over time banks have also shown specialization in financing certain types of industrial/economic activities. Some of them have shown particular preference to specialize in foreign exchange areas or funds movement across the country as profit centers the new banks including those in the private sector have invested significantly in high technology especially for retail banking. They have introduced the concept of anywhere baking and some of them have tried to get their names associated with certain types of products and services. Many banks are now realizing that instead of providing all types of products or services it would be more advantageous to focus on a limited number of them, both from the point of building a niche for themselves as also from the risk management perspective. Emphasis on specialization and offering of core set of services will lead to building of appropriate information systems effective database that help to analyse performance as also devise proper business strategies. Many banks are preparing themselves to adopt this new approach but are yet to start seriously redesigning their organizational set up and staff recruitment. The nationalized banks in particular suffer from a severe handicap as they do not have sufficient freedom in recruitment of quality staff. Another equally serious handicap is the remuneration levels in the nationalized banking sector. The staff compensation levels being very much out of alignment of the market realities they are not able to attract good talent at the base levels of recruitment. The new banks are posing another difficulty to the older banks as they are able to wean away the highly experienced quality staff particularly from the nationalized banks. This may not have significant negative impact on banks like the SBI but it does pose a serious problem to most of the nationalized banks which have not adopted highly effective officer level recruitment policies as the SBI. Board & Senior Management Oversight While the importance of risk management is being increasingly recognized all round especially because of the growing level uncertainly and market volatility it is not being very seriously implemented in all its aspects by most of the banking institutions in India. As already noted above, the main reason for this has been the tight regulatory regime within which the banks had to work. Given the importance of risk management for protecting profitability of the banking institutions in an increasingly deregulated environment RBI may have to urge the banks to take this activity seriously: With active involvement of RBI, the risk management function will get due attention of the top management of the banks including their board of directions. Even otherwise, it is

desirable and senior management is absolutely essential if risk management is to be effectively adoptee by any enterprise. Since the board of director is responsible for deciding business strategy it is desirable that this authority also bears the ultimate responsibility for defining the nature and level of risk to be borne by the bank. The board should be periodically reviewing overall business in the light of the risks associated with the business strategy and provide unambiguous guidelines regarding the levels or risks in different business activities that will be acceptable to the bank. In this context it should be admitted that all the members of the board may not be in a position to fathom the complexities involved in the measurement of risk levels since often mathematical models are used in such exercises. It may often be that the senior management is in a much better position to understand the complexities of risk assessment exercises. It should therefore be the responsibility of the senior management of explain to the members of the board in simpler terms the nuances of risk management and their impact on viability of the bank. Given the composition of boards of most of the banks in India the risk management strategy will have to be primarily defined by the senior managements themselves. Once detailed risk management policies and procedures are defined it would be desirable that the lines of authority are also clearly spelt out. Appropriate limits on risk taking should be defined for different levels either to individual officers or committees. It is also desirable that adequate systems and standards of measuring risks are clearly laid down and along with that effective internal control and review procedure are also defined. Whenever new products are considered for introduction there should be through review of their complexities and associated risks. When the new products are introduced the bank should also simultaneously have in place the risk containment measure and all the required internal controls. The risks containment policies should be implemented on a consolidated basis by any banking institution including its subsidiaries. The risks faced by the parent as also its subsidiaries should be calculated on a gross and not on net basis. The surpluses in one unit should not be set off against the deficits of other units if they are separate legal entities. Risk adjusted rate of return Many banks are aware of ROR but often do not know how to quantity it. They are tempted to regard difference between the return and average funding cost to be the profit margin. The return has to be adjusted for the various types of risks associated with the lending/investments. There are basically three types of risks, viz. market risk, credit risk and operational risk. Each types of these risks can be further subdivided into specific risk areas. Market risk may arise because of movements in prices of commodities, currencies or equities. In respect of tradable assets credit risk is composed basically of counter party risk or issuer risk. Quantifying the impact of risks is not easy task as absolutely reliable methodology does not exist. Risk measurement is as much of an art as a science. Some types of risks could be quantified relatively more accurately then others. In so far as market risk is concerned certain techniques have been developed that help to quantity more reliably almost 90% of the total risk. In regard to credit risk about 30% to 40% of the risk could be quantifies. However in so far as the operational risk is concerned it is more of an art than science.

The principle of profit maximization tells us that marginal risk adjusted rates of return from different business activities should be equalized. In real life situations, a clear cut application of this profit maximization principle has to be based more or less on intuitive sense since risk adjusted rates of return from different types of business activities have to be arrived at in a rough and ready manner. All the same, judgement on this aspect should not be left free to the discretion of the operating wide common approach for risk management so that operational guidelines are well understood by all the concerned staff. The method of calculating risk adjusted rates of return should be uniform across the bank. There are various approaches for measuring levels of risks associated with different activities of a bank. The more reliable method is be often specific to particular activity. For example for measuring level or degree of risk of the trading portfolio generally the value at risk (VAR) technique is used. For loan portfolio other methods have to be deployed. Most of the time it has been noted that the standard statistical techniques are helpful in all risk management techniques. The way these techniques are actually used may not be the same across different banks or institutions. In any case it is desirable that a consistent methodology for measuring risks associated with different types of activities are employed in any institution. Similarly, a consistent methodology should be used for estimating and comparing risk/return trade-offs. In real life situations the risk of ensuring uniformity of approach in regard to risk/reward matrix becomes a difficult task. For this purpose an efficient and accurate internal management reporting system should be in firmly in place. The reporting system should be comprehensive and diaggregated enough so that meaning full management reviews become possible. Based on such periodic reviews conducted at much shorter intervals suitable corrective guidelines should be issued to the various operating levels. This would ensure better co-ordination of activities and control of risks. For having an effective feedback mechanism it is desirable that the groups or individuals involved with both measurement of risk and those monitoring the risks should be distinct for ensuring objective evaluation of the risk management practices. It is also necessary that those involved in the actual business decisions of say lending or market operations should not be directly involved either in detailed reviews or reporting on risk management strategies, policies and practices. Otherwise the bank would become of a victim of unsatisfactory working systems because of conflict of interests. In a way the problem is the same as when the bank has the same staff for both front office and back office functions dealing with tradable stock.

Asset Liability Mismatches It may be noted that for a banking institution the major sources of risk spring from the mismatches of different types of assets and liabilities. In so far so the banks in India are

concerned they face very high risks as they are not yet fully aware of their asset liability mismatches. When banks deploy their funds in various assets more often than not they are not aware of the pattern of their deposit maturities. Excessive fluctuations in the call money rates do provide us the proof that banks do not have the necessary information about the emerging cash surpluses and deficits. It is true that the sudden and sometimes massive intervention by RBI to mop up liquidity from the system leads to unexpected volatility in call money rates. Even if we exclude such situations it is often not possible to predict the unexpected movements in the call money rates prices of government securities. One of the contributing factor for such highly volatile movements in asset prices or call money rates in absence of information about the maturity pattern of deposits of the bank as a whole. Hence, when the banks lend to various category of borrowers they do not plan for loan maturities based on their liability patterns. It is high time that the banks make a beginning in collecting information about their prevailing asset and liability patterns at least once in a quarter. Since their major metropolitan branches account for significant proportion of the assets and liabilities banks should have information on these items at least on a monthly basis. Over time, the banks should gear up themselves to collect such information at least on a weekly basis if not daily. For this purpose the banks should link all branches with the head office or alternatively with regional offices which are linked with the head office on a real time basis They should build a sound communication network for linking all the branches with the head office and the regional offices. In this absence basic information on deposit maturity patterns banks will not a position to deploy funds in the most profitable way. Effective networking of branches and the regional offices is necessary for many other purposes. For years we are bemoaning about the massive backlog in inter-branch reconciliation of transactions. Such unrecognized amounts of the banking system in India were estimated at one stage to be far in excess of the deposit base of the banks. This is a highly unsatisfactory state of affairs. It is sometimes argued that the risk of loss crystallization may be relatively by the banks. But it is difficult to be dogmatic about it especially if we note the various types of frauds in banks that periodically come to light. The possible risks of loss should not be taken lightly especially in view of the fact that in some of the detected frauds employee complicity has come to light. It would therefore be unwise to treat the persistent problem of the huge unreconciled amounts as being purely an administrative back log of minor consequence. Another area which has not been taken seriously by the banks relates to the information base they are expected to create for proper credit appraisal of medium and larger sized loans. Many banks are getting into term loans to industry and infrastructure. In the past the banks used to participate in such loans in the consortium of term lending institutions. With the liberalization of guidelines of RBI and growing competition in the field of term lending banks are preferring to go alone. But they need to recognize that term lending is not the same thing as working capital loans. Term lending institutions have specialized staff (including engineers) in various disciplines and an internal expertise built over a ;long period of time. Banks also need to build similar expertise before they consider entering this area in a big way.

Regulatory environment As already noted, for banks to inculcate risk management practices the regulatory environment needs to be conducive. Banks should enjoy the required degree of freedom to protect themselves from the different types of risks. Banks may be able to control certain types of risks by entering into suitable transactions in the derivative market. The derivative products may relate to the foreign exchange market or the local dept market. But if banks do not have the freedom to enter into certain types of transactions because of regulatory constraints theres little they can do in the matter. The risks that the clients of banks carry on their books ultimately affect the banks. The clients how have foreign exchange looms are exposed to exchange risk. As they do not have free access to hedging facilities Indian banks also in the process carry the consequential risks. The secondary domestic debt market is yet to develop on sound lines. There is not adequate level of liquidity in most of the instruments. Hence the market prices of even the quoted instruments cannot be taken as reference points for risk management as one is not sure whether transactions can be executed at prices closer to their prevailing levels. The treasury bills futures market does not exist at the moment. Banks are also not free to enter into repo transactions in all debt instruments in their portfolio. Nor can they do enter into transactions with all the players who operate in the debt market today. Many difficulties debt. The problems related to stamp duties of different states as also tax related to the special purpose vehicle (SPV) needed for issuing securities debt instruments have prevented development of an active debt market. The money market is still not well developed in the country. As of today money market is synonymous with the call money market. No meaningful quotes are available for products with maturities beyond two days. The foreign exchange forward market is not linked to the money market as the two markets almost function independent of each other. An active term money market is yet to take off. Absence of database The risk management subject has developed phenomenally during the last two decades. It has attracted some of the best academic brains. Some of the contributors to the subject have been rewarded with nobel prize economics. The literature on the subject has grown almost exponentially. Many serious contributions on the subject use statistical probabilistic models. It needs to be straightaway admitted that the techniques that have been employed by major international banks are such that they cannot be transplanted into the Indian soil. Our bank staff is also not adequately equipped to employ those techniques into their day to operations. It, however, needs to be noted most of these complex technologies of risk management cannot be employed in India for another reason. For a meaningful application of these statistical models we need a strong data base on several variable. Such data base just does not exist as of today. For example the value at risk models measure the market or price risk of a portfolio of financial assets. The models help in measuring the risk that the market value of the portfolio will decline as a result of changes in interest rates, equally prices or exchange rates. We need historical ore time series data for the variables incorporated in

these models. But such data just do not exist for India. One does not know for sure as to what type of probabilistic distribution model is relevant for Indian conditions especially because we know that markets are not yet well developed. One easy way of getting this problem would be to assume that the models applied in the developed countries would hold good equally for our country. While not denying the utility of the models for risk management it may be advisable to go in stages and adopt simple risk management practices to begin with in India.

CHAPTER V SUMMARY, CONCLUSIONS AND SUGGESTIONS Assuming and managing risk is the essence of business decision marking. Investing in a new technology, hiring a new employee, choosing funding plan or launching a marketing campaign are all decisions with uncertain outcomes. Risk is unavoidable as long as we do not know what the future brings. As a result, all management decisions are choices of how much risk to take and how to manage those risks. Understanding the risk is the first step in risk management. Some assessment of the likelihood of possible changes is required to understand the risk. The step could be termed exposure measurement. The second step is tool analysis. This step involves analyzing various tools that can alter risk exposure. The important characteristic of any risk management tool is its risk cost trade off. When a bank is to purchase a security/asset, it might consider hedging, purchasing derivative security so that the combined position is risk free. But the bank should be able to analyse whether the price of the derivative security is commensurate with the benefits to risk reduction. Exposure management is third step. The alternatives range from no exposure to a selective exposure risk with the same benefit traded for some protection in unavoidable events, to a magnified exposure in which potential gains and potential losses are deliberately increased. New information about subsequent events affects risk exposure. Effort is expended in responding to changes in exposure. Effective exposure management results from preparedness for different future outcomes. Failure to anticipate and plans, adversely affect the quality of response. The final step in the risk management process is performance evaluation. How accurate was diagnosis and exposure management? How useful were the risk management tools used? Were risk cost trade off properly estimated? Were events a surprise? What can be learnt from the experience and how can the quality of risk management be improved?

The four steps model outlined above captures the essence of risk management not only in banking industry but also in other industries. Although risk managements situations in

different sectors are different in the implementation aspect, the model by an large include all possible variations. Over the past few decade in the world over and over the past few years in India the performance of financial markets has been greatly improved by the development of new technologies in communication and information processing. Financial market performance has also been improved because of the creation of new type of securities know as derivations. The creation and use of derivatives has helped various financial institutions to value and to hedge complex risks. Of course everybody has not accepted this instrument as a boon to the financial services sector. Some questions the value of derivatives and call for regulations on its use. Risk management has been practiced since the commencement of the history of corporate management and traditionally it included (i) Management of the capital structure of the concern/firm with focus on debt-equity ratios (ii) Diversification of business both geographical and product line (iii) Choosing of less risky investments (iv) Profit sharing with employee via incentives / compensation lined to productivity (v) Public offerings, etc. Perhaps these measures might not have been adopted with the sole aim of risk reduction. But risk transferring risk shifting was also the aim consequence of these management strategies. But today the financial services sector has been placed in an unenviable position, mainly because of globalization, the increased volatility of financial markets and emergence of sophisticated new financial products. The new reality has complicated the handing of financial transactions and lengthened the transaction processing change. The collective of impact of changes in the financial markets and the increased complexity of new products such as financial derivatives have raised the question of ability of the institutions to mange these risks. This calls for an apparatus quite different from the traditional one, which was equipped only to process simple, loans and deposit. Further, organizational failures to monitor and control day to day activities also result in substantial risk from fraud, embezzlement or theft. In fine the need of the hour is a people strategy. The new strategy must address important human resources issues such as organizational structure, critical skills developments and control procedures. Banks must adopt an organization wide view of responsibilities of from top to bottom and information channels from bottom to top. **********