Risk Management in Bank

RISK MANAGEMENT IN BANKS
A PROJECT REPORT ON
SUBMITTED BY
AARTI R. MAURYA
ROLL# 28
IN THE PARTIAL FULFILLMENT FOR THE DEGREE IN
T.Y.B.BI (COMERCE)
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2013-2014
University Of Mumbai
ACKNOWLEDGEMENT
INDEX
1. Introduction ..5 2. Types of Risk in Bankin..8 3. Scams in Indian Banking Sector.....28
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4. Seven tenets of risk management in the banking industry ...30
5. Conclusion...41
6. Questinare ...42
7. Bibiography ......43
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1. INTRODUCTION
Risk management is the process of measuring the actual or potential danger of particular situation. The technology of the word risk can be traced to the Latin word rescum meaning risk at sea or that which cuts.
Risk inherent in any walk of life in a general and financial sector in particular. Due to regulated environment, bank could not afford to take risk. Risk and uncertainties form an integral part of banking with by nature essential taking risk. Risk management system is the pro active action in the present for the future. Managing risk is nothing but managing the change before the risk management. Riak management in Indian banks is relatively newer practice. Indian banks have been making great advancement in term of technology and quality as well as stability such that they have started to expand and diversify at a rapid rate .However such expansion brings these banks into the context of risk especially at the onset on increasing Globalization and liberalization. In banks and other financial institution.
Risk plays a major part in the earning of a bank.Higher the risk higher the return. Hence it is an essential to maintain parity between risk and return.
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There are mainly two types of risk Financial risk Non financial risk
The type of risks can be fundamentally subdivided in primarily of two types, i.e. Financial and Non-Financial Risk. Financial risks would involve all those aspects which deal mainly with financial aspects of the bank. These can be further subdivided into Credit Risk and Market Risk. Both Credit and Market Risk may be further subdivided.
Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk, and Legal Risk.
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2. TYPES OF RISK IN BANKING
1.FINANCIAL RISK
Financial risks would involve all those aspects which deal mainly with financial aspects of the bank.
A. CREDIT RISK
Credit Risk is the potential that a bank Borrower/counter party fails to meet the obligations on Agreed terms. There is always scope for the borrower to Default from his commitments for one or the other reason resulting in crystalisation of credit risk to the bank. These losses could take the form outright default or alternatively losses from changes in portfolio value arisen Credit Risk is the potential that a bank Borrower/counter party fails to meet the obligations on agreed terms. There is always scope for the borrower to default from his commitments for one or the other reason resulting in crystallization of credit risk to the bank. These losses could take the form outright default or alternatively, losses from changes in portfolio value arising
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from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to market risk variables. The objective of credit risk management is to minimize the risk and maximize banks risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters. from actual or perceived deterioration in credit quality that is short of default. Credit risk is inherent to the business of lending funds to the operations linked closely to minimize the risk and maximize banks risk Adjusted rate of return by assuming and maintaining Credit exposure within the acceptable parameters.
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a. TYPES OF CREDIT RISK MANAGEMENT
Counterparty or borrower risk Intrinsic or industry risk Portfolio or concentration risk
1. COUNTERPARTY RISK
A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay what it is obligated to do on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed to.[11]Financial institutions may hedge or take out credit insurance of some sort with a counterparty, which may find themselves unable to pay when required to do so, either due to temporary liquidity issues or longer term systemic reasons.
2. PORTFOLIO OR CONCENTRATION RISK
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Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan represents.
b. TOOLS FOR MANAGING CREDIT RISK MANAGEMENT
While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties.
Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive
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approach to risk management and essential to the long-term success of any banking organization.
For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.
c. SOUND PRACTICE FOR MANAGING CREDIT RISK

Establish an appropriate credit risk environment
Operate under a sound credit granting process.
Maintain an appropriate credit administration measurement and monitoring process.
Insure adequate control over credit risk environment
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Boar4df of director should review credit risk strategy periodically.
Senior manager should implement credit risk stragy approved by the board.
B. MARKET RISK
Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables.
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It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equityand interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the banks Earnings and capital due to changes in the market level of Interest rates or prices of securities, foreign exchange and Equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the banks business strategy. Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given port-folio. Identification of future changes in economic condictions like economic/industry overturns, market risk events, liquidity conditions etc that could have unfavorable effect on banks portfolio is a conditionprecedent forcarrying out stress testing. As the underlying assumption keep changing from time to time, out-put of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market
a. TYPES OF MARKET RISK MANAGEMENT
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Interest rate risk Liquidity rate risk Currency forex risk Hedging / commodity risk
1. INTREST RATE RISK:

Interest rate risk is the risk that arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. How to manage interest rate risk: Banks must have an adequate system of internal controls over their interest rate risk management process.
Banks must have adequate information systems for measuring, monitoring, controlling and reporting interest rate exposures.
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2. LIQUIDITY RATE RISK:
Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals.
Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims.
The cash flows are placed in different time buckets based on future likely behavior of assets, liabilities and off-balance sheet items.
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Liquidity risk consists of Funding Risk, Time Risk & Call Risk. Funding Risk : It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit. Time risk : It is the need to compensate for nonreceipt of expected inflows of funds i.e. performing assets turning into nonperforming assets. Call risk : It happens on account of crystalisation of contingent liabilities and inability to undertake profitable business opportunities when desired.
The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their
maturity profiles cost, yield, risk exposure,etc.
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It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities. Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc. Bank should track the impact of pre-payment of loans & premature closure of deposits so as to realistically estimate the cash flow profile.
How to manage Liqudity rate risk: The risk must be managed within a management framework (decision-making) defined risk
A clear liquidity risk management and funding strategy must be agreed at an executive and non-executive board level Procedures for liquidity planning under alternative scenarios must be agreed, including crisis situations.
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3. CURRENCY FOREX RISK:

Currency Forex risk (also known as exchange rate risk or foreign exchange risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately. Developing a strategy. Implementation of plans.
4. HEDGING
/ COMMODITY RISK:
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. A commodity enterprise needs to deal with the following kinds of risks:
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Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices) Quantity risk Cost risk (Input price risk) Political risk
How to manage commodity risk: Employing differing tools, employ differing tools.
Plan and budget with a greater accuracy.
Control cost.
Create certainty around fluctuating commodity prices.
Remove the possibility of margin for specific needs associated with using futures
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2.NON FINANCIAL RISK
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Non-Financial risks would entail all the risk faced by the bank in its regular workings, i.e. Operational Risk, Strategic Risk, Funding Risk, Political Risk, and Legal Risk.
A. OPERATIONAL RISK Always banks live with the risks arising out of human Error, financial fraud and natural disasters. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter-linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit Systems are used as the primary means. Risk education for familiarizing the complex operations. At all levels of staff can also reduce operational risk. Insurance cover is one of the important mitigates of operational risk. Operational risk events are associated with weak links in internal control procedures.
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The key to management of operational risk lies in the banks ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank resulting in financial loss. OPERATIONAL RISK INCLUDES
INTERNAL FRAUD: Internal fraud refers to a type that is committed by an individual against an organization.
Internal fraud has following Unauthorized activity Transaction not reported Transaction types unauthorized Money laundering Forgery
EXTERNAL FRAUD: External bank fraud is the use potentially illegal means to obtain money, assets or held by a financial institution External fraud has following
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Theft and robbery Hacking changes Theft and information Elder financial abuse
EMPLOYMENT PRACTICE AND WORK PLACE SAFETY: Occupational safety and healthy is an area concerned with protecating safety health and welfare of people engaged in work or employment Employee relation Organized labor issue Employee health and safety rules Workers comperession
Client, product and business practice:
Breach of privacy Misuse of confidential information Aggressive sales Inadequate product offering
IMPROPER BUSINESS OR MARKET PRACTICE
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Antitrust Improper trade Insider trading Market manipulation
HOW TO MANAGE AN OPERATIONAL RISK : Internal audit coverage should be adequate to an independent verify that the frame work.
Bank should develop, implement and maintain a framework that fully integrates into banks overall risk management process.
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The board of director should establish approve and periodically review of the framework.
Senior management should ensure the identification and assessment of the operational risk inherent in all material.
Product, activities, process and system to make sure the inherent risk and incentives are well understood.
Inherent risks ae in the new product services of activities.
Bank should have a strong control environment that utilizes polices, processes and system appropriate risk mitigation and transfer strategies. Banks public disclosures should allow stakeholder to assess its approach to operational risk management.
B. STRATEGIC RISK MANAGEMENT What is strategic risk management (SRM)? Is it the sameas or different from enterprise risk management (ERM)? What kinds of events or risks are strategic risks? Boards of directors and management teams have been asking these questions a lot lately.
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One of the lessons many organizations learned from the global financial crisis is that they need to clearly link strategy and risk management and be able to identify and manage risk in a highly uncertain environment. Another is that they must focus risk management on creating value as well as protecting value. C. LEGAL RISK
Legal risk is a risk of loss that results from a counterparty
being unable to legally enter into a contract. Another legal risk relates to regulatory risk, i.e., that a transaction could conflict with a regulator's policy or, more generally, that legislation might change during the life of a financial contract. Assigning Specific responsibilities to the various stakeholders in the bank, which may include appointing legal risk managers.
Identication of the legal risk universe applicable to the bank.
Implementing controls to mitigate identied legal risks. Monitoring legal risks.
Reporting on legal risks
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D. POLITICAL RISK
Political risk is a type of risk faced by investors, corporations,
and governments. It is a risk that can be understood and managed with reasoned foresight and investment. Broadly, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisionsor any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives Political risk faced by firms can be defined as the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection) Portfolio investors may face similar financial losses.
Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. How to manage political risk
Stage 1: Identify: An important part of political risk Identification lies in separating headline hype, or perceived risk, from real political risk. For example, in India, political risks vary significantly from state to state Some states have
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had highly publicized conflicts with some foreign companies but also offer significant investment incentives, such as a highly educated workforce. The ability to manage political risk therefore unlocks an investment opportunity. Stage 2: armed with a very specific set of political risk scenarios, risk managers assess and quantify the impact of each scenario on the business. Stage 3: Manage Once risks have been identified and measured, an effective system for active political risk management can be put in place. The first element in managing political risks is to map potential risk management methods against the priority risk. E. FUNDING RISK The standard framework to measure funding liquidity risk compares expected cumulative cash shortfalls over a particular time horizon against stock of available funding sources. This requires assigning cash-flows to future periods for financial products with uncertain cashflow timing.
F. PROFIT RISK
Profit risk is a risk management tool that focuses on
understanding concentrations within the income statement and assessing the risk associated with those concentrations from a net income perspective. Profit risk is a risk measurement methodology most appropriate for the financial services industry, in that it complements other risk management methodologies commonly used in the financial services industry
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Reputational RISK
reputation risk, is a risk of loss resulting from damages to a
firm's reputation, in lost revenue or destruction of shareholder value, even if the company is not found guilty of a crime.
Reputational risk can be a matter of corporate trust, but serves also as a tool in crisis prevention.
This type of risk can be informational in nature that may be difficult to realize financially. Extreme cases may even lead to bankruptcy
3. SCAMS IN INDIAN BANKING SECTOR
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Derivative Scam, 2007-08 In 2007-08 many of the major banks were accused of selling currency derivatives to exporters in an illegal manner. For the most part SMEs, who had very less knowledge about the probable risks of such instruments, were involved. The overall losses were anticipated to be over 30, 000 crore.
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The regulatory was taken in the year 2011 by the Reserve Bank of India imposing fines starting from 5 to 15 lakhs on nineteen banks for allegedly selling currency derivative products. Though the penalty was considered to be very less and was worthless, it resulted into the end of derivative trade for banks. 2003-05 IPO scam The 2003-05 IPO scam came into limelight when an investigation into Yes Bank IPO found market investor had unlawfully got shares in the primary market. Some individuals had acquired shares intended for retail candidates using benami demat accounts. Same happened with IDFC IPO. The regulatory action was taken by Sebi, regulator of capital markets.
4. SEVEN TENETS OF RISK MANAGEMENT IN THE BANKING INDUSTRY "If a bank is serious about risk management, then it will be serious from the top down. Before we discuss this statement in more detail, lets first look at the events that precipitated such a statement.
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The chain of events that led to the global economic crisis are outlined in figure 1.
The resulting global economic downturn led to a vicious cycle of companies failing or downsizing, thus leading to unemployment, which further reduced demand for goods and services. In addition, banks across the globe retrenched and in place of the liberal lending practices credit tightened across the board.
Governments stepped in with fiscal supportthe likes of which has never been seen in modern recorded history. And now, everyone waits to see what will happen with this never-beforetried experiment of flooding the world markets with government money.
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What happened? Why did everything turn so bad so fast when it looked like the good times would go on unabated and it appeared that the very predictable five- and 10-year recession cycle had been overcome?
Different people like to point fingers at different culprits.
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Some experts put the blame on credit default swap instruments that were sold worldwide with promises of high returns and low risk.
Others blame those who promoted mortgage access to people who normally would not qualify for a housing loan. But we believe that the issue is more fundamental .
The worlds financiers lost sight of the requirement to manage risk effectively and, in many cases, it is questionable if the basics of risk management were ever put in place. A Banks Business The core business of a bank is to manage risk and provide a return to shareholders in line with the accepted risk profile.
The credit crisis and ensuing global recession seem to indicate that the banking sector has failed to tend to its core business. If it had done so effectively, then credit default swaps would not have been bought up with so much eagerness.
If the banks had attended to risk management, then there would not have been the flood on the U.S. market of cheap short-term interest rate mortgages that led to the so-called housing bubble and the ultimate wave of personal bankruptcies and home foreclosures. A.T. Kearney believes that the framework for risk management in a bank is fundamentally no different today than it was prior to the credit crunch and recession.
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Indeed, the risk function lacks a certain business acumen, and continues to be considered a handbrake on growth.
Chief economists and their macro perspectives are still divorced from the banks own strategy function.
We believe that a return to managing risksnot ignoring them or believing they can be passed offis the cure for the ailment that has hit the economy so hard.
Let us therefore review what we call The Seven Tenets of Risk Management to see why the paradigm has neither been altered nor fundamentally changed in this new world order.
1. Establish a Language System to Discuss and Categorize Risk :
A risk manager is overheard at a recent intra-departmental meeting: The Basel II second pillar requires that we focus on the ICAAP, and it is inherent that the board of the bank fulfill their obligations in this respect and that sufficient oversight is provided by the SREP at which point many of the participants have no idea what the risk manager is talking about, but they are too afraid to ask questions so they nod their heads in polite agreement and hope no one will ask them for their personal opinion.
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This scene is played out all too frequently at many banks. Each function within a bank has its own lingo and acronyms that are useful in the right format and context.
Take them out of their natural environment and they cause untold confusion and misunderstandings.
It is incumbent upon risk experts to translate risk issues into a language and terms that all inter-ested parties can understand, and it is the responsibility of the other functions to make the effort to understand.
2. Develop a Big Picture View of Risk Exposure and Focus on the Most Important : Not all risks are created or end equally. Banks need to be mindful of credit, market and operational risks.
Within the three main areas of risk, further stratification is embedded to allow for a comprehensive overall view of risk.
Tools such as VaR (Value at Risk), Monte Carlo simulations, CFaR (Cash Flow at Risk), stress testing and others are applied to judge the level of risk and subsequently the actions required to contain the risks.
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Yet within banks there is often a lack of tools and sophistication to keep pace with a rapidly changing set of products.
At any point in time, one or more risk elements may be more relevant than others, but the bank needs to know its risk framework and monitor developments in real time to provide the right level of attention and action.
As a whole, Canadian banks seem to have fared better than banks in other countries.
Canadian banks in general steered away from the credit derivative craze, adopting a more conservative approach as other banks were ambitiously buying the risky instruments.
By taking the big picture view, Canadian banks avoided a major melt down. According to a report by TD Bank: "There appears to be a more risk-averse culture in Canada running through government, the public and banks.
Canadian banks benefited from prudent and disciplined riskmanagement practices, and higher capital ratios pre-crisis. The fact that Canadas major investment banks were part of a large diversified financial services institution also played a role." 3. Centralize Ownership of Process and Decentralize Decision Making :
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Risk management can be most effective when it is applied consistently across the banking organization with policies and procedures developed by risk experts who have the training and experience for their specific country, area and client mix.
It is incumbent upon front-line officers to use the tools and processes to guide their daily inter-actions with customers. Interactions are clear.
Answers are given in a timely manner and the responses leave no ambiguity about what the bank is able to do for its customer.
A good example can be drawn from banks in Central Europe preand post-privatization.
Prior to privatization and modernization, many banks had a decentralized business model and it was a public secret that the branch managers made up the rules and profited handsomely from insufficiently transparent business practices.
This led to the failure of many banks in Central Europe.
Post privatization, the banks focused on centralizing key processes around risk and then decentralizing decision making down to the branch level, with the knowledge that decisions would be made within the centrally developed framework; this provided safeguards against unwanted risk.
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4. Drive the Process from the Top and Clearly Define Roles and Responsibilities: In the lead up to the big bustthe credit crunchbanks were reporting record profits and the leaders were receiving bonuses for relatively short-term results.
It seemed that everybody wanted in on the big profits and pay days, and little heed was given to people calling for curbing the growing risk profiles.
The clear lesson: what the leaders in the organization do, not so much what they say, is what defines an organizations behavior.
Risk management in a bank is everyones responsibility, not just the risk departments.
Leadership must not only espouse a vision but also behave in a manner consistent with it and demonstrate to employees that prudent risk management is a cornerstone to success.
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5. Quantify Risk Exposure and the Costs and Benefits of Managing Risks: The warnings were everywhere, renowned financial experts were quoted almost every day.
The risks of credit derivatives are not quantified and nobody really knows how much is out there and what will happen when contracts come due.
We know now at least to this point what has happened. Had individual organizations been looking appropriately at the risks of purchasing the seemingly too-good-to-be-true derivative instruments, perhaps they would not have taken them on with such zeal and the problem would have been more contained at the original source, which was the overheated mortgage market in the United States.
Consistent and rigorous assessment of risk and quantification of the net benefits of appropriately dealing with the risk cannot be replaced with promises of above-average returns with no knowledge of the potential downsides.
A recent article in Fortune may have said it best when describing Blackrock, the large money management company. "When instruments get complicated, do your homework.
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In fact, at BlackRock, executives are constantly refining their models to stay one step ahead of the latest funky financial product from Wall Street's wizards.
The firms that design securitized products are always conspiring against us with new, increasingly complex instruments,' explains Rob Goldstein, who oversees BlackRock Solutions, which leases an ultrasophisticated technology platform to clients and has a team that helps companies analyze and run their portfolios. 'Its our mission to make sure they dont win.' On behalf of the Federal Reserve, BlackRock Solutions is managing troubled assets from AIG and Bear Stearns."
Even the most sophisticated models will not make an organization 100 percent foolproof as BlackRock found when it misjudged the market for commercial mortgage-backed securities. Regardless, strong and rigorous analytical capabilities will lessen the chance of failure.
6. Embed IT Systems to Facilitate the Risk-Management Process The value of IT appears to be increasing over time to banking organizations as the environment grows ever more complex so there is no change in this variable in troubled times. However, the IT value will be realized only if IT systems development is driven by user needs and not vice versa.
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IT systems, if properly developed and used, can assist the company in risk management by providing control and compliance monitoring technology, databases, market and industry research and analysis tools, and communication tools.
These are all critical tools that assist in the delivery of the required information to decision makers in the bank. This can happen if the IT systems are developed with the users needs in mind.
7. Embed a Risk-Management Culture If a bank is serious about risk management, then it will be serious from the top down.
Leadership will espouse a culture of responsible risk management through its behaviors and through the systems and programs it puts into place.
In the run up to the financial crisis, organizations talked about good risk management; however, few in leadership positions espoused effective risk management, which is evident in the dismal failures in the financial sector.
A risk-management culture can be embedded in the organization through training, communications and incentives
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6. Conclusion : Hence it is depends upon a banking industry whether to manage accept ignore avoid exploit or reduce the banking risk. A managing a risk is a tool and technique differs from one bank to another that how they are treat with them and this will directly decide the future of bank. A good risk managing banking industry can easily survive in a competitive banking area.
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