Risk Management in Banking Sector

CHAPTER 1

INTRODUCTION

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Risk Management in Banking Sector

Introduction
The past decade has seen dramatic losses in the banking industry. Firms that had been performing well suddenly announced large losses due to credit exposures that turned sour, interest rate positions taken, or derivative exposures that may or may not have been assumed to hedge balance sheet risk. In response to this, commercial banks have almost universally embarked upon an upgrading of their risk management and control systems. The etymology of the word Risk can be traced to the Latin word Rescum meaning Risk at Sea or that which cuts. Risk is associated with uncertainty and reflected by way of charge on the fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that protects the liability holders of an institution. These risks are inter-dependent and events affecting one area of risk can have ramifications and penetrations for a range of other categories of risks. Foremost thing is to understand the risks run by the bank and to ensure that the risks are properly confronted, effectively controlled and rightly managed. Each transaction that the bank undertakes changes the risk profile of the bank. The extent of calculations that need to be performed to understand the impact of each such risk on the transactions of the bank makes it nearly impossible to continuously update the risk calculations. Hence, providing real time risk information is one of the key challenges of risk management exercise. Till recently all the activities of banks were regulated and hence operational environment was not conducive to risk taking. Better insight, sharp intuition and longer experience were adequate to manage the limited risks. Business is the art of extracting money from others pocket, sans resorting to violence. But profiting in business without exposing to risk is like trying to live without being born. Everyone knows that risk taking is failure prone as otherwise it would be treated as sure taking. Hence risk is inherent in any walk of life in general and in financial sectors in particular. Of late, banks have grown from being a financial intermediary into a risk intermediary at present. In the process of financial intermediation, the gap of which becomes thinner and thinner, banks are exposed to severe competition and hence are compelled to encounter various types of financial and non financial risks. Risks and uncertainties form an integral part of banking which by nature entails taking risks. Business grows mainly by taking risk. Greater the risk, higher the profit and hence the business unit must strike a trade-off between the two. The essential functions of risk management are to identify measure and more importantly monitor the profile of the bank. While
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Risk Management in Banking Sector Non-Performing Assets are the legacy of the past in the present, 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 manages. While new avenues for the bank has opened up they have brought with them new risks as well, which the banks will have to handle and overcome.

1.1 Bank
A bank is a financial institution whose primary activity is to act as a payment agent for customers and to borrow and lend money. In other words, an institution where one can place and borrow money and take care of financial affairs. Functions of Banks: Lending money to public(loans) Transferring money from one place to another (Remittances) Acting as trustees Keeping valuables in safe custody Government business Types of Banks: Public sector Banks Private sector Banks Co-operative Banks Development Banks/Financial institutions

1.2 Risks in Providing Banking Services:

The risks associated with the provision of banking services differ by the type of service rendered. For the sector as a whole, however the risks can be broken into six generic types: systematic or market risk, credit risk, counterparty risk, liquidity risk, operational risk and legal risks.

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Risk Management in Banking Sector Systematic risk is the risk of asset value change associated with systematic factors. It is sometimes referred to as market risk, which is in fact a somewhat imprecise term. By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk, whenever assets owned or claims issued can change in value as a result of broad economic factors. As such, systematic risk comes in many different forms. For the banking sector, however, two are of greatest concern, namely variations in the general level of interest rates and the relative value of currencies. Because of the bank's dependence on these systematic factors, most try to estimate the impact of these particular systematic risks on performance, attempt to hedge against them and thus limit the sensitivity to variations in undiversifiable factors. Accordingly, most will track interest rate risk closely. They measure and manage the firm's vulnerability to interest rate variation, even though they cannot do so perfectly. At the same time, international banks with large currency positions closely monitor their foreign exchange risk and try to manage, as well as limit, their exposure to it. In a similar fashion, some institutions with significant investments in one commodity such as oil, through their lending activity or geographical franchise, concern themselves with commodity price risk. Others with high single-industry concentrations may monitor specific industry concentration risk as well as the forces that affect the fortunes of the industry involved.

Credit risk arises from non-performance by a borrower. It may arise from either an inability or an unwillingness to perform in the pre-committed contracted manner. This can affect the lender holding the loan contract, as well as other lenders to the creditor. Therefore, the financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to its bank. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable, but difficult to eliminate completely. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for banks that lend in local markets and ones that take on highly illiquid assets. In such cases, the credit risk is not easily transferred, and accurate estimates of loss are difficult to obtain.
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Counterparty risk comes from non-performance of a trading partner. The non-performance may arise from counterpartys refusal to perform due to an adverse price movement caused by systematic factors, or from some other political or legal constraint that was not anticipated by the principals. Diversification is the major tool for controlling nonsystematic counterparty risk. Counterparty risk is like credit risk, but it is generally viewed as a more transient financial risk associated with trading than standard creditor default risk. In addition, counterpartys failure to settle a trade can arise from other factors beyond a credit problem.

Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth and unexpected expansion of credit, the risk here is seen more correctly as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis. In any case, risk management here centers on liquidity facilities and portfolio structure. Recognizing liquidity risk leads the bank to recognize liquidity itself as an asset, and portfolio design in the face of illiquidity concerns as a challenge.

Operational risk is associated with the problems of accurately processing, settling, and taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing system failures and compliance with various regulations. As such, individual operating problems are small probability events for well-run organizations but they expose a firm to outcomes that may be quite costly.

Legal risks are endemic in financial contracting and are separate from the legal ramifications of credit, counterparty, and operational risks. New statutes, tax legislation, court opinions and regulations can put formerly well-established transactions into contention even when all parties have previously performed adequately and are fully able to perform in the future. For example, environmental regulations have radically affected real estate values for older properties and imposed serious risks to lending institutions in this area.

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Risk Management in Banking Sector A second type of legal risk arises from the activities of an institution's management or employees. Fraud, violations of regulations or laws, and other actions can lead to catastrophic loss, as recent examples in the thrift industry have demonstrated. All banks face all these risks to some extent. Non-principal or agency activity involves operational risk primarily. Since institutions in this case do not own the underlying assets in which they trade, systematic, credit and counterparty risk accrues directly to the asset holder. If the latter experiences a financial loss, however, legal recourse against an agent is often attempted. Therefore, institutions engaged in only agency transactions bear some legal risk, if only indirectly. The main interest, however, centers around the businesses in which the bank participates as a principal, i.e., as an intermediary. In these activities, principals must decide how much business to originate, how much to finance, how much to sell, and how much to contract to agents. In so doing, they must weigh both the return and the risk embedded in the portfolio. Principals must measure the expected profit and evaluate the prudence of the various risks enumerated to be sure that the result achieves the stated goal of maximizing shareholder value.

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Risk Management in Banking Sector

CHAPTER 2

LITERATURE REVIEW

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Risk Management in Banking Sector

The following are the literature reviews that have been conducted at the preliminary stage of the project:-

(Raghvan,2006) A Paper titled as Risk Management in Banks written by R.S.Raghavan. The paper talks about how risk has become an inherent aspect of life in general and in financial sector in particular. Banks are now exposed to competition and hence are compelled to encounter various types of financial and non financial risks. Risk and uncertainties form an integral part of banking which by nature entails taking risks. The extent of calculations that need to be performed to understand the impact of each such risk on the transactions of the bank makes it nearly impossible to continuously update the risk calculations. Hence, providing real time risk information is one of the key challenges of risk management exercise. 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 from actual or perceived deterioration in credit quality that is short of default. 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. Another has also mentioned relevant points of Basels New Capital Accord and role of capital adequacy, Risk Aggregation & Capital Allocation and Risk Based Supervision (RBS), in managing risks in banking sector.

(Basel Committee) A document titled International Convergence of Capital Measurement and Capital Standards by Basel Committee on Banking Supervision. The first part, scope of application, details how the capital requirements are to be applied within a banking group. Calculation of the minimum capital requirements for credit risk, operational risk, and market risk are provided in part two. The third and fourth parts outline expectations concerning supervisory review and market discipline, respectively. The Committee also highlights the need for banks and supervisors to give appropriate attention to the first (minimum capital requirement), second (supervisory review) and third (market discipline) pillars of the 8

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Framework. It is critical that the minimum capital requirements of the first pillar be accompanied by a robust implementation of the second, including efforts by banks to assess their capital adequacy and by supervisors to review such assessments. In addition, the disclosures provided under the third pillar of this Framework will be essential in ensuring that market discipline is an effective complement to the other two pillars. .

The paper titled Credit Quality In India: Issues for the future, January 15, 2009 highlights the credit quality in India. The Dialogue had two presentations followed by discussions. Mr. Amit Tandon, Managing Director, Fitch Ratings, provided the perspective from the rating agencies. Dr K.C. Chakrabarty, Chairman and Managing Director, Punjab National Bank shared market practices in credit assessment/monitoring. The discussion was introduced and moderated by Mr. Jignesh Shah, Chairman and Group CEO; Financial Technologies (India) Limited. It highlights the Global Meltdown in light of Indian economy and the present & future of Indian Banks.

(David, 2008) The research paper is Bank Risk Management by David.H.Pyle from Haas School of Business, University of California, and Berkeley. It talks about the need for risk management in the financial and non financial firms and in government agencies. Risk management is the process by which managers satisfy the needs by identifying key risks, obtaining consistent, understandable, operational risk measures, choosing which risks to reduce and which to increase and by what means and establishing procedures to monitor the resulting risk position. To be consistent with market risk measurement, credit risks are defined as changes in portfolio value due to failure of counterparties to meet their obligations or due to changes in the markets perception of their ability to continue to do so. A bank risk management system should include credit scoring, ratings, credit committees to assess the credit worthiness of counterparties. The article thus states the means and the measure to credit assessment with respect to the banking sector. If a bank follows an appropriate strategy for extending credit and defines the kind of portfolio it is creating and has some knowledge of probability of default, then risk is contained. The market is very 9

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Risk Management in Banking Sector

large, so we do not need to be overly aggressive either on credit or pricing. In any market, overly aggressive people have suffered. When will you suffer, nobody knows, but you will suffer. That is what history tells, said by MR. ADITYA PURI. We are not going for top line growth, but quality growth. Lending is not new, but super -aggressive lending is new. We want a quality portfolio and do not necessarily want to be number one. We want to be among the top three, Mr. Puri avers1, CEO, HDFC BANK. The world of finance is experiencing intense challenge of growth and sustainability. Having experienced new peaks in growth for about five years, a series of setbacks ranging from steep fall in stock markets to failure of financial institutions daunted the landscape of global finance. Looking back, the growing consensus is that much of the current malaise is brought about bydeficiencies in pricing risk and assessing the quality of financial assets. Credit quality thus assumed centre stage with policy and regulation all over the world devisingnew means and mechanisms that could help strengthen it. Most capital flows into emerging markets have been in the form of loans. Loans from banks and other institutions account for 57% of total net private sector flows, while foreign direct investments account for 35%. The rest is made up by portfolio investments. The World Bank estimates that private inflows into emerging markets will fall from $1 trillion to $800 billion in 2009. The basic difference between Asian crisis and the present recession is that most debt then was sovereign. Now, most of it is corporate, taken out by Indian, Chinese, and other emerging market companies. Trade financing is experiencing a sharp slowdown and trade-led economies could be severely hit. Corporate distress stemming from lower demand and tighter financial conditions could impair bank assets. Corporates are looking afresh at domestic bank credit with foreign funding channels drying up. Rising cost of capital for banks is exerting pressure on net interest margins. Indian banking benefits from government support and strong capitalization and the scenario that is unfolding is rather alarming.

http://www.financialexpress.com/news/hdfc-banks-assets-mix-to-tilt-in-favour-of-retail/88792/0

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No theory works when we try to assess what will happen, what is going to happen. Here we have companies rated AAA, but they have lost billions of rupees. Lehman Brothers was also AAA till it went for bankruptcy. In fact, by and large the banks which have lost money in the Western markets were all rated AAA. We, in India, have BB-rated banks that have not lost that much money. Let me say the risk management theory applies only with 95% or 99% confidence interval, and that the remaining 1%of cases are outside and nobody knows what happens in the 1% of cases. Companies disappear and thats why theories do not work. Theories are valid and we must follow them because in normal period they are very important, but they will notwork in this difficult period that we are facing. This period falls outside the 99% confidence interval and none of the theories will work. 2

Credit quality in India: issues for future- Jan 15, 2009. 11

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CHAPTER 3

RESEARCH METHODOLOGY

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3.1 Background to the Study

Credit creation is the main income generating activity for the banks. But this activity involves huge risks to both the lender and the borrower. The risk of a trading partner not fulfilling his or her obligation as per the contract on due date or anytime thereafter can greatly jeopardize the smooth functioning of a banks business. On the other hand, a bank with high credit risk has high bankruptcy risk that puts the depositors in jeopardy. Among the risk that face banks, credit risk is one of great concern to most bank authorities and banking regulators. This is because credit risk is that risk that can easily and most likely prompts bank failure. Credit risk management is a structured approach to managing uncertainties through risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources. The strategies include transferring to another party, avoiding the risk, reducing the negative effects of the risk, and accepting some or all of the consequences of a particular risk. Some traditional risk managements focused on risk stemming from physical or legal causes (such as natural disasters or fires, accidents, deaths and lawsuits). Financial risk management on the other hand focuses on risks that can be managed using traded financial instruments. The objective of risk management is to reduce the effects of different kinds of risks related to a preselected domain to the level accepted by society. It may refer to numerous types of threats caused by environment, technology, humans, organizations and politics. On the other hand it involves all means available for humans, or in particular, for a risk management entity (person, staff, organization). This thesis takes a fast look on Banking and Credit risk management and further probes into bank risk exposure, assessment, management and control. An attempt will be made to unfold the use of some risk management, evaluation and assessment tools, models, and techniques.

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3.2 Statement of the Problem

The very nature of the banking business is so sensitive because more than 85% of their liability is deposits from depositors (Saunders, Cornett, 2005). Banks use these deposits to generate credit for their borrowers, which in fact is a revenue generating activity for most banks. This credit creation process exposes the banks to high default risk which might led to financial distress including bankruptcy. All the same, beside other services, banks must create credit for their clients to make some money, grow and survive stiff competition at the market place. The principal concern of this thesis is to ascertain to what extent banks can manage their credit risks, what tools or techniques are at their disposal and to what extent their performance can be augmented by proper credit risk management policies and strategies.

3.3 Objective of the Project:

To understand how risk management is done in the banking sector, to see the effect of credit risk management in banking and to learn the techniques of how risk is evaluated and managed effectively. The main objective of the study is to have a bigger picture of how banks manage their credit risk. Thus attention is geared towards: Ascertaining why and how banking credit risk exposure is evolving recently. Seeing how banks use credit risk evaluation and assessment tools to mitigate their credit risk exposure. The steps and methodologies used by banks to identify, plan, map out, define a framework, develop an analysis and mitigate credit risk (steps in the risk management process). Determine the relationship between the theories, concepts and models of credit risk management and what goes on practically in the banking world. Ascertain the scope to which resourceful credit risk management can perk up bank performance.

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3.4 Methodology:
The study will explore the problem in an interpretative view, using a descriptive approach which uses observation and survey. Primary and secondary research will be integrated. The reason for this is to be able to provide adequate discussion for the readers that will help them understand more about the issue and the different variables that involve with it. In the primary research, public managers will be surveyed. On the other hand, sources in secondary research will include previous research reports, newspaper, magazine and journal content. Existing findings on journals and existing knowledge on books will be used as secondary research. The interpretation will be conducted which can account as qualitative in nature. Study of various types of risks faced by banks. Study of how banks ascertain and measure these risks. Studying risk management process. Study of the various risk management approaches used by the banks. Relationship between returns and net performing loans of HDFC bank to see the effect of credit risk and survey from the branch manager. Finding out how banks make consistent risk management decisions. How effectively banks are able to manage these risks.

3.5 What Type of Risk Is Being Considered?

Commercial banks are in the risk business. In the process of providing financial services, they assume various kinds of financial risks. Suffice it to say that market participants seek the services of these financial institutions because of their ability to provide market knowledge, transaction efficiency and funding capability. In performing these roles they generally act as a principal in the transaction. As such, they use their own balance sheet to facilitate the transaction and to absorb the risks associated with it. To be sure, there are activities performed by banking firms which do not have direct balance sheet implications. These services include agency and advisory activities such as:
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(i) (ii) (iii) (iv)

trust and investment management, private and public placements through "best efforts" or facilitating contracts, standard underwriting through Section 20 Subsidiaries of the holding company, or The packaging, securitizing, distributing and servicing of loans in the areas of consumer and real estate debt primarily. These items are absent from the traditional financial statement because the latter rely on generally accepted accounting procedures rather than a true economic balance sheet. Nonetheless, the overwhelming majority of the risks facing the banking firm are in on-balance-sheet businesses. It is in this area that the discussion of risk management and the necessary procedures for risk management and control has centered. Accordingly, it is here that the review of risk management procedures will concentrate.

3.6 What Kinds Of Risks Are Being Absorbed?

The risks contained in the bank's principal activities, i.e., those involving its own balance sheet and its basic business of lending and borrowing, are not all borne by the bank itself. In many instances the institution will eliminate or mitigate the financial risk associated with a transaction by proper business practices; in others, it will shift the risk to other parties through a combination of pricing and product design. The banking industry recognizes that an institution need not engage in business in a manner that unnecessarily imposes risk upon it; nor should it absorb risk that can be efficiently transferred to other participants. Rather, it should only manage risks at the firm level that are more efficiently managed there than by the market itself or by their owners in their own portfolios. In short, it should accept only those risks that are uniquely a part of the bank's array of services. These are:

(i) (ii) (iii)

risks that can be eliminated or avoided by simple business practices, risks that can be transferred to other participants, and Risks that must be actively managed at the firm level.

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Risk Management in Banking Sector In the first of these cases, the practice of risk avoidance involves actions to reduce the chances of idiosyncratic losses from standard banking activity by eliminating risks that are superfluous to the institution's business purpose. Common risk avoidance practices here include at least three types of actions. The standardization of process, contracts and procedures to prevent inefficient or incorrect financial decisions is the first of these. The construction of portfolios that benefit from diversification across borrowers and that reduce the effects of any one loss experience is another. Finally, the implementation of incentive-compatible contracts with the institution's management to require that employees be held accountable is the third. In each case the goal is to rid the firm of risks that are not essential to the financial service provided, or to absorb only an optimal quantity of a particular kind of risk. There are also some risks that can be eliminated, or at least substantially reduced through the technique of risk transfer. Markets exist for many of the risks borne by the banking firm. Interest rate risk can be transferred by interest rate products such as swaps or other derivatives. Borrowing terms can be altered to effect a change in their duration. Finally, the bank can buy or sell financial claims to diversify or concentrate the risks that result in from servicing its client base. To the extent that the financial risks of the assets created by the firm are understood by the market, these assets can be sold at their fair value. Unless the institution has a comparative advantage in managing the attendant risk and/or a desire for the embedded risk they contain, there is no reason for the bank to absorb such risks, rather than transfer them. However, there are two classes of assets or activities where the risk inherent in the activity must and should be absorbed at the bank level. In these cases, good reasons exist for using firm resources to manage bank level risk. The first of these includes financial assets or activities where the nature of the embedded risk may be complex and difficult to communicate to third parties. This is the case when the bank holds complex and proprietary assets that have thin, if not non-existent, secondary markets. Communication in such cases may be more difficult or expensive than hedging the underlying risk. Moreover, revealing information about the customer may give competitors an undue advantage. The second case included proprietary positions that are accepted because of their risks, and their expected return. Here, risk positions that are central to the bank's business purpose are absorbed because they are the raison dtre of the firm. Credit risk inherent in the lending activity is a clear case in point, as is market risk for the trading desk of banks active in certain markets. In all such circumstances, risk is absorbed and needs to be
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Risk Management in Banking Sector monitored and managed efficiently by the institution. Only then will the firm systematically achieve its financial performance goal.

3.7 Why Do Banks Manage These Risks At All?

It seems appropriate for any discussion of risk management procedures to begin with why these firms manage risk. According to standard economic theory, managers of value maximizing firms ought to maximize expected profit without regard to the variability around its expected value. These include managerial self-interest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. Any one of these justifies the firms' concern over return variability.

Approaches to Risk management

Once the different types of risks are identified, the next step involves identifying the alternate approaches available for managing/reducing the risks. Avoidance The concept of risk is relevant if the bank is holding an asset/liability, which is exposed to risk. Avoidance refers to not holding such an asset/liability as means of avoiding the risk. Exchange risk can be avoided by not holding assets/liabilities denominated in foreign currencies. Business risk is avoided by not doing the business itself. This method can be adopted more as an exception than as a rule since any business activity necessitates holding of assets and liabilities. This approach has application when a bank is planning to decide exposure limits. For example, a bank may decide to avoid a particular industry, say, aquaculture or poultry, while extending credit or it may decide not to lend to certain type of banks in the money market. Loss Control Loss control measures are used in case of the risks which are not avoided. These risks might have been assumed either voluntarily or because they cannot be avoided. The objective of these measures is either to prevent a loss or to reduce the probability of loss. Insurance, for example, is a loss control measure. Introduction of systems and procedures, internal or external audit helps in

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Risk Management in Banking Sector controlling the losses arising out of personnel. Raising funds through floating rate interest bearing instruments can reduce the losses due to interest rate risk. Separation The scope for loss by concentrating an asset at a single location can be reduced by distributing it to different locations. Assets which are needed for routine consumption can be placed at multiple locations so that loss in case of any accident can be minimized. However, this does simultaneously increase the number of risk centers. Consider two banks, one which has a wide network across the country and another which is confined to one state. An adverse economic scenario of the state will affect the latter more than the former. This is more conspicuous when one compares a cooperative bank with a commercial bank. Combination This reflects the old adage of not putting all eggs in one basket. The risk of default is less when the financial assets are distributed over a number of issuers instead of locking them with a single issuer. It pays to have multiple suppliers of raw materials instead of relying on a sole supplier. A well-diversified company has a lower risk of experiencing a recession. Transfer Risk reduction can be achieved by transfer. The transfer can be of three types. In the first type, the risk can be transferred by transferring the asset/liability itself. For instance, the risk emanating by holding a property or a foreign currency security can be eliminated by transferring the same to another. The second type of transfer involves transferring the risk without transferring the asset/liability. The exchange risk involved in holding a foreign currency asset/liability can be transferred to another by entering into a forward contract/currency swap. Similarly, the interest rate risk can be transferred by entering into an interest rate swap. The third type of transfer involves making a third party pay for the losses without actually transferring the risk. An insurance policy covering the third party risk is an example of this. When a bank takes a policy to cover the losses incurred on account of misuse of lost credit cards, it is in effect finding someone to finance the losses while it still has the obligation to pay the Merchant Establishment.

Except for the approach of avoidance, the bank can effectively adopt others since by avoiding risks the bank will not be making any profits. Banks can neither do without profits nor risks.
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Risk Management in Banking Sector However, mere acceptance of these risks to remain profitable does not suffice. Apart from the losses that can be incurred due to the risks, there is also an ultimate danger that the bank itself may fail. The question that arises at this point is what should the bank do in order to take risk for greater returns and at the same time does not end up in losses? Risk management is the solution to such a situation.

3.8 How Are These Risks Managed?

In light of the above, what are the necessary procedures that must be in place to carry out adequate risk management? In essence, what techniques are employed to both limit and manage the different types of risk, and how are they implemented in each area of risk control? After reviewing the procedures employed by leading firms, an approach emerges from examination oflarge-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:

(i) Standards and reports, (ii) Position limits or rules, (iii) Investment guidelines or strategies, (iv) Incentive contracts and compensation.

In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives.

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(i) Standards and Reports

The first of these risk management techniques involves two different conceptual activities, i.e. standard setting and financial reporting. They are listed together because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the extent to which these risks must be mitigated or absorbed. The standardization of financial reporting is the next ingredient. The outside audits, regulatory reports, and rating agency evaluations are essential for investors to gauge asset quality and firm level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity.

(ii) Position Limits and Rules

A second technique for internal control of active management is the use of position limits, and/or minimum standards for participation. In terms of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some pre-specified quality standard. Then, even for those investments that are eligible, limits are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to establish and administer, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole. In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained, accurate and timely reporting is difficult, but even more essential.

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(iii) Investment Guidelines and Strategies

Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here, strategies are outlined in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. The limits described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management's guidelines.

(iv)Incentive Schemes

To the extent that management can enter incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, then the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper internal control systems. Such tools which include position posting, risk analysis, the allocation of costs, and setting of required returns to various parts of the organization are not trivial. Notwithstanding the difficulty, well designed systems align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the cases of the deposit insurance and maverick traders so clearly illustrate.

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3.9 Bank Risk Management Systems

The banking industry has long viewed the problem of risk management as the need to control risks which make up most, if not all, of their risk exposure, viz., credit, interest rate, foreign exchange and liquidity risk. While they recognize counterparty and legal risks, they view them as less central to their concerns. Where counterparty risk is significant, it is evaluated using standard credit risk procedures, and often within the credit department itself. Likewise, most bankers would view legal risks as arising from their credit decisions or, more likely, proper process not employed in financial contracting. Accordingly, the study of bank risk management processes is essentially an investigation of how they manage these four risks. In each case, the procedure outlined above is adapted to the risk considered so as to standardize, measure, constrain and manage each of these risks. To illustrate how this is achieved, this review of firmlevel risk management begins with a discussion of risk management controls in each area. The more difficult issue of summing over these risks and adding still other, more amorphous, ones such as legal, regulatory or reputational risk, will be left to the end. The banks approach is based on three basic elements:

i. a clear understanding of the relationship between risk and shareholder value, using economic value added (EVA) as the key measure;

ii. A stress-testing regime to assess the financial impact of potential extreme events and a breakdown in risk models; and

iii. A decision making and performance management framework that translates the insights acquired from i and ii into a consistent set of business decisions.

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3.10 Measuring Risk

For each Risk class, it is necessary to derive a means of estimating expected loss (for credit risk) and unexpected losses (for all three risk groups) such that an appropriate amount of capital can be held and the performance of each business assessed. As in the figure below, the output of the risk measurement process is such that ANZ allocates 55 per cent of total capital to credit risk, 25 percent to operational risk and the remaining 20 percent to market risk (both trading risk and balance sheet risk).

Figure showing Probability distribution of portfolio losses

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Risk Management in Banking Sector

Measuring Credit Risk

There are three factors that drive expected and unexpected losses on a credit portfolio: i. customer default risk determined by the risk-grade profile of the portfolio, the tenor of the exposures and the degree of exposure to country risk. Typically, the default rates are calibrated to those of Moodys Investors Service and Standard & Poors Ratings Service; ii. Exposure the amount that is likely to be outstanding at the time of default. This includes current drawn amounts as well as an allowance for contingent liabilities and undrawn lines; and iii. Loss given default determined by the level of security cover, the effectiveness of the workout process and the credit cycle. The calculation of expected loss is based on the current risk profile of the portfolio. Whenever possible, the calculation of expected loss ignores historical loss rates. Banks that rely on their average loss experience to derive expected loss are assuming that the risk profile, business mix and risk management processes remain constant over time. Other than for homogeneous consumer portfolios, ANZ has found this to be a flawed assumption. In most cases, the existing profile is considerably better than the one that created the losses of the past, and penalizing current business owners for past events seems unnecessary. In addition, any absence of past losses would be driven mostly by external variables, such as government regulation or inflation, rather than by a true absence of risk. Losses in Asia, for example, were very low for many years. The allocation of capital for credit risk is complicated by portfolio effects. Three of these warrant explicit consideration: i. the shape of the loss distribution in allocating capital it is necessary to determine the number of standard deviations that equates to a level of confidence of99.95 per cent. This number depends on the shape of each portfolio distribution. Of course, each portfolio may have a very different distribution. A credit card portfolio, for example, may reach

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Risk Management in Banking Sector 99.95 per cent at five standard deviations, while a corporate lending portfolio may require up to nine standard deviations;

ii. Correlation between default risk and loss given default during the early 1990s, default rates were insignificantly higher than they are now, while recovery rates were lower. The correlation between the two measures helps to explain the large losses incurred during the property downturn of that period; and iii. The impact of diversification between portfolios this is one of the traditional dilemmas of capital allocation. To what degree should the effects of diversification between businesses be taken into account? Although progress has been made in the area of credit risk modeling, the industry as a whole is still struggling to find a consistent measure of credit risk. To overcome the lack of consistency, several industry initiatives are underway. These initiatives are crucial for the development of a common language for credit risk and the gradual establishment of a more liquid market for credit instruments, similar to that which exists for traded market products.

Credit Risk Management Procedures

In presenting the approach employed to manage credit risk, refer to the four-step process mentioned before, beginning with standards and reports, each bank must apply a consistent evaluation and rating scheme to all its investment opportunities in order for credit decisions to be made in a consistent manner and for the resultant aggregate reporting of credit risk exposure to be meaningful. To facilitate this, a substantial degree of standardization of process and documentation is required. This has lead to standardized ratings across borrowers and a credit portfolio report that presents meaningful information on the overall quality of the credit portfolio. Given these standards, the bank can report the quality of its loan portfolio at any time. Note that total receivables, including loans, leases and commitments and derivatives, are reported in a single format. Assuming the adherence to standards, the entirety of the firm's credit quality is reported to senior management monthly via this reporting mechanism. Changes in this report from one period to another occur for two reasons, viz., loans have entered or exited the
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Risk Management in Banking Sector system, or the rating of individual loans has changed over the intervening time interval. The first reason is associated with standard loan turnover. Loans are repaid and new loans are made. The second cause for a change in the credit quality report is more substantive. Variations over time indicate changes in loan quality and expected loan losses from the credit portfolio. In fact, credit quality reports should signal changes in expected loan losses, if the rating system is meaningful. However, the lack of available industry data to do an appropriate aggregate migration study does not permit the industry the same degree of confidence in their expected loss calculations. For this type of credit quality report to be meaningful, all credits must be monitored, and reviewed periodically. It is, in fact, standard for all credits above some dollar volume to be reviewed on a quarterly or annual basis to ensure the accuracy of the rating associated with the lending facility. In addition, a material change in the conditions associated either with the borrower or the facility itself, such as a change in the value of collateral, will trigger a re-evaluation. This process, therefore, results in a periodic but timely report card on the quality of the credit portfolio and its change from month to month. Generally accepted accounting principles require this monitoring. The credit portfolio is subject to fair value accounting standards, which have recently been tightened by The Financial Accounting Standards Board (FASB). Commercial banks are required to have a loan loss reserve account (a contra asset) which accurately represents the diminution in market value from known or estimated credit losses. As an industry, banks have generally sought estimates of expected loss using a two-step process, including default probability, and an estimate of loss given default.

Measuring Market Risk

Banks are exposed to market risk via their trading activities and their balance sheets. The common measure used to express market risk is value-at-risk (VaR). In ANZ, VaR measures the maximum loss in portfolio value over a one-day holding period with 97.5 per cent confidence. For example, if an activity has a VaR of $5 million, it can be expected that in39 out of 40 days losses will be less than $5 million. Conversely, in 1 out of 40 days, or about 6 times a year, losses can be expected to exceed $5 million. The translation of VaR into a capital allocation number requires a number of steps. These include the annualisation of the daily risk measure and an increase in the confidence interval from 97.5 per cent to 99.95 per cent (in line with the
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Risk Management in Banking Sector required AA credit rating). Effectively, this process makes capital a multiple of VaR. In most commercial banks, the amount of capital allocated to trading risk is relatively small when compared to the other major risks. For ANZ, it represents less than 5 per cent of total allocated capital. Although VaR is based on a measure of volatility, risk managers cannot rely solely on this measure for comfort. For example, VaR does not capture the very low-probability events that are of real concern. Moreover, it is based on assumptions that may not be true in the real world. Two particular assumptions should be kept in mind: i. the shape of the loss distribution under VaR, changes in asset prices are commonly assumed to follow a normal distribution. While this may be reasonable in some cases, it is not true in general. Moreover, in extreme circumstances the distribution of asset prices can change shape quite significantly. During the Russian debt crisis, for example, price movements were mostly one way for weeks in a row; and ii. The data period used it is easy to believe that longer data series create more reliable results when estimating price volatility and correlations, since they involve a greater number of data points. This idea can be very deceptive. When predicting events that may occur over the next day or the next week, circumstances that existed a year ago are usually irrelevant. By contrast, what happened in the previous week could be very important and should be weighted more heavily in the estimate of future price volatility? To overcome the shortcomings of the modeling process, banks need to supplement the VaR-based limit structure with other risk management tools. For example, banks should have in place controls on the concentration of exposures, by market or by instrument, as well as controls on liquidity and non-linear risk. In addition, banks need to implement a stress-testing regime that systematically analyses the potential financial impact of a breakdown in any risk measurement models. These breakdowns typically occur at the same time as markets move in unexpected ways. The drive for improvement in market risk management within banks recently received a boost with the introduction of regulatory capital rules for traded market risk. These rules provide for the use of an internal models approach, which allows banks to apply their own risk measurement models to calculate a regulatory capital charge for traded market risk.
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Risk Management in Banking Sector The other component of market risk is the interest rate risk on banks balance sheets. This risk results from timing differences in the re-pricing of assets and liabilities, and the investment of capital. The capital allocated to this type of risk is intended to cover the potential loss in earnings resulting from a change in interest rates. Essentially this capital is an estimate of the cost of closing out the mismatches following an extreme event. In the calculation, a separate allowance is made for basis risk and option risk on the balance sheet. In this context, basis risk arises because movements in market interest rates do not translate directly into changes in the interest rates applied to customers, while option risk (or prepayment risk) refers to the ability of customers to repay a loan earlier than contractually agreed.

Measuring Operational Risk

Greater dependence on technology and centralized operations mean that banks are becoming increasingly exposed to operational risk. Some recent trends are:

banks are expanding their use of the Internet to service customers and perform basic functions; globalization is creating complex linkages between institutions and countries; part of the risk has been outsourced to third parties and so cannot be directly controlled; and Rules and regulations are expanding in an increasingly litigious society.

Measuring operational risk requires identification of the underlying operational drivers or risk factors. The objective is to build a minimum level of resilience in the organization, not to plan for every possible event by holding commensurate levels of capital. One way to increase the focus on operational risk is to allocate it to its natural owners. In most cases, these are the managers of the businesses and support areas who have ultimate responsibility for the continued operation of the organization. If the businesses rely on services from central areas such as information technology, they must insist on service-level agreements that specify the amount of back-up protection and associated costs. To avoid each business focusing on short-term costs, the service units need to define minimum standards that must be complied with. Although it is
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Risk Management in Banking Sector accepted that, in many cases, capital alone is insufficient to protect the business, it is nevertheless important to make the level of risk as visible as possible for performance management purposes. ANZ currently applies some basic rules to allocate capital for operational risk. In aggregate, this leads to an allocation that is approximately 25 per cent of total operating expenses.

Figure showing Sources of Operational Risk

Other Risks Considered But Not Modeled

Beyond the basic four financial risks, viz., credit, interest rate, foreign exchange and liquidity risk, banks have a host of other concerns as was indicated above. Some of these, like operating risk, and/or system failure, are a natural outgrowth of their business and banks employ standard risk avoidance techniques to mitigate them. Standard business judgment is used in this area to measure the costs and benefits of risk reduction expenditures and system design, as well as operational redundancy. While generally referred to as risk management, this activity is substantially different from the management of financial risk addressed here. Yet, there are still
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Risk Management in Banking Sector other risks, somewhat more amorphous, but no less important. In this latter category are legal, regulatory, suitability, reputational and environmental risk. In each of these risk areas, substantial time and resources are devoted to protecting the firm's franchise value from erosion. As these risks are less financially measurable, they are generally not addressed in any formal, structured way. Yet, they are not ignored at the senior management level of the bank.

Interest Rate Management Procedures

The area of interest rate risk is the second area of major concern and on-going risk monitoring and management. Here, however, the tradition has been for the banking industry to diverge somewhat from other parts of the financial sector in their treatment of interest rate risk. Most commercial banks make a clear distinction between their trading activity and their balance sheet interest rate exposure. Investment banks generally have viewed interest rate risk as a classic part of market risk, and have developed elaborate trading risk management systems to measure and monitor exposure. For large commercial banks and European-type universal banks that have an active trading business, such systems have become a required part of the infrastructure. But, in fact, these trading risk management systems vary substantially from bank to bank and generally are less real than imagined. In many firms, fancy value-at-risk models, now known by the acronym VaR, are up and running. But, in many more cases, they are still in the implementation phase. In the interim, simple ad hoc limits and close monitoring substitute for elaborate real-time systems. While this may be completely satisfactory for institutions that have little trading activity and work primarily on behalf of clients, the absence of adequate trading systems elsewhere in the industry is a bit distressing. For institutions that do have active trading businesses, value-at-risk has become the standard approach. Suffice it to say that the daily, weekly, or monthly volatility of the market value of fixed-rate assets are incorporated into a measure of total portfolio risk analysis along with equity's market risk, and that of foreign denominated assets. Given the generally accepted accounting procedures (GAAP) established for bank assets, as well as the close correspondence of asset and liability structures, commercial banks tend not to use market value reports, guidelines or limits. Rather, their approach relies on cash flow and book values, at the expense of market values. This system has been labeled traditionally a "gap reporting system", as the asymmetry of the re-pricing of assets and liabilities results in a gap. This has
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Risk Management in Banking Sector classically been measured in ratio or percentage mismatch terms over a standardized interval such as a 30-day or one-year period. This is sometimes supplemented with a duration analysis of the portfolio. However, many assumptions are necessary to move from cash flows to duration. Asset categories that do not have fixed maturities, such as prime rate loans, must be assigned a duration measure based upon actual re-pricing flexibility. A similar problem exists for core liabilities, such as retail demand and savings balances. Nonetheless, the industry attempts to measure these estimates accurately, and include both on- and off-balance sheet exposures in this type of reporting procedure. The result of this exercise is a rather crude approximation of the duration gap. Most banks, however, have attempted to move beyond this gap methodology. They recognize that the gap and duration reports are static, and do not fit well with the dynamic nature of the banking market, where assets and liabilities change over time and spreads fluctuate. In fact, the variability of spreads is largely responsible for the highly profitable performance of the industry over the last two years. Accordingly, the industry has added the next level of analysis to their balance sheet interest rate risk management procedures. Currently, many banks are using balance sheet simulation models to investigate the effect of interest rate variation on reported earnings over one-, three- and five-year horizons. These simulations, of course, are a bit of science and a bit of art. They require relatively informed re-pricing schedules, as well as estimates of prepayments and cash flows. In terms of the first issue, such an analysis requires an assumed response function on the part of the bank to rate movement, in which bank pricing decisions in both their local and national franchises are simulated for each rate environment. In terms of the second area, the simulations require precise prepayment models for proprietary products, such as middle market loans, as well as standard products such as residential mortgages or traditional consumer debt. In addition, these simulations require yield curve simulation over a presumed relevant range of rate movements and yield curve shifts. Once completed, the simulation reports the resultant deviations in earnings associated with the rate scenarios considered. Whether or not this is acceptable depends upon the limits imposed by management, which are usually couched in terms of deviations of earnings from the expected or most likely outcome. This notion of Earnings at Risk, EaR, is emerging as a common benchmark for interest rate risk. However, it is of limited value as it presumes that the range of rates considered is correct, and/or the bank's response mechanism contained in the simulation is accurate and feasible. Nonetheless, the results are viewed as indicative of the effect of underlying interest rate
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Risk Management in Banking Sector mismatch contained in the balance sheet. Reports of these simulations, such as contained in Table 8, are now commonplace in the industry. Because of concerns over the potential earnings outcomes of the simulations, treasury officials often make use of the cash, futures and swap markets to reduce the implied earnings risk contained in the banks embedded rate exposure. However, as has become increasingly evident, such markets contain their own setoff risks. Accordingly, every institution has an investment policy in place which defines the set of allowable assets and limits to the bank's participation in any one area. All institutions restrict the activity of the treasury to some extent by defining the set of activities it can employ to change the banks interest rate position in both the cash and forward markets. Some are willing to accept derivative activity, but all restrict their positions in the swap caps and floors market to some degree to prevent unfortunate surprises. As reported losses by some institutions mount in this area, however, investment guidelines are becoming increasingly circumspect concerning allowable investment and hedging alternatives.

Foreign Exchange Risk Management Procedures

In this area there is considerable difference in current practice. This can be explained by the different franchises that coexist in the banking industry. Most banking institutions view activity in the foreign exchange market beyond their franchise, while others are active participants. The former will take virtually no principal risk, no forward open positions, and have no expectations of trading volume. Within the latter group, there is a clear distinction between those that restrict themselves to acting as agents for corporate and/or retail clients and those that have active trading positions. The most active banks in this area have large trading accounts and multiple trading locations. And, for these, reporting is rather straightforward. Currencies are kept in real time, with spot and forward positions marked-to-market. As is well known, however, reporting positions is easier than measuring and limiting risk. The latter is more common than the former. Limits are set by desk and by individual trader, with monitoring occurring in real time by some banks, and daily closing at other institutions. As a general characterization, those banks with more active trading positions tend to have invested in the real-time VaR systems discussed above, but there are exceptions. Limits are the key elements of the risk management systems in foreign exchange trading as they are for all trading businesses. It is fairly standard for limits to
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Risk Management in Banking Sector be set by currency for both the spot and forward positions in the set of trading currencies. At many institutions, the derivation of exposure limits has tended to be an imprecise and inexact science. For these institutions, risk limits are set currency-by-currency by subjective variance tolerance. Others, however, do attempt to derive the limits using a method that is analytically similar to the approach used in the area of interest rate risk. Even for banks without a VaR system in place, stress tests are done to evaluate the potential loss associated with changes in the exchange rate. This is done for small deviations in exchange rates, but it also may be investigated for historical maximum movements. The latter is investigated in two ways. Either historical events are captured and worse-case scenario simulated, or the historical events are used to estimate a distribution from which the disturbances are drawn. In the latter case, a one or two standard deviation change in the exchange rate is considered. While some use these methods to estimate volatility, until recently most did not use co-variability in setting individual currency limits or in the aggregating exposure across multiple correlated currencies. Incentive systems for foreign exchange traders are another area of significant differences between the average commercial bank and its investment banking counterpart. While, in the investment banking community trader performance is directly linked to compensation, this is less true in the banking industry. While some admit to significant correlation between trader income and trading profits, many argue that there is absolutely none. This latter group tends to see such linkages leading to excess risk taking by traders who gain from successes but do not suffer from losses. Accordingly, to their way of thinking, risk is reduced by separating foreign exchange profitability and trader compensation.

Factors influencing the Value of Currency:

Demand and Supply Trade Deficit Government Budget Inflation Interest Rates Political Stability Traders Psychology
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Risk Management in Banking Sector

Types of Forex Exposures:

Transaction Exposure: Arises due to the change in the foreign exchange rate between the time the transaction is executed and the time it is settled.

Translation Exposure: Risk arising on a/c of changes in the exchange rates at the time of finalizing/consolidating the financial statements which has assets/liabilities denominated in foreign currencies.

Operating Exposure: Arises because of the impact of the change in currency rates on profits of a corporate.

Liquidity Risk Management Procedures

Two different notions of liquidity risk have evolved in the banking sector. Each has some validity. The first, and the easiest in most regards, is a notion of liquidity risk as a need for continued funding. The counterpart of standard cash management, this liquidity need is forecast able and easily analyzed. Yet, the result is not worth much. In today's capital market banks of the sort considered here have ample resources for growth and recourse to additional liabilities for unexpectedly high asset growth. Accordingly, attempts to analyze liquidity risk as a need for resources to facilitate growth, or honor outstanding credit lines are of little relevance to the risk management agenda pursued here. The liquidity risk that does present a real challenge is the need for funding when and if a sudden crisis arises. In this case, the issues are very different from those addressed above. Standard reports on liquid assets and open lines of credit, which are germane to the first type of liquidity need, are substantially less relevant to the second. Rather, what is required is an analysis of funding demands under a series of "worst case scenarios. These include the liquidity needs associated with a bank-specific shock, such as a severe loss, and a crisis that is system-wide. In each case, the bank examines the extent to which it can be self-supporting in the event of a crisis, and tries to estimate the speed with which the shock will result in a funding crisis. Other institutions attempt to measure the speed with which assets can be liquidated to respond to the situation using a report that indicates the speed with which the
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Risk Management in Banking Sector bank can acquire needed liquidity in a crisis. Response strategies considered include the extent to which the bank can accomplish substantial balance sheet shrinkage and estimates are made of the sources of funds that will remain available to the institution in a time of crisis. Results of such simulated crises are usually expressed in days of exposure, or days to funding crisis. Regulatory authorities have increasingly mandated that a liquidity risk plan be developed by members of the industry. Yet, there is a clear distinction among institutions, as to the value of this type of exercise. Some attempt to develop careful funding plans and estimate their vulnerability to the crisis with considerable precision. They contend that, either from prior experience or attempts at verification, they could and would use the proposed plan in a time of crisis. Others view this planning document as little more than a regulatory hurdle. While some actually invest in backup lines without "material adverse conditions" clauses, others have little faith in their ability to access them in a time of need.

3.11 Risk Aggregation and the Knowledge of Total Exposure

Thus far, the techniques used to measure, report, limit, and manage the risks of various types have been given. In each of these cases, a process has been developed, to measure the risk considered, and techniques have been deployed to control each of them. The extent of the differences across risks of different types is quite striking. The credit risk process is a qualitative review of the performance potential of different borrowers. It results in a rating, periodic reevaluation at reasonable intervals through time, and on-going monitoring of various types or measures of exposure. Interest rate risk is measured, usually weekly, using on- and off-balance sheet exposure. The position is reported in re-pricing terms, using gap, as well as effective duration, but the real analysis is conducted with the benefit of simulation techniques. Limits are established and synthetic hedges are taken on the basis of these cash flow earnings forecasts. Foreign exchange or general trading risk is monitored in real time with strict limits and accountability. Here again, the effects of adverse rate movements are analyzed by simulation using ad-hoc exchange rate variations, and/or distributions constructed from historical outcomes. Liquidity risk, on the other hand, more often than not, is dealt with as a planning exercise, although some reasonable work is done to analyze the funding effect of adverse news. The analytical approaches that are subsumed in each of these analyses are complex, difficult and not
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Risk Management in Banking Sector easily communicated to non-specialists in the risk considered. The bank, however, must select appropriate levels for each risk and select or, at least articulate, an appropriate level of risk for the organization as a whole. How is this being done? The simple answer is "not very well." Senior management often is presented with a myriad of reports on individual exposures, such as specific credits, and complex summaries of the individual risks, as outlined above. The risks are not dimensioned in similar ways, and management's technical expertise to appreciate the true nature of both the risks themselves and the analyses conducted to illustrate the bank's exposure is limited. Accordingly, over time, the managers of specific risks have gained increased authority and autonomy. In light of recent losses, however, things are beginning to change. As the organizational level, overall risk management is being centralized into a Risk Management Committee, headed by someone designated as the Senior Risk Manager. The purpose of this institutional response is to empower one individual or group with the responsibility to evaluate overall firm-level risk, and determine the best interest of the bank as a whole. At the same time, this group is holding line officers more accountable for the risks under their control, and the performance of the institution in that risk area. Activity and sales incentives are being replaced by performance compensation, which is based not on business volume, but on overall profitability. At the analytical level, aggregate risk exposure is receiving increased scrutiny. To do so, however, require the summation of the different types of risks outlined above. This is accomplished in two distinct, but related ways. The first of these, pioneered by Bankers Trust, is the RAROC system of risk analysis. In this approach, risk is measured in terms of variability of outcome. Where possible, a frequency distribution of returns is estimated, from historical data, and the standard deviation of this distribution is estimated. Capital is allocated to activities as a function of this risk or volatility measure. Then, the risky position is required to carry an expected rate of return on allocated capital which compensates the firm for the associated incremental risk. By dimensioning all risk in terms of loss distributions, and allocating capital by the volatility of the proposed activity, risk is aggregated and priced in one and the same exercise. A second approach is similar to the RAROC, but depends less on a capital allocation scheme and more on cash flow or earnings effects of the implied risky position. This was referred to as the Earnings at Risk methodology above, when employed to analyze interest rate risk. When market
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Risk Management in Banking Sector values are used, the approach becomes identical to the VaR methodology employed for trading exposure. This method can be used to analyze total firm-level risk in a similar manner to the RAROC system. Again, a frequency distribution of returns for any one type of risk can be estimated from historical data. Extreme outcomes can then be estimated from the tail of the distribution. Either a worst-case historical example is used for this purpose, or a one- or two standard deviation outcome is considered. Given the downside outcome associated with any risk position, the firm restricts its exposure so that, in the worst-case scenario, the bank does not lose more thana certain percentage of current income or market value. Therefore, rather than moving from volatility of value through capital, this approach goes directly to the current earnings implications from a risky position. The approach, however, has two very obvious shortcomings. If EaR is used, it is cash flow based, rather than market value driven. And, in any case, it does not directly measure the total variability of potential outcomes through an a priori distribution specification. Rather it depends upon a subjectively prespecified range of the risky environments to drive the worst-case scenario. Both measures, however, attempt to treat the issue of trade-offs among risks, using a common methodology to transform the specific risks to firm-level exposure. In addition, both can examine the correlation of different risks and the extent to which they can, or should be viewed as, offsetting. As a practical matter, however, most, if not all, of these models do not view this array of risks as a standard portfolio problem. Rather, they separately evaluate each risk and aggregate total exposure by simple addition. As a result, much is lost in the aggregation. Perhaps over time this issue will be addressed.

3.12 The Need for a Stress-Testing Regime

The advancement in risk measurement techniques across the industry is impressive. With the implementation of risk-adjusted profitability, it is now possible to view all the key risks in terms of a common unit of measurement. Provided the right amount of capital is allocated to an activity, the bank has effectively accounted for risk. Moreover, if two activities produce the same RAROC, the investment decision should be neutral. While this logic works well over a full economic cycle, it can be deceptive at any specific point in time. In particular, there can be circumstances that lead to losses that are well outside of known scenarios because the future
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Risk Management in Banking Sector hardly ever produces the same combination of circumstances as the past. There are three possible reasons for why existing risk measurement techniques can fail under stress:

i. markets move further and faster;

ii. Risks that are usually unrelated suddenly move together (and risks that are usually related suddenly move apart); or

iii. New risks emerge.

Risk management should therefore focus most attention on the tail of the loss distribution. To develop an understanding of what might happen under extreme circumstances; banks need to adopt a stress-testing regime that systematically analyses the impact of different scenarios on their earnings. This involves a number of steps. First, those variables that are most likely to have an adverse impact on future earnings or credit quality must be determined. Some examples are interest rates changes or the debt structure of a country, or discrete events such as an election or the Olympics. The next step is to systematically design scenarios and attach probabilities to them. The challenge here is to define events that are well outside conventional wisdom. Given these scenarios, the existing portfolio must then be stress tested so as to analyse the impact on earnings and portfolio quality. A good example of a stress event is the contagion effect that took hold of emerging markets. In September1997, the correlations between the bond indices of Eastern Europe and Latin America were relatively low. On the surface, this meant that attractive diversification benefits could be achieved by investing in both regions. By September 1998 the same correlations had doubled and both markets moved well outside normal model estimates. Banks incurred losses that easily exceeded 10 or 15 times the calculated VaR. Typically, once an event has occurred somewhere in the world it provides a good foundation for the development of stress scenarios in the same market or in other markets. The final stage in the formation of an effective stress-testing framework is the development of alternative actions that could be taken to either prevent the bank being caught in such a scenario or to protect against the consequences. For ANZ, a good example in this regard is the Asian crisis of late 1997 and 1998. In the very early stages of the crisis, ANZ conducted a stress test on its lending portfolio to understand the
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Risk Management in Banking Sector impact of a shock on loan losses. Together with a bottom-up assessment of individual customers, the bank was able to make early decisions on the best way to manage the credit portfolio. Another example is the impact of the Year 2000Millennium Bug on the banks customers. The issue is the degree to which the Year 2000 problem may increase default risk and the financial consequences of the potential rise in bankruptcies. ANZs assessment of the effect of the Year 2000 problem on its customers takes into account the customers current default probability, the impact of technology on that customers business and the level of preparedness for the date change. This information is now being used to model the impact of the scenario on credit quality and to develop management strategies. In some cases, potential consequences (or risks) can be hedged using off-balance sheet tools, such as credit derivatives or securitization. The market for these structures has been growing rapidly. This growth, however, poses a significant risk in its own right with most instruments not having been tested under a severe economic downturn. Moreover, increasingly it is becoming clear that many banks and investors have limited insight into the levels of risk they are exposed to. At some stage, the markets for credit derivatives and securitization will create surprises for a few participants. Passing on the very significant downside risk of credit to a third party assumes that this third party can absorb that risk under extreme circumstances how many banks, investors and regulators truly understand the ability of the market to deal with such an occurrence?

The Importance of Stress Testing

A fundamental component of risk management is stress testing. The experiences of the Asian crisis and emerging markets have served to reiterate the importance of a comprehensive stresstesting regime. To understand the impact of extreme events, banks must implement a stresstesting framework that systematically analyses the impact of different scenarios on the values of their portfolios. The difficulty is in determining which events to stress test and/or which parameters to use. The paper provides some useful starting points in this regard. Most importantly, the stress-testing framework should be tailored to the characteristics of the banks individual portfolios and should capture all the risks associated with those portfolios, i.e. market risk, credit risk and operational risk (including liquidity risk and business risk). The need to regularly, and rigorously, stress test trading portfolios for market risk is now universally
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Risk Management in Banking Sector accepted. Many banks, or at least those with relatively sophisticated trading portfolios, have in place some form of scenario analysis based on large shifts in market prices. I think that the industry is less developed in stress testing credit- and liquidity-related events. This may be because these types of stress tests are more difficult to implement. Whatever the reason, it seems that fewer banks have developed a comprehensive set of scenarios encompassing exposures to such risks as counterparty risk and liquidity risk. This is an area on which the industry should focus over the next few years.

3.13 Breaking the Vicious Cycle of Risk

The cycle refers to the process by which a bank assumes uneconomic risks and, by definition, makes large losses. As a consequence, the risk appetite of the bank is reduced, lending and trading risks are foregone and the bank loses market share. In turn, the bank adopts an aggressive marketing strategy to regain market share and the cycle starts over. Funke Kuppers vicious cycle aptly describes the risk-taking practices observed in the industry time and time again. Inarguably, all banks are faced with the challenge of breaking through the vicious cycle of risk. An appropriate framework for performance and decision making is critical in this respect. Many banks have adopted a performance-based strategy similar to the economic value added methodology here. It is widely recognized that such an approach most appropriately manages the trade-off between risk and reward. This type of approach provides suitable incentives for management while being consistent with shareholder objectives. Ultimately, a balanced scorecard approach to managing the institution is required it is important not to allow one particular area of business to dictate the strategy of the firm to the detriment of other businesses. The move to dynamic provisioning methodologies witnessed across the industry is also important in breaking the cycle. Dynamic provisioning refers to the practice of setting aside reserves, or provisions, to cover potential losses. The amounts provisioned are based on statistical assessments of the risks inherent in exposures and are adjusted continually as exposures change. While dynamic provisioning techniques are still evolving, the development of these types of approaches to risk management is undoubtedly contributing to a greater understanding, within individual banks, of the risks they are exposed to and how those risks changeover time.
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Risk Management in Banking Sector

Breaking the Vicious cycle of Risk

Basel Committee:

Basel 1:

In July 1988, the Basel Committee came out with a set of recommendations aimed at introducing minimum levels of capital for internationally active banks. These norms required the banks to maintain capital of at least 8 per cent of their risk-weighted loan exposures. Different risk weights were specified by the committee for different categories of exposure. For instance, government bonds carried risk-weight of 0 per cent, while the corporate loans had a risk-weight of 100 per cent.

Basel II:

To set right these aspects, the Basel Committee came up with a new set of guidelines in June 2004, popularly known as the Basel II norms. These new norms are far more complex and
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Risk Management in Banking Sector comprehensive compared to the Basel I norms. Also, the Basel II norms are more risk-sensitive and they rely heavily on data analysis for risk measurement and management. They have given three pillars which act as guideline for implementation of Basel II.

Pillar 1:

Basel II norms provide banks with guidelines to measure the various types of risks they face credit, market and operational risks and the capital required to cover these risks.

Pillar II (Supervisory Reviews):

Ensures that not only do the banks have adequate capital to cover their risks, but also that they employ better risk management practices so as to minimize the risks. Capital cannot be regarded as a substitute for inadequate risk management practices. This pillar requires that if the banks use asset securitization and credit derivatives and wish to minimize their capital charge they need to comply with various standards and controls. As a part of the supervisory process, the supervisors need to ensure that the regulations are adhered to and the internal measurement systems are standardized and validated.

Pillar III (Market Discipline):

this market discipline is brought through greater transparency by asking banks to make adequate disclosures. The potential audiences of these disclosures are supervisors, bank's customers, rating agencies, depositors and investors. Market discipline has two important components: Market signaling in form of change in bank's share prices or change in bank's borrowing rates.

Responsiveness of the bank or the supervisor to market signals.

What they Mean for banks?

Basel II norms are expected to have far-reaching consequences on the health of financial sectors
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Risk Management in Banking Sector worldwide because of the increased emphasis on banks' risk-management systems, supervisory review process and market discipline.

3.14 Asset liability management (ALM)

ALM is concerned with strategic balance sheet management involving management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. The main reasons for the growing significance of ALM are:

I. II. III. IV.

Volatility Product innovations Regulatory environment; and Enhanced awareness of top management

There are both macro and micro-level objectives of ALM and it is, however, the micro-level objectives that hold the key for attaining the macro-level objectives. At the macro-level, ALM leads to the formulation of critical business policies, efficient allocation of capital and designing of products with appropriate pricing strategies. And at the macro-level, the objective functions of the ALM are two-fold. It aims at profitability through price matching while ensuring liquidity by means of maturity matching. Price matching basically aims to maintain spreads by ensuring that the deployment of liabilities will be at a rate higher than the costs. Similarly, grouping the assets/liabilities based on their maturing profiles ensures liquidity. The gap is then assessed to identify future financing requirements. This ensures liquidity.

An effective ALM technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio. The purpose of ALM is thus, to enhance the asset quality, quantify the risks associated with the assets and liabilities and further manage them.

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Risk Management in Banking Sector The process involves the following steps: I. Review the interest rate structure and compare the same to the interest/product pricing of both assets and liabilities. This to a certain extent will highlight the impending risks and the need for managing the same. II. Examine the loan and the investment portfolios in the light of the foreign exchange risk and liquidity risk that might arise. At the same time the effect of these risks on the value and cost of liabilities should also be given due consideration. III. Examine the probability of the credit risk and contingency risk that mat originate either due to rate fluctuations or otherwise and assess the quality of assets. IV. Finally, review the actual performance against the projections made and analyzes the reasons for any effect on the spreads. Non-Performing Assets (NPAs): An NPA is one where interest is overdue for two quarters or more. In respect of NPAs, interest is not to be recognized on accrual basis, but is to be treated as income, only when actually received.

Asset Classification:

The banks classify their assets based on weaknesses and dependency on collateral securities and classify them as follows:

Standard assets: It carries not more than the normal risk attached to the business and is not an NPA. Sub-standard assets: An asset which remains as NPA for a period not exceeding 24 months, where the current net worth of the borrower, guarantor or the current market value of the security charged to the bank is not enough to ensure recovery of the debt due to the bank in full. Doubtful assets: An NPA that continues to remain so for a period (12 months).

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Risk Management in Banking Sector Loss assets: An asset identified by the bank or internal/external auditors or RBI inspection as loss asset, but the amount has not yet been written off wholly or partly.

Provisioning Norms:

Based on the asset classification, banks will have to make the following provisioning:

Loss assets- 100 percent of the outstanding amount Doubtful assets- 100 percent for the unsecured portion and 20-50 percent for the secured portion; Sub-standard assets- 10 percent of the total outstanding amount Standard assets- 5 percent provisioning is to be made.

The ALM technique so designed to manage the various risks will primarily aim to stabilize the short-term profits, long-term earnings and long-run sustenance of the bank. The parameter that is selected for the purpose of stabilizing will also indicate the target account that needs to be managed. The most common target accounts in ALM of banks are:

Net Interest Income (NII):

The impact of volatility on the short-term profits is measured by NII. Hence, if a bank has to stabilize its short-term profits, it will have to minimize the fluctuations in the NII.

Market value of Equity (MVE):

The market value of equity represents the long-term profits of the bank. The bank will have to minimize adverse movement in this value due to rate fluctuations. The target account will thus be MVE. In the case of unlisted banks, the difference between the market value of assets and liabilities will be the target account.

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Risk Management in Banking Sector Economic Equity Ratio:

The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. This in fact assesses the sustenance capacity of the bank. Stabilizing this account will generally come as a statutory requirement.

Addressing the Mismatches:

Mismatches can be positive or negative Positive Mismatch: M.A.>M.L. and Negative Mismatch M.L.>M.A. In case of +ve mismatch, excess liquidity can be deployed in money market instruments, creating new assets & investment swaps etc. For ve mismatch, it can be financed from market borrowings (Call/Term), Bills rediscounting, Repos & deployment of foreign currency converted into rupee.

Strategy:

To meet the mismatch in any maturity bucket, the bank has to look into taking deposit and invest it suitably so as to mature in time bucket with negative mismatch.

3.15 Investment portfolio of banks

The banks investment port folio can be used to generate both income and liquidity for the bank. It consists of the sovereign securities and other corporate securities. These securities which form the total investment portfolio are as follows: Government securities Approved securities Shares Debentures and Bonds Subsidiaries/Joint Ventures Other investments
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Risk Management in Banking Sector

VALUATION OF INVESTMENTS:

The banks also need to value its investment portfolio. This is done as under:

Held to Maturity

Investments classified under Held to maturity category need not be marked to market and will be carried at acquisition cost unless it is more than the face value, in which case the premium should be amortized over the period remaining to maturity. Banks should recognize any diminution. Other than temporary, in the value of their investments in subsidiaries/joint ventures, which are included under Held to maturity category and provide therefore. Such diminution should be determined and provided for each investment individually.

Held for Trading

The individual scrips in the Held for trading category will be revalued at monthly or at more frequent intervals and the net appreciation/depreciation will be recognized in the income account. The book value of the individual scrip will change with the revaluation.

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CHAPTER 4

RESULTS AND DISCUSSIONS

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Hypothesis Testing.
4.1 Research Design:
Prior research finds that banks manage credit risk for two main purposes: to enhance interest income (profitability) and to reduce loan losses (bad debts) which results from credit default (Sim, 2006). We expect that banks with better credit risk management practice have lower loan losses (non performing loans). We use profitability (ROA, ROE) as proxy for credit risk management indicators. Accordingly we have the following hypotheses:

4.2 Hypothesis:
1: Banks with higher profitability (ROE, ROA) have lower loan losses (Non-Performing Loans/ Total Loans). 2: Banks with higher interest income (net interest/Average total assets, interest net /total\ income) also have lower bad loans (NPL). Thus we test the hypothesis using the following regression model: P (ROA, ROE) = + NPL/TL+ .. (7)

Where, NPL denotes non-performing loans, TL denotes total loan and P denotes profitability (ROA, ROE). Also, is the intercept and is the parameter of explanatory variable ROA and ROE, represents the disturbance terms.

4.3. Data description

We use the data from HDFC Bank in our analysis. We do a time-series analysis of a five year financial data of HDFC Bank, to examine the relationship between profitability (ROE and ROA, separately) which are performance indicators and loan losses (NPL/TL) which represent the credit risk management effectiveness.

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Definitions: 1. Capital Adequacy Non-Performing Loans/Capital 2. Asset Quality Standards Non- Performing Loans/Total Loans Loans Provisions/Non-Performing Loans Loans Provisions/Total Loans Total Provisions/Total Assets NPL/TL LP/NPL LP/TL TP/TA NPL/C

3. Profitability Standards Net Profits/ Average Shareholders' Equity Net Profits/Average Total Assets ROE ROA

Summarization of variables for 2006-2010 (in percentages)

YEAR 2006 2007 2008 2009 2010 ROE 15,8 18,1 20,8 20,8 28,5 ROA 1,9 2,1 2,5 2,8 5,3 NPL/TL 10,7 11,1 8,1 6,3 4,3 LP/NPL 61,9 70,9 85,4 87,6 84,3 LP/TL 6,6 7,9 6,9 5,5 3,6 TP/TA 5,3 5,9 5,2 3,9 2,4 NPL/C 21,6 17,4 6,8 3,6 3,3

Regression result of ROE on NPL/TL

Model Summary

Adjusted R Std. Error of Model 1 R .910(a) R Square .828 Square .771 the Estimate 2.29047

a Predictors: (Constant), Net Performing Loans/Total Loans

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ANOVA(b)

Sum Model 1 Regression Residual Total Squares 75.841 15.739 91.580

of df 1 3 4 Mean Square 75.841 5.246 F 14.456 Sig. .032(a)

a Predictors: (Constant), Net Performing Loans/Total Loans b Dependent Variable: Return on Equity

Coefficients(a)

Unstandardized Coefficients Model 1 (Constant) Net Performing Loans/Total Loans B 32.998 -1.506 Std. Error 3.368 .396

Standardized Coefficients Beta t B 9.798 -.910 -3.802 Sig. Std. Error .002 .032

a Dependent Variable: Return on Equity

Regression result of ROA on NPL/TL.

Model Summary

Adjusted R Std. Error of Model 1 R .876(a) R Square .768 Square .690 the Estimate .76526

a Predictors: (Constant), Net Performing Loans/Total Loans

ANOVA(b)

Sum Model 1 Regression Residual Total Squares 5.811 1.757 7.568

of df 1 3 4 Mean Square 5.811 .586 F 9.923 Sig. .051(a)

a Predictors: (Constant), Net Performing Loans/Total Loans b Dependent Variable: Return on assets

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Risk Management in Banking Sector

Coefficients(a)

Unstandardized Coefficients Model 1 (Constant) Net Performing Loans/Total Loans B 6.297 -.417 Std. Error 1.125 .132

Standardized Coefficients Beta t B 5.596 -.876 -3.150 Sig. Std. Error .011 .051

a Dependent Variable: Return on assets

4.4 Analysis
The results of ROE on NPL/TL show that non-performing loan of the FIs is significantly negatively related to profitability. That is, 1 percent increase in non-performing loans decreases profitability (ROE) by 1.506 percent. The results of ROA on NPL/TL show that non-performing loan of the FIs is significantly negatively related to profitability. The parameter value shows that 1 percent increase in nonperforming loans decreases profitability (ROA) by 0.4168 percent. The results verify our hypothesis that better credit risk management results in better bank performance. We are aware that profitability is an endogenous variable which means that it can influence the magnitude of non-performing loans, since better profitability affords the FIs to write off more bad loans. But we focus our analysis on one sided relations of NPLs on profitability for our purposes.

4.5 Risk management at HDFC bank

HDFC bank manages its Operational and Credit Risk from the time for application for loan for all of its customers. But the Market Risk which consists of Interest rate risk, Forex Risk, Liquidity risk and all other Risks which comes into the ambit of market risk are being managed at the Head office and Regional offices by the Treasury Department. At Branch level the Risk management process is described below: Operational Risk: For managing the operational risk at the branch the Bank makes sure that the loan process and procedures are followed strictly. The sanctioning and disbursement is not under
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Risk Management in Banking Sector control of a single person and for taking the approval there is a hierarchy to be followed. There are inspection procedures laid for sanctioning the loan where the request for the loan is considered and is processed by the junior level officers and after their approval the file is forwarded to the manager who has the authority to pass the loan but to a certain extent. If the loan is of the higher amount then the file is again forwarded to the regional office where the Loan department permission is required which is given only after satisfying all the formalities and documentation on the loan. For large corporate and PSUs there is a s eparate dedicated office which proceeds on the loans by preparing the Credit Appraisal memorandum which contains all the details about the company and is sent to the Vice-president of the office who after reviewing it sends to his superior and the loan is sanctioned only when it gets its final signature from the concerned Authority in the Bank. Credit Risk: The loans at the branch level are provided after taking careful steps by looking into the applicants history and financial profile. The loan is granted only after taking into consideration the Know your customer norms and the 5 Cs of Lending. The bank also ask for a guarantee from some other person related to the applicant so that if the applicant fails to pay back then the collateral can be sold and if that is also not recovered then the person who as taken the guarantee is liable to repay the loan amount. And also the feasibility of the project and the return on the investment is also considered by calculating the Debt Service coverage ratio and if the project seems feasible then only the loan is granted. For large corporate and PSUs the Credit appraisal memorandum is prepared which consists each and every detail about the company and outstanding loans from other banks. The credit rating agencies are also contacted to provide the rating for a particular company if the rating is good then only granting of loan is considered. The company also believes in the regular inspection of the projects and asks for the quarterly reports of the company to see if the company is doing good. Market Risk: This risk is controlled directly from the Head office and Regional offices where the treasury department takes care of the banks positions with the help of Asset Liability management committee which works at the middle office. The front office only makes the deals and the back office executes the deals. There is no single person who works at any of two offices at any point of time so that the deals are cross checked. They have to strictly follow up with the open position limits and have to update the middle office frequently.

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4.5 Discussions
Making Consistent Risk Management Decisions

Making Consistent Risk Management Decisions

Despite the growth in secondary markets and hedging instruments, there is no market place yet for many illiquid instruments. Once a bank decides to participate in and assume the risks associated with any instrument, it should be prepared to incur stress-related losses. Taking a short-term earnings view can be dangerous; an event that could happen once in 20 years can just as easily happen tomorrow as it can in the year 2019. The main challenge for banks is to be decisive with regard to the level of risk to accept. In order to achieve this, banks need to develop management systems that provide a natural focus on risk as one of the drivers of performance.

There are four components to the management process:

i.

define the desired shape and risk profile of the institution, covering the mix of businesses and geographies;

ii.

manage the risk profile at the business level, recognising that risk management challenges and responses can vary considerably between businesses;
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Risk Management in Banking Sector iii. establish a management information system (MIS)that monitors performance and is tailored to the requirements of each business; and iv. Implement a performance management system that provides clear incentives to eliminate unacceptable and unprofitable risks.

For this framework to be effective, it needs to be supported by a strong and consistent risk culture. Set Top-Down Direction

The first stage of the risk management process is to define the risk appetite of the institution. In deciding the shape and risk profile of the bank, the challenge is to differentiate clearly between activities that are of strategic importance and those that are not. This is not easy as business managers tend to consider all activities and customers to be of strategic importance, particularly if future rewards depend on them. In some cases, several activities can be profitable on a riskadjusted basis yet, when the size of the institution is considered, it may not Be desirable to undertake all those activities. In late 1997, ANZ was confronted with a level of Exposure to the Asian region that left little room for the bank to support its core activities. Therefore, it was decided to eliminate a large part of the banks nonstrategic assets while ensuring that there was sufficient room for the banks franchise businesses, including trade finance, network customers and international project finance. As a result, wholesale banking and local corporate lending to the region were curtailed significantly. The inter-bank credit-spread business was closed down, other than for balance sheet management and customer-related business. Where possible, facilities were not renewed or rolled over, material adverse Change was invoked on undrawn lines, and net settlement was pursued in higher-risk countries within the Asian region. These actions resulted in a reduction of exposure to Asia of over 40 per cent, creating room to provide continued support to the banks core activities and customers. It was evident that a bank cannot be all things to all customers. While the Asian crisis required a rapid response, the experience reinforced the need to maintain a sound balance between wholesale and consumer banking, both domestically and offshore. As a first step to improve this balance, it was decided to exit all proprietary trading. Although the measures undertaken by
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Risk Management in Banking Sector many financial institutions in Asia were necessary, this action does not mean that Australian business should turn its back on the region. On the contrary, the volatility of the market provides attractive opportunities in trade finance and foreign exchange, with some banks using lower valuations to increase their coverage of the region. From a risk perspective, a complete withdrawal to the domestic market would be the wrong thing to do. Such a move would increase domestic concentration risk, although this would only become apparent when the cycle in Australia turns. International diversification reduces risk.

Manage by Line of Business

Once the desired risk profile of an institution has been defined, individual lines of business are best placed to manage the risk of their activities. The risk management challenges of each business require a specialist and integrated approach. In corporate banking, for example, the focus is largely on credit risk and the economic value of individual customers and transactions. Credit risk is managed through a series of concentration limits (for counterparties, industries and countries) and a discretions framework that forces the most significant risks to be approved by an independent credit chain. Measuring the risk and reward trade-off through EVA reinforces the need for sound risk management practices. ANZs analysis indicates that the vast majority of customers below an equivalent rating of BB are unprofitable on a risk-adjusted basis. This group of customers is also the most sensitive to adverse changes in economic conditions. With improvements in credit risk measurement, banks are now starting to adopt a portfolio approach to Managing wholesale credit risk. In this regard, some banks have formally separated credit origination and ongoing portfolio management. Within this framework, credit risk is transferred to the portfolio manager either by using a risk-neutral spread or through an actual sale of the assets on a mark-to-market basis. The challenge of the portfolio manager is to enhance EVA by actively shaping the risk profile of those assets. This can be achieved by physically adding or removing assets, or by transferring the risk synthetically. In personal banking, there is a greater balance between the three main types of risk. Next to credit risk the business is significantly Exposed to balance sheet risk and operational risk. While balance sheet risk is largely transferred to the asset and liability management function, operational risk remains with the business.
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Building a Management Information System for Risk

The third stage of the process is to establish a management information system (MIS) that is tailored to the requirements of each business. Risk management is highly dependent on information to support and monitor a wide range of business issues. In particular, banks need to: ensure that the assumption of risk is in line with the articulated strategy and risk appetite of the institution; develop customer segment strategies and marketing programs that optimize EVA; and understand the impact of a changing environment and stress events on the risk profile of the institution. In times of uncertainty, the MIS requirements tend to increase significantly. For example, without knowing what the banks Asian profile looks like, it becomes difficult to differentiate actions on the basis of higher risk exposures versus core franchise activities. There are two ways in which banks create an MIS to monitor risk. The first approach involves integrating all exposures into an information warehouse that provides standard reporting across a range of different dimensions. Unfortunately, building a warehouse can be very time consuming and is usually hampered by a lack of consistency and accuracy in data definitions and integrity. The alternative method, referred to as a bottom-up approach, starts with decisions at the transaction and customer level and gradually captures the data centrally. This approach provides immediate benefits for front-line staff, but does allow aggregated risk data to be available early in the process. Most bank send up taking a hybrid approach. In ANZ, domestic data are captured in a central warehouse and are supplemented by detailed data from the customer profitability models in place offshore.

Provide Consistent Incentives

The establishment of a clear direction in risk management will only work when the incentive systems of the institution support the desired behavior. Generally, executive reward systems should be based on a measure that adjusts for risk. If performance incentives are tied to shortterm revenue generation, they will inevitably reward increased risk-taking behavior, particularly
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Risk Management in Banking Sector when earnings are down. This ultimately leads to surprises. There are different ways to link incentives to EVA. One-way is to focus entirely on the change in EVA from year to year. This provides a clear incentive to improve performance, but does not reward the protection of existing EVA under competitive pressure. A different approach is to tie incentives to a combination of absolute EVA and changes in EVA. If the change is positive there is significant upside to bonuses, while a reduction in EVA erodes the available bonus pool. This approach motivates managers to protect and grow value, but may lead to some debate on the measurement of EVA. Specifically, there may be debate about the way results are risk adjusted, and the levels of costs and revenues that are attributed to each line of business. The focus on EVA does not mean that businesses cannot have more specific targets in their business plans. However, these targets need to be consistent with the principles underlying the EVA methodology. For example, one way to reduce exposure to higher-risk assets is to combine a revenue growth target with a reduction in allocated capital. This approach would force the business to move along the risk curve, reducing exposure to higher-risk assets while growing the lower risk, and more attractive, segments of the business.

Reinforce a Consistent Risk Culture Stern Stewart, the consulting firm widely regarded as one of the founding fathers of EVA, has defined four success factors in making the EVA methodology work: measurement determine the earnings and capital adjustments appropriate for the company and define the cost of capital; ii. management develop a framework for decision-making, including identification of EVA drivers; iii. motivation design a compensation system that ties bonuses to EVA and offers substantial upside; and iv. Mindset create training programs for staff and communications material for shareholders and other external stakeholders. Frequently, the mindset is forgotten when implementing new ways of managing risk. Developing a consistent risk culture

i.

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Risk Management in Banking Sector is the most powerful means of ensuring that risk is well controlled at all levels. The development of a consistent risk culture requires banks to take three basic steps: a) b) communicate the risk management objectives and the desired shape of the institution; create and maintain a core competency in risk management and ensure it is represented in all key lines of business; and c) Develop a track record for making decisions that are consistent with the specified objectives.

When designing a risk management function, culture is an important consideration. A strong and consistent culture can afford greater delegation of decisions down the line. A less coherent culture requires greater intervention in the decision making process. Risk management is a business responsibility and should not be delegated entirely to a support function. Ultimately, The Chief executive is the only company-wide risk manager. Many banks still failing on implementing risk management | Deloitte survey & report Deloitte have released a report based on a survey of banks and their approach to risk management, including the degree to which they have embedded risk into compensation decisions. The survey includes financial institutions from around the world, with 27% being banks over $100 Bn. Slightly more than 50% have not integrated risk across the enterprise and into compensation. This is somewhat surprising considering the public attention paid to the matter, and the lessons learned over the last two years about the disassociation of compensation from negative results. Risk management in the spotlight-Deloitte Recent developments in the financial markets have tested the capabilities of risk management across the financial services industry. Against this backdrop, Deloitte conducted its sixth biannual survey of risk management practices across the industry, receiving responses from 111 financial institutions around the world, with aggregate assets of more than $19 trillion.

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Risk Management in Banking Sector Banks and other financial institutions continue to have significant opportunities to strengthen their risk management processes and tools. The surveys findings include: 1. Risk management is not fully integrated throughout many institutions. Forty-nine percent of the institutions surveyed had completely or substantially incorporated responsibilities for risk management into performance goals and compensation decisions for senior management. 2. Overall responsibility for oversight and governance of risks rested with the board of directors at 77 percent of the institutions participating and 63 percent of these had a formal, approved statement of risk appetite. 3. Seventy-three percent of the institutions surveyed had a Chief Risk Officer (CRO) or equivalent position. As an indicator of the roles importance, the CRO reported to the board of directors and/or the CEO at roughly three-quarters of these institutions. 4. Only 36 percent of the institutions had an enterprise risk management (ERM) program, although another 23 percent were in the process of creating one. 5. Many institutions may have significant work to do to upgrade their IT risk management infrastructure. Roughly half of the executives were extremely or very satisfied with the capabilities of their risk systems to provide the information needed to manage market and credit risk. Some notable comments from the report: Roughly 80 percent of the institutions employed stress tests. Among institutions that conducted stress tests of their structured product exposures, only 17 percent conducted them daily, while 68 percent conducted these tests quarterly or less often. Other operational risk methodology areas, such as key risk indicators, external loss event data, and scenario analysis, were said to be well-developed by 20 percent or less of the institutions surveyed. Only roughly 40% of executives considered their operational risk assessments and their internal loss event data to be well-developed.

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CHAPTER 5

RECOMMENDATIONS AND CONCLUSIONS

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5.1 Recommendations

Areas Where Further Work Will Improve the Methodology

The banking industry is clearly evolving to a higher level of risk management techniques and approaches than had been in place in the past. Yet, as this review indicates, there is significant room for improvement. Before the areas of potential value added are enumerated, however, it is worthwhile to reiterate an earlier point. The risk management techniques reviewed here are not the average, but the techniques used by firms at the higher end of the market. The risk management approaches at smaller institutions, as well as larger but relatively less sophisticated ones, are less precise and significantly less analytic. In some cases they would need substantial upgrading to reach the level of those reported here. Accordingly, our review should be viewed as a glimpse at best practice, not average practices. Nonetheless, the techniques employed by those that define the industry standard could use some improvement. By category, recommended areas where additional analytic work would be desirable are listed below.

CREDIT RISK

The evaluation of credit rating continues to be an imprecise process. Over time, this approach needs to be standardized across institutions and across borrowers. In addition, its rating procedures need to be made compatible with rating systems elsewhere in the capital market. Credit losses, currently vaguely related to credit rating, need to be closely tracked. As in the bond market, credit pricing, credit rating and expected loss ought to be demonstrably closer. However, the industry currently does not have a sufficiently broad data base on which to perform the migration analysis that has been studied in the bond market. The issue of optimal credit portfolio structure warrants further study. In short, analysis is needed to evaluate the diversification gains associated with careful portfolio design. At this time, banks appear to be too concentrated in idiosyncratic areas, and not sufficiently managing their credit concentrations by either industrial or geographic areas.

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Risk Management in Banking Sector INTEREST RATE RISK

While simulation studies have substantially improved upon gap management, the use of book value accounting measures and cash flow losses continues to be problematic. Movements to improve this methodology will require increased emphasis on market-based accounting. However, such a reporting mechanism must be employed on both sides of the balance sheet, not just the asset portfolio. The simulations also need to incorporate the advances in dynamic hedging that are used in complex fixed income pricing models. As it stands, these simulations tend to be rather simplistic, and scenario testing rather limited.

FOREIGN EXCHANGE RISK

The VaR approach to market risk is a superior tool. Yet, much of the banking industry continues to use rather ad hoc approaches in setting foreign exchange and other trading limits. This approach can and should be used to a greater degree than it is currently. LIQUIDITY RISK

Crisis models need to be better linked to operational details. In addition, the usefulness of such exercises is limited by the realism of the environment considered. If liquidity risk is to be managed, the price of illiquidity must be defined and built into illiquid positions. While this logic has been adopted by some institutions, this pricing of liquidity is not commonplace.

OTHER RISKS

As banks move more off balance sheet, the implied risk of these activities must be better integrated into overall risk management and strategic decision making. Currently, they are ignored when bank risk management is considered.

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Risk Management in Banking Sector AGGREGATION OF RISKS

The decisions to accept risk and the pricing of the risky position are separated from risk analysis. If aggregate risk is to be controlled, these parts of the process need to be integrated better within the banking firm. Both aggregate risk methodologies presume that the time dimensions of all risks can be viewed as equivalent. A trading risk is similar to a credit risk, for example. This appears problematic when market prices are not readily available for some assets and the time dimensions of different risks are dissimilar. Yet, thus far no one firm has tried to address this issue adequately. Finally, operating such a complex management system requires a significant knowledge of the risks considered and the approaches used to measure them. It is inconceivable that Boards of Directors and even most senior managers have the level of expertise necessary to operate the evolving system. Yet government regulators seem to have no idea of the level of complexity, and attempt to increase accountability even as the requisite knowledge to control various parts of the firm increases.

5.2 The Way Forward for India

Continue to deepen the collaborative dialogue between industry and regulators, to deepen shared understanding of the challenges and opportunities for strengthening risk management capability in Indian banks. We also need acceptance of pragmatic solutions to the challenges of Basel II implementation. We need to make sure that bureaucracy and costs are minimized, & business benefits maximized. The main goal is improved risk management, not regulatory compliance. In this context, banks need to upgrade their credit assessment and risk management skills and retrain staff, develop a cadre of specialists and introduce technology driven management information systems.

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5.3 Key benefits out of this project:

Deepen understanding of the various categories of risk and how they interact Build new tools and techniques to evaluate and manage risk effectively Expand understanding of the broader context behind analytical models and approaches to risk in banking Draw lessons from the economic downturn as they relate to liquidity risks, fund transfer pricing, the future of capital regulation and performancerelated pay

Limitations of the Project: No primary data available

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5.4 Conclusion
The banking industry is clearly evolving towards higher levels of risk management techniques and approaches. However, several issues need to be addressed by the banking system in this regard. I would flag a few of them for you to dwell over. First, risk management is closely related to ALM. Any mismatch between assets and liabilities increases risks, whether it is interest rate risk, credit risk or liquidity risk. The recent experience of the South East Asian economies clearly demonstrated the need for having effective risk management techniques. Accurate risk identification and classification of past losses into expected and unexpected losses would help in positioning comprehensive internal controls. Secondly, the evaluation of credit rating continues to be an imprecise process. Over time, one should expect that the banking industry's rating procedures should be compatible with rating systems elsewhere in the capital market and have the same degree of objectivity. A third area where improvements seem warranted is the analysis of ex-post outcomes from lending. Credit losses are, currently not precisely related to credit rating. They need to be more closely tracked by the banking industry than they currently are. In short, credit pricing, credit rating and expected losses ought to be demonstrably linked. Fourthly, interest rate risk approaches include both the trading systems and balance sheet risk analysis. On trading systems, there has been considerable improvement. The VaR methodology has converted a rather subjective hand-on process of risk control to a more quantitative one. However, several questions still remain unanswered. The first of these is that the whole approach of VaR is dependent upon estimated distribution of returns. These are the key inputs to the risk measure, but the true ex-ante distribution is unknown. Estimates are obtained from either historical data or Monte Carlo simulation, but in either case, the estimated distribution is not unique. This problem in risk management will need to be examined by the banking industry. Finally, as banks move more towards off-balance sheet activities, the implied risk of agency activities must be better integrated into overall risk management and strategic decision-making. Currently, they are ignored when bank risk management is considered or are at a fairly primitive
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Risk Management in Banking Sector stage. If reasonable exposure estimates are to be obtained, and the true costs of risk absorption are to be factored in the operations, much more needs to be done including building up of a strong Management Information System (MIS) backed up by a sound database. To conclude, risk management systems have attracted considerable attention in the financial sector. Considerably more work needs to be done. The current state of risk management is merely a beginning. Many questions still remain unanswered, many questions have been answered only superficially and for certain others, we have no complete and comprehensive answers. It is here that the management science professionals have a clear role to play in this important task.

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REFERENCES

1. HDFC Bank Annual Report 2. Risk Management In Banks By R.S. Raghavan 3. Treasury and Risk Management in Banks 4. IMF working paper on Capital Account Convertibility and Risk Management in India By Amadou N. R. Sy 5. Risk Based Internal Audit in Banks By Gourav Vallabh Sharma 6. Banking In India (en.wikipedia.org/wiki/Banking_in_India) 7. Indian Banking Association (www.iba.org.in) 8. Risk Management- ICMR Publications 9. Credit Management- ICMR Publications 10. Commercial Bank Risk Management: an Analysis of the Process by Anthony M. Santomero

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