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BACKGROUND
1.1 BACKGROUND
The following table provides an overview of the major risks that can be managed by financial
instruments with corresponding classes of instruments as per different project types.
Risk
Nature of Risk
FRM Instruments
Construction/
Project does not meet technical specifications
Construction
All
Risks (CAR/EAR)
Completion Risk Changes to project assumptions make the project
unviable
Surety bonds
Counterparty
Risk that the Construction Contractor does not
Performance
Risk
perform as per contract
guarantees
Liquidation damages
Operating Phase
Performance
Risk
Counterparty
Risk
Fuel
Technical performance
Managing the facility
Physical damage to the facility
Insurance
Surety bonds
Risk that the O & M Contractor does not perform
Performance
as per contract
guarantees
Liquidation damages
Weather
Insurance/
Derivatives
Risk
Credit Risk
Force
exchange Standard
Currency inconvertibility
Expropriation
Political violence
Breach of contract
derivative
products
Political
Risk
Insurance
MFI Guarantees
Export
Credit
guarantees
Insurance
Catastrophe bonds
Project Developer
Development
(Credit) Risk
Guarantee Funds
credit history
End User
Risks of
physical
damage
including theft
Micro-insurance
Credit Risk
Guarantees
Credit lines
Standard derivative
products to
hedge
against price
Insurance carbon
delivery Project fails to generate projected CERs. This is
delivery
guarantee,
linked to the intermittent nature of resource supply
permit
delivery
guarantee
concerns and barriers associated with for example technology performance risks and the harsh
offshore locations, which can restrict / limit participation.
The ability to deploy insurance capacity in developing countries is also hampered by local
insurance regulations which restrict foreign market access. Insurance availability in developing
countries is restricted by a lack of adequate financial, legal and service infrastructure as well as
lack of credit worthy local insurers, restrictive local insurance regulations and limited
distribution channels.
As most renewable technologies (with the exception of onshore wind) are perceived to be
prototypical in nature the limited data on commercial operating history presents a huge challenge
to the insurance industry who are unable to accurately model future loss projections and price
risk in an economic and sustainable manner. Further practical evaluation of the scope for
improving actuarial data and technical risk information flow and studies into new risk based
pricing methodologies would serve as useful interventions in catalyzing new thinking for RE
projects in insurance market.
CHAPTER-2
OVERVIEW OF RISKS
2.1 INTRODUCTION
Physical hazard This is a danger likely to happen due to the physical characteristics of an
object, which increases the chance of loss. For example defective wiring in a building which
enhances the chance of fire.
Moral hazard It is an increase in the probability of loss due to dishonesty or character
defects of an insured person. For example, Burning of unsold goods that are insured in order to
increase the amount of claim is a moral hazard.
Morale hazard It is an attitude of carelessness or indifference to losses, because the losses
were insured. For example, careless acts like leaving a door unlocked which makes it easy for a
burglar to enter, or leaving car keys in an unlocked car increase the chance of loss.
Legal hazard It is the severity of loss which is increased because of the regulatory
framework or the legal system. For example actions by government departments restricting the
ability of insurers to withdraw due to poor underwriting results or a new environment law that
alters the risk liability of an organization.
2.2 RISK AS REALITY
Risk is inherent in all activities. It is a normal condition of existence. Risk is the potential for a
negative future reality that may or may not happen. Risk is defined by two characteristics of a
possible negative future event: probability of occurrence (whether something will happen), and
consequences of occurrence (how catastrophic if it happens). If the probability of occurrence is
not known then one has uncertainty, and the risk is undefined.
Risk is not a problem. It is an understanding of the level of threat due to potential problems. A
problem is a consequence that has already occurred.
In fact, knowledge of a risk is an opportunity to avoid a problem. Risk occurs whether there is an
attempt to manage it or not. Risk exists whether you acknowledge it, whether you believe it,
whether if it is written down, or whether you understand it. Risk does not change because you
hope it will, you ignore it, or your bosss expectations do not reflect it. Nor will it change just
because it is contrary to policy, procedure, or regulation. Risk is neither good nor bad. It is just
how things are. Progress and opportunity are companions of risk. In order to make progress, risks
must be understood, managed, and reduced to acceptable levels.
2.3. DEGREE OF RISK
Degree of risk refers to the intensity of objective risk, which is the amount of uncertainty in a
given situation. It can be assessed by finding the difference between expected loss and actual
loss. The formula used is
Degree of risk = loss Expected loss actual and expected the between Difference
Degree of risk is measured by the probability of adverse deviation. If the probability of the
occurrence of an event is high, then greater is the likelihood of deviation from the outcome that
is hoped for and greater the risk, as long as the probability of loss is less than one. In the case of
exposures in large numbers, estimates are made based on the likelihood of the number of losses
that will occur. With regard to aggregate exposures the degree of risk is not the probability of a
single occurrence but it is the probability of an outcome which is different from that expected or
predicted. Therefore insurance companies make predictions about the losses that are expected to
occur and formulate a premium based on that.
2.4 CERTAINTY, RISK AND UNCERTAINTY
Certainty is when there is no doubt of the outcome of an event. But uncertainty is when there is
doubt in the achievement of the desired outcome and the potential deviation in the outcome is
called risk. The uncertainty in an event arises because of the knowledge which is not sufficient to
predict the outcome with certainty. Uncertainty implies that the person does not have thorough
knowledge and hence can only make a vague assessment about an objective risk situation.
Uncertainty is a perceptual phenomenon that exists in different degrees to different people. It can
be represented on a straight line called continuum. This continuum can be divided into different
levels of uncertainty.
Certainty
Uncertainty
Uncertainty is zero
Uncertainty is
very high at this
level
At level zero, the exposure to uncertainty is zero and at the right extremity the exposure to
uncertainty is 100%.
Level 0 (certainty) There is no uncertainty at this level. The outcome of an event is known in
certain. Events that come under the law of nature such as laws of physics and chemistry fall in
this category.
Level 1 (objective probability) Lowest level of uncertainty, events occurring in this level are
categorized by the likelihood of their occurrence. For example tossing of a coin, has an
established fact that there are two outcomes either heads or tails, each with a probability 0.5.
Level 2 (subjective probability) In this level, the degree of uncertainty increases. The outcomes
of the events in this level are known but assigning probabilistic values to these outcomes is
difficult. Probability is assigned with respect to a person, scenario or circumstances. Therefore it
is referred to as subjective probability.
Level 3 (complete uncertainty) The degree of uncertainty is the highest here. The outcomes of
the events in this level are difficult to predict and hence the probability of occurrence is not
known.
2.5 CLASSIFICATION OF RISK .
Risks are classified or grouped into a similar category in the insurance industry to quantify risk
and define the insurance premium to be charged. Classification of risks also helps in placing
individual risks with similar expectations of loss in a group or class of risks. By classifying we
can also estimate risks from probabilities associated with occurrence, timing and magnitude of
events.
2.5.1 Pure and speculative risk
Pure risks are defined as situation in which there are only two outcomes that is the possibility of
loss or no loss to an organization but no gain the event either happens or does not happen.
When this risk happens, the chance of making any profit is very badly low. Few examples of
pure risk are earthquake, theft, accident, fire etc. A car may or may not meet with an accident. If
an insurance policy is bought for the car, then if accident occurs the insurance company incurs
loss but on the contrary if accident does not occur there is no gain to the insured.
Speculative risks describe situations in which there is a possibility of gain as well as loss. The
element of gain is inherent or structured based on the situation. Few examples are gambling on
horses, investing in a stock market, merging with an organisation. Thus most of the speculative
risks are business related and some speculative risks are optional and can be avoided if desired.
This classification is based on the people who are affected by the event. Those risks which affect
an entire economy or a large group within the economy are termed as fundamental risks. For
example, cyclic unemployment, epidemics, drought, political and economic changes, and
terrorist attacks of recent times affect a large group of people and hence these are fundamental
risks. On the other hand, losses that arise out of individual events and are felt by particular
individuals and not by a community or a group is termed as particular risks. Examples are
burning of a house or an automobile accident.
The distinction between a fundamental and a particular risk is that an individual or a concern can
have control over particular risk but fundamental risks can hardly be controlled. Social insurance
and government insurance compensates for the loss incurred by a fundamental risk but in case of
particular risk an individual or a particular enterprise bears the burden of loss.
2.5.3 Static and dynamic risk
Based on the nature of the environment, risks are classified as static and dynamic. Static risks are
those which happen within a stable environment and are constant over an observed period of
time. They have a regular pattern of occurrence and can be reasonably predicted. Dynamic risks
arise from changes in the environment like economic, social, technological and political changes.
They are generally less predictable because they do not occur in any degree of regularity.
Static risks are immune to the changes in the environment. Dynamic risk resembles speculative
risk and static risk resembles pure risk.
2.5.4 Enterprise risk
This is a risk which includes all major risks faced by a business firm. It encompasses risks such
as pure risk, speculative risk, strategic risk, operational risk and financial risk. We already
studied about pure and speculative risks. Strategic risk is when an organization is uncertain about
its goals and objectives. Operational risks may result due to a firms business operations.
Financial risk is when there is uncertainty of loss because of changes in interest rates, foreign
exchange rates and value of money.
Enterprise risk plays a vital role in commercial risk management, which is a process in an
organization to treat all minor and major risks. Major risks can be addressed by bringing them all
together and treating them as one single program. By doing so, the firm can offset one risk
against another and also if some risks are negatively correlated overall risk can significantly be
reduced.
CHAPTER-3
INTRODUCTION OF RISK
MANAGEMENT
The strategies to manage risk typically include transferring the risk to another party, avoiding the
risk, reducing the negative effect or probability of the risk, or even accepting some or all of the
potential or actual consequences of a particular risk.
In ideal risk management, a prioritization process is followed whereby the risks with the greatest
loss (or impact) and the greatest probability of occurring are handled first, and risks with lower
probability of occurrence and lower loss are handled in descending order. In practice the process
of assessing overall risk can be difficult, and balancing resources used to mitigate between risks
with a high probability of occurrence but lower loss versus a risk with high loss but lower
probability of occurrence can often be mishandled.
These risks are less predictable and may not result in losses because it contains an element of
gain to the organisation.
o Natural factors It refers to the natural calamities over which the organisation has little or no
control. It results from events like earthquake, flood, cyclone, famine. Such events may cause
loss of life or property to the organisation.
o Political factors It plays an important role in functioning of long and short term business. It
occurs due to the political changes in government, communal violence, civil wars. The changes
in government policies and regulations may affect the position and profits of an organisation.
The risks are inevitable and hence it cannot be eliminated completely but can be controlled
through proper preventive and corrective measures of risk management.
3.4 RISK CATEGORIES
3.4.1 Credit risk
Credit risk comprises counterparty risk, settlement risk and concentration risk. These risk types
are defined as follows:
Counterparty risk is the risk of credit loss to the group as a result of failure by a counterparty
to meet its financial and/or contractual obligations to the group. This risk type has three
components:
primary credit risk, which is the exposure at default (EAD) arising from lending and related
banking product activities including their underwriting;
pre-settlement credit risk, which is the EAD arising from unsettled forward and derivative
transactions. This risk arises from the default of the counterparty to the transaction and is
measured as the cost of replacing the transaction at current market rates; and
issuer risk, which is the EAD arising from traded credit and equity products including their
primary market underwriting.
Settlement risk is the risk of loss to the group from settling a transaction where value is
exchanged, but where it fails to receive all or part of the counter value.
Credit concentration risk is the risk of loss to the group as a result of excessive build-up of
exposure to, among others, a single counterparty or counterparty segment, an industry, a market,
a product, a financial instrument or type of security, a country or geography, or a maturity. This
concentration typically exists where a number of counterparties are engaged in similar activities
and have similar characteristics, which could result in their ability to meet contractual obligations
being similarly affected by changes in economic or other conditions.
3.4.1.1 Tools of Credit Risk Management.
The instruments and tools, through which credit risk management is carried out, are detailed
below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds say 15% for individual
borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by
the group, Threshold limit is fixed at a level lower than Prudential Exposure; Substantial
Exposure, which is the sum total of the exposures beyond threshold limit should not exceed
600% to 800% of the Capital Funds of the bank (i.e. six to eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise delegation of
powers, Higher delegated powers for better-rated customers; discriminatory time schedule for
review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal
based on risk rating, etc are formulated.
c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point scale.
Clearly define rating thresholds and review the ratings periodically preferably at half yearly
intervals. Rating migration is to be mapped to estimate the expected loss.
d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category
borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb
the unexpected loss. Adopt the RAROC framework.
e) Portfolio Management : The need for credit portfolio management emanates from the
necessity to optimize the benefits associated with diversification and to reduce the potential
adverse impact of concentration of exposures to a particular borrower, sector or industry.
Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of
borrowers in various industry, business group and conduct rapid portfolio reviews. The existing
framework of tracking the non-performing loans around the balance sheet date does not signal
the quality of the entire loan book. There should be a proper & regular on-going system for
identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio
quality and integrate portfolio reviews with credit decision-making process.
f) Loan Review Mechanism : This should be done independent of credit operations. It is also
referred as Credit Audit covering review of sanction process, compliance status, review of risk
rating, pick up of warning signals and recommendation of corrective action with the objective of
improving credit quality. It should target all loans above certain cut-off limit ensuring that at least
30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit
risks embedded in the balance sheet have been tracked. This is done to bring about qualitative
improvement in credit administration. Identify loans with credit weakness. Determine adequacy
of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the
credit audit needs to be broadened from account level to overall portfolio level. Regular, proper
& prompt reporting to Top Management should be ensured.
Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the
main operative limits are made available. However, it is not required to visit borrowers
factory/office premises.
3.4.2 Country risk
Cross-border transfer risk, herein referred to as country risk, is the uncertainty that a client or
counterparty, including the relevant sovereign, will be able to fulfil its obligations to the group
outside the host country due to political or economic conditions in the host country.
The management of country risk is delegated by the GCC to the group country risk management
committee (GCRC), a subcommittee of GROC. The GCRC recommends country risk appetite
for individual countries and ensures, through compliance with the country risk standard, that
country risk is effectively governed, identified, measured, managed, controlled and reported in
the group.
An internal rating model is used to determine the rating of each country in which the group has
an exposure. The model inputs are continually updated to reflect economic and political changes
in countries. The country risk model output provides an internal risk grade which is calibrated to
a 1 to 25 rating scale. Reviews of all countries to which the group is exposed are conducted
annually. In determining ratings, the groups network of operations, country visits and external
sources of information are used extensively.
3.4.3 Liquidity risk
Liquidity risk arises when the group, despite being solvent, cannot maintain or generate
sufficient cash resources to meet its payment obligations as they fall due, or can only do so at
materially disadvantageous terms.
This type of event may arise where counterparties who provide the bank with funding withdraw
or do not roll over that funding, or as a result of a generalised disruption in asset markets which
results in normally liquid assets becoming illiquid.
Group unencumbered surplus liquidity
Assets are nothing but any item of economic value owned by an individual or corporation.
Assumptions regarding a banks future stock of assets include their possible marketability and
use an asset as a guarantee of existing assets which could increase flow of cash and others.
To determine the marketability of an asset, the method segregates the assets into three categories
according to their degree of relative liquidity:
The highly liquid group of assets consists of components such as interbank loans, cash and
securities. Some of the assets might instantaneously be converted into cash at existing market
values under almost any situation whereas others, such as interbank loans might lose liquidity in
a common crisis.
A less liquid group of assets consists of bank's saleable loan portfolio. The assignment here is
to develop assumptions about a reasonable plan for the clearance of a bank's assets. Some assets,
while marketable, might be viewed as unsaleable within the time frame of the liquidity analysis.
The least liquid group of assets consist of basically unmarketable assets such as loans that are
not capable of being readily sold, bank premises and investments in subsidiaries.
Because of the difference in the banks internal asset-liability management, different banks can
allot the same assets to different groups on maturity ladder.
While categorising the assets, banks should take care of the effects on the assets liquidity under
the various conditions. Under normal conditions, there may be assets which are much liquid then
during a time of crisis. Therefore a bank may classify the assets according to the type of scenario
it is forecasting.
Liabilities
To check the cash flows occurring due to a bank's liabilities, a bank should first examine the
behaviour of its liabilities under normal business situations. This would include forming:
The level of roll-overs of deposits and other liabilities remain normal.
The actual maturity of deposits with non-contractual maturities, such as demand deposits and
others; the normal growth in new deposit accounts.
While examining the cash flow arising from a bank's liabilities during the two crisis scenario, a
bank would look at four basic questions. The first two questions represent the proceedings in the
flow of cash that tend to reduce the cash outflows planned directly from contractual maturities.
The four questions are as follows:
What are the different sources of funding that are likely to stay with a bank under any
situation, and can the count of these sources be increased?
Other than the liabilities identified from this step, a bank's capital and term liabilities that are not
maturing within the prospect of the liquidity analysis provide a liquidity buffer.
The total liabilities identified in the first category may be assumed to stay with the bank even
when its a worst scenario. Some core deposits generally remain with a bank because retail and
small scale industry depositors may rely on the public-sector security net to shield them from
occurring loss, or because the cost of changing banks, especially for some business services that
include transactions accounts, is unaffordable in the very short term.
What are the sources of funding that can be estimated to run off gradually if problems occur,
and at what rate? Is deposit pricing a way for controlling the rate of runoff?
The second category consists of liabilities that have chances of staying back with the bank during
the period of slight difficulties and can be used during crisis. Liabilities, includes core deposits
that are not already included in the first category. In some countries, other than core deposits,
some of the interbank deposits and government funding remains with the bank even though they
are considered volatile .for these kinds of cash flows a bank's very own past experience related to
liabilities and the experiences of other such firms with similar problems may come handy. And
help in creating a time table.
Which maturing liabilities can be estimated to run off instantly at the first warning of trouble?
The third category consists of the maturing liabilities that remained, including some without
contractual maturities, such as wholesale deposits. Under each case, this approach adopts a
conservative stand and assumes that these remaining liabilities will be paid back at as early as
possible before the maturity date, especially when there is high crisis, as such money may flow
to government securities and other safe refuges.
Factors such as diversification and relationship building are considered important during the
evaluation of the degree of the outflow of funds and a bank's capacity to replace funds.
Nevertheless, in a general market crisis, sometimes high scale firms may find that they receive
larger than the usually got wholesale deposit inflows, even though there are no cash inflows
existing for other firms in the market.
Does the bank have a reliable back-up facility?
For example, small banks in local areas may also have credit lines that they can bring down to
offset cash discharges. These facilities are rarely found in larger banks but however it depends on
the assumptions made on the banks liabilities. Such facilities usually need to undergo many
changes but only to a limit, especially in a bank specific crisis.
A bank should also examine the availability of sufficient cash flows from its off balance sheet
activities (other than the loan commitments already considered), even if they are not a portion of
the banks recent liquidity analysis.
In addition, the Contingent liabilities, such as letters of credit and financial guarantees, represent
potentially significant cash outflow for a bank, but are usually not dependent on a bank's
condition. A bank may be able to create a "normal" level of out flow of cash on a regulatory
basis, and then estimate the possibility a raise in these flows during periods of stress. However, a
general market crisis may generate a considerable increase in the total invocation of letters of
credit because of an increase in defaults and liquidations in the market.
Other possible sources of cash outflows are swaps, written Over-The-Counter (OTC) options,
and forward foreign exchange rate contracts. For instance, consider that a bank has a large swap
book; it would then want to study the circumstances under which it could become a net payer,
and whether or not the total net pay-out is significant.
Consider another situation wherein a bank acts as a swap market-maker, with a possibility that in
a bank-specific or general market crisis, customers with in-the-money swaps (or a net in-themoney swap position) would try to reduce their credit exposure to the bank by requesting the
bank to buy the swaps back. Similarly, a bank would like to review its written OTC options book
and any warrants that are due, along with hedges if any against these positions, since certain
types of crises sometimes arouse an increase in early exercises or requests that the banks should
buy the offer back. These activities could result in an unexpected cash loss, if hedges can neither
be quickly liquidated to generate cash nor provide insufficient cash.
Other assumptions
Until now the discussion was centered on the assumption about the behaviour of the specific
instrument under different scenarios. At the time of looking the components exclusively, there
might be some of the factors that might have a major impact on the cash flows.
The need for liquidity arises from business activities. The banks too need excess funds to support
extra operations.
For example, the majority of the banks provide clearing services to financial institutions and
correspondent banks. These institutions generate a major sum of cash inflow and cash outflows
and unpredicted variations in these services can reduce a banks funds to a large extent.
The other expenses such as rent and salary however are not given much importance in the
analysis of the banks liquidity. But they can be sources of cash outflows in some cases.
3.4.4 Market risk
This is the risk of a change in the actual or effective market value or earnings of a portfolio of
financial instruments caused by adverse movements in market variables such as equity, bond and
commodity prices; currency exchange and interest rates; credit spreads; recovery rates and
correlations; as well as implied volatilities in all of the above.
3.4.5 Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events. This includes information and legal risk but excludes
reputational and strategic risk.
3.4.5.1 Responsibility and approach to operational risk management
Operational risk is recognized as a distinct risk category which the group manages within
acceptable levels through sound operational risk management practices. The groups approach to
managing operational risk is to adopt practices that are fit for purpose to suit the organizational
maturity and particular business environments.
Executive management defines the operational risk appetite at a business unit and group level.
This operational risk appetite supports effective decision making and is central to embedding risk
management in business decisions and reporting.
3.4.6 Business risk
Business risk relates to the potential revenue shortfall compared to the cost base due to strategic
and/or reputational reasons. From an economic capital perspective, business risk capital
requirements are calculated as the potential loss arising over a one-year timeframe, within a
certain level of confidence, as implied by the groups chosen target rating. The groups ability to
generate revenue is impacted by, among others, the external macroeconomic environment, its
chosen strategy and its reputation in the markets in which it operates.
Economic capital by risk type
Credit risk
Equity risk
Market risk
Operational risk
Business risk
June
2010
Rm
28 597
1 865
1 768
6 814
1 817
December
2009
Rm
31 336
1 293
1 747
6 965
1 504
economic capital
Available
financial
resources
Capital coverage ratio
1 620
1 917
42 481
44 762
86 830
81 503
2,04
1,82
Foreign exchange risk occurs during the change of investments value occurring due to the
changes in currency exchange rates. It refers to the probability of loss occurring due to an
adverse movement in foreign exchange rates. For example Consider an investor residing in
United States purchases a bond denominated in Japanese Yen. By this the investor experiences
decline in rate of return at which the Yen exchanges for dollars.
Trade options The foreign currencies contain options which allow the buyers to buy or sell
financial assets at a specified price and time. The process to hedge foreign currency with options
is similar to hedging futures and forwards, which minimizes the risk of loss in currency trade.
Purchasing swaps It refers to the exchange of future income streams in different currencies.
The organizations use swaps sparingly for portions of their foreign holdings.
Open a foreign bank account The method of depositing foreign currency in foreign banks
creates gain in interest rate. When the exchange rate increases, the value of foreign currency also
increases.
3.4.11 Environmental risk
The organisations must be able to monitor certain risks with respect to their daily operations. The
organisations must identify the specific risk that is concerned with local and global
environments. The various factors causing environmental risks include accidents, assaults, and
natural events like earthquake, volcano, tornado, floods, and famine. Hence the organizations
must induce environmental risk management which helps in implementing a system of metrics to
prevent the environmental problems.
The organizations must emphasize the process of environmental risk management which
includes certain protocols to manage the uncertainties within the organizational operations. The
procedures must be applied in daily activities and overall infrastructure assessments to eliminate
the damages caused in the organisation. The first step is to ensure whether the environmental risk
management is effective within the organisation to identify the most critical assets. It is also
important for the organizations to determine whether the assets are hampering the long term
stability of the environment and their impact on the business. For example if a company uses
large amount of paper then the threat of decline in tree growth arises. Hence the organisation
must devise recycle paper program method to solve the problem.
The organisation must assess the environment of the specific region in which it desires to make
investments. The environmental forecasts are necessary as far as there are no physical hindrances
to the organisation. Environmental issues can have significant impact on a companys stock
price.
Raising awareness and training will be an ongoing element of managing environmental risk and
identifying opportunities and business solutions to global environmental and social concerns.
3.4.12 Interest rate risk
Interest rate risk occurs due to the change in absolute level of interest rates causing variations in
the value of investments. Such changes usually affect the securities like shares, bonds, mutual
funds or money market instruments and can be reduced by diversifying or hedging techniques.
The evaluation of interest rate risk should consider illiquid hedging products or strategies, and
potential impact on fee income which are sensitive to changes in interest rates. They are
classified into the following:
Term structure risk (yield curve risk) It arises from the variations in the movement of
interest rates across maturity spectrum. It consists of changes in relationship between interest
rates of various maturities of similar market. The changes in relationships occur when the shape
of yield curve for a market flattens, steepens, or becomes inverted during interest rate cycle. The
yield curve variations can emphasize a banks risk position by increasing the effect of maturity
mismatches.
Basis risk It occurs due to the changes in relationship between interest rates for different
market sectors.
Options risk It arises when bank or bank customer gains privileges to alter the level and
timing of cash flows of asset, liability or off balance sheet instruments. The option holder has the
rights to buy or sell the financial instruments over a specified period of time. But the option
holder faces limited downside risks (amount paid for option) and unlimited upside reward. The
option seller faces unlimited downside risk (option exercised during the time of disadvantage)
and limited upside reward (retaining premium).
3.4.12.1 Factors Affecting Interest Rate
Interest rate is the amount claimed by a lender from a borrower for the use of the borrowed
money. Interest is an opportunity cost in terms of a lenders perspective and is the cost of capital
according to a borrowers perception.
Interest rate is a vital component in market assessments and so it is an important economic
indicator. Interest rate is important to companies as well as governments because it is an
important constituent of the capital cost.
The following are the factor that influences the level of market interest rate:
Intensity of inflation Inflation is defined as an increase in the typical price level of goods
and services in an economy over a period of time. Inflation reduces the procuring power of a
currency. So people with excess funds claim higher interest rates, as they want to protect their
investment returns against the unfavorable conditions of higher inflation.
Fluctuation of monetary policy The central bank of a country controls the money supply in
the economy through its monetary policy. In India, the monetary policy of RBI focuses at the
price stability and economic growth. If RBI loosens its monetary policy then the interest rate gets
reduced which leads to higher inflation. Whereas, if RBI strengthens its monetary policy then
interest rate increases, this thereby limits the inflation. Repo rate is used by RBI to inject or
remove liquidity from the monetary system.
General economic conditions If the economic growth of an economy improves then the
demand for money goes up. It ultimately compels the interest rates to move forward.
Global liquidity If global liquidity is high then the domestic liquidity of a country will also
be high which ultimately reduces the pressure on interest rates.
Foreign exchange market activity Foreign investor demand for debt securities influences the
interest rate. Higher inflows of foreign capital lead to increase in domestic money supply which
in turn leads to higher liquidity and lower interest rates.
Credit and payment history Making timely mortgage or rent payment is very important.
Late payments on credit cards, car payments and other bills affect the interest rate.
Debt to income ratio The higher the debt to income ratio, the higher will be the interest
rate.
Property type The interest rate depends upon the type of property owned by an individual.
The less risky is the property, the better the interest rate proposed.
Loan amount The amount of money the borrower borrows makes a difference in the interest
rate.
Reduced paperwork activities Many lenders offer reduced paperwork alternatives. These
alternatives increase the suitability of getting a loan for the consumer. It also increases the risks
for the lender.
Property state Varying property states have different regulations and requirements that
results in fluctuating business costs. These costs are often passed to the consumer in the form of
an interest rate for the lenders.
Budgetary deficit Budgetary deficit and increased borrowing programme of the Government
will lead to increase in interest rates as the demand for funds increases. With increase in interest
rates, costs go up and this will result in inflation
3.4.12.2 Methods To Reduce Interest Rate Risks :
Diversifying maturities The rate of return is usually not fixed across all maturity dates.
Usually long term securities pay higher return than short term dated securities. Hence these
factors can be hedged by spreading fixed income investments across entire yield curve from
short term dated maturities to long term bonds. Doing this effectively will provide expectations
about future interest rate movements.
Buy fixed or floating swaps The swaps is an agreement to exchange capital streams from
assets to qualities within a period of time. The fixed or floating swaps allow the fixed rate debtor
to exchange capital stream debt of identical maturity by paying floating interest rate. Hence, if
the interest rate rises, then the debtors receive difference in interest revenues through swaps.
Use real interest rate strategy It is important to analyse the presence of risk. One way to
determine is by using real interest rate, the nominal interest rate (interest earned on a high yield
savings account) minus rate of inflation.
Real interest rate = Nominal interest rate Rate of inflation
The yield curve shows high interest rate risk when it is steep or flat. Hence using such
indicator can provide investor with information to diversify across various maturities
events. Risk management depends on risk management planning, early identification and
analysis of risks, continuous risk tracking and reassessment, early implementation of corrective
actions, communication, documentation, and coordination.
As depicted in Figure all of the parts are interlocked to demonstrate that after initial planning the
parts begin to be dependent on each other.
Risk planning
Risk Planning is the continuing process of developing an organized, comprehensive approach to
risk management. The initial planning includes establishing a strategy; establishing goals and
objectives; planning assessment, handling, and monitoring activities; identifying resources, tasks,
and responsibilities; organizing and training risk management IPT members; establishing a
method to track risk items; and establishing a method to document and disseminate information
on a continuous basis.
Risk Assessment
Risk assessment consists of identifying and analyzing the risks associated with the life cycle of
the system.
Risk identification activities establish what risks are of concern. These activities include:
Identifying risk/uncertainty sources and drivers,
Transforming uncertainty into risk,
Quantifying risk,
Establishing probability, and
Establishing the priority of risk items.
After identifying the risk items, the risk level should be established. One common method is
through the use of a matrix such as shown in Figure 15-5. Each item is associated with a block in
Analysis Activities
Risk analysis activities continue the assessment process by refining the description of identified
risk event through isolation of the cause of risk, determination of the full impact of risk, and the
determination and choose of alternative courses of action. They are used to determine what risk
should be tracked, what data is used to track risk, and what methods are used to handle the risk.
Risk analysis explores the options, opportunities, and alternatives associated with the risk. It
addresses the questions of how many legitimate ways the risk could be dealt with and the best
way to do so. It examines sensitivity, and risk interrelationships by analyzing impacts and
sensitivity of related risks and performance variation. It further analyzes the impact of potential
and accomplished, external and internal changes.
Risk analysis activities that help define the scope and sensitivity of the risk item include finding
answers to the following questions:
If something changes, will risk change faster, slower, or at the same pace?
If a given risk item occurs, what collateral effects happen?
How does it affect other risks?
How does it affect the overall situation?
Development of a watch list (prioritized list of risk items that demand constant attention by
management) and a set of metrics to determine if risks are steady, increasing, or decreasing.
Development of a feedback system to track metrics and other risk management data.
Development of quantified risk assessment.
Risk Handling
Once the risks have been categorized and analyzed, the process of handling those risks is
initiated. The prime purpose of risk handling activities is to mitigate risk. Methods for doing this
are numerous, but all fall into four basic categories:
Risk Avoidance,
Risk Control,
Risk Assumption, and
Risk Transfer.
Monitoring and Reporting
Risk monitoring is the continuous process of tracking and evaluating the risk management
process by metric reporting, enterprise feedback on watch list items, and regular enterprise input
on potential developing risks. (The metrics, watch lists, and feedback system are developed and
maintained as an assessment activity.) The output of this process is then distributed throughout
the enterprise, so that all those involved with the program are aware of the risks that affect their
efforts and the system development as a whole.
CHAPTER-4
PROCESS OF RISK
MANAGEMENT
According to the standard ISO 31000 , the process of risk management consists of several
steps as follows:
Source analysis - Risk sources may be internal or external to the system that is the target
of risk management (use mitigation instead of management since by its own definition
risk deals with factors of decision-making that cannot be managed).
Examples of risk sources are: stakeholders of a project, employees of a company or the
weather over an airport.
Problem analysis - Risks are related to identified threats. For example: the threat of losing
money, the threat of abuse of confidential information or the threat of human errors,
accidents and casualties. The threats may exist with various entities, most important with
shareholders, customers and legislative bodies such as the government.
When either source or problem is known, the events that a source may trigger or the events
that can lead to a problem can be investigated. For example: stakeholders withdrawing
during a project may endanger funding of the project; confidential information may be stolen
by employees even within a closed network; lightning striking an aircraft during takeoff may
make all people on board immediate casualties.
The chosen method of identifying risks may depend on culture, industry practice and
compliance. The identification methods are formed by templates or the development of
templates for identifying source, problem or event. Common risk identification methods are:
Objectives-based risk identification- Organizations and project teams have objectives.
Any event that may endanger achieving an objective partly or completely is identified as
risk.
Scenario-based risk identification - In scenario analysis different scenarios are created.
The scenarios may be the alternative ways to achieve an objective, or an analysis of the
interaction of forces in, for example, a market or battle. Any event that triggers an
undesired scenario alternative is identified as risk see Futures Studies for methodology
used by Futurists.
Taxonomy-based risk identification - The taxonomy in taxonomy-based risk
identification is a breakdown of possible risk sources. Based on the taxonomy and
knowledge of best practices, a questionnaire is compiled. The answers to the questions
reveal risks.
Common-risk checking- In several industries, lists with known risks are available. Each
risk in the list can be checked for application to a particular situation.
Risk charting - This method combines the above approaches by listing resources at risk,
threats to those resources, modifying factors which may increase or decrease the risk and
consequences it is wished to avoid. Creating a matrix under these headings enables a
variety of approaches. One can begin with resources and consider the threats they are
exposed to and the consequences of each. Alternatively one can start with the threats and
examine which resources they would affect, or one can begin with the consequences and
determine which combination of threats and resources would be involved to bring them
about.
4.1.2.Risk assessment:
Once risks have been identified, they must then be assessed as to their potential severity of
impact (generally a negative impact, such as damage or loss) and to the probability of
occurrence. These quantities can be either simple to measure, in the case of the value of a lost
building, or impossible to know for sure in the case of the probability of an unlikely event
occurring. Therefore, in the assessment process it is critical to make the best educated decisions
in order to properly prioritize the implementation of the risk management plan.
Even a short-term positive improvement can have long-term negative impacts. Take the
"turnpike" example. A highway is widened to allow more traffic. More traffic capacity leads to
greater development in the areas surrounding the improved traffic capacity. Over time, traffic
thereby increases to fill available capacity. Turnpikes thereby need to be expanded in a
seemingly endless cycles. There are many other engineering examples where expanded capacity
(to do any function) is soon filled by increased demand. Since expansion comes at a cost, the
resulting growth could become unsustainable without forecasting and management.
The fundamental difficulty in risk assessment is determining the rate of occurrence since
statistical information is not available on all kinds of past incidents. Furthermore, evaluating the
severity of the consequences (impact) is often quite difficult for intangible assets. Asset valuation
is another question that needs to be addressed. Thus, best educated opinions and available
statistics are the primary sources of information. Nevertheless, risk assessment should produce
such information for the management of the organization that the primary risks are easy to
understand and that the risk management decisions may be prioritized. Thus, there have been
several theories and attempts to quantify risks. Numerous different risk formulae exist, but
perhaps the most widely accepted formula for risk quantification is:
Rate (or probability) of occurrence multiplied by the impact of the event equals risk
magnitude
The above formula can also be re-written in terms of a Composite Risk Index, as follows:
The impact of the risk event is commonly assessed on a scale of 1 to 5, where 1 and 5 represent
the minimum and maximum possible impact of an occurrence of a risk (usually in terms of
financial losses). However, the 1 to 5 scale can be arbitrary and need not be on a linear scale.
The probability of occurrence is likewise commonly assessed on a scale from 1 to 5, where 1
represents a very low probability of the risk event actually occurring while 5 represents a very
high probability of occurrence. This axis may be expressed in either mathematical terms (event
occurs once a year, once in ten years, once in 100 years etc.) or may be expressed in "plain
english" (event has occurred here very often; event has been known to occur here; event has been
known to occur in the industry etc.). Again, the 1 to 5 scale can be arbitrary or non-linear
depending on decisions by subject-matter experts.
The Composite Index thus can take values ranging (typically) from 1 through 25, and this range
is usually arbitrarily divided into three sub-ranges. The overall risk assessment is then Low,
Medium or High, depending on the sub-range containing the calculated value of the Composite
Index. For instance, the three sub-ranges could be defined as 1 to 8, 9 to 16 and 17 to 25.
Note that the probability of risk occurrence is difficult to estimate, since the past data on
frequencies are not readily available, as mentioned above. After all, probability does not imply
certainty.
Likewise, the impact of the risk is not easy to estimate since it is often difficult to estimate the
potential loss in the event of risk occurrence.
Further, both the above factors can change in magnitude depending on the adequacy of risk
avoidance and prevention measures taken and due to changes in the external business
environment. Hence it is absolutely necessary to periodically re-assess risks and intensify/relax
mitigation measures, or as necessary. Changes in procedures, technology, schedules, budgets,
market conditions, political environment, or other factors typically require re-assessment of risks.
4.1.3. Create a risk management plan
Select appropriate controls or countermeasures to measure
each risk. Risk mitigation needs to be approved by the
appropriate level of management. For instance, a risk
concerning the image of the organization should have
top management decision behind it whereas IT management
would have the authority to decide on computer virus risks.
The risk management plan should propose applicable and effective security controls for
managing the risks. For example, an observed high risk of computer viruses could be mitigated
by acquiring and implementing antivirus software. A good risk management plan should contain
a schedule for control implementation and responsible persons for those actions.
According to ISO/IEC 27001, the stage immediately after completion of the risk
assessment phase consists of preparing a Risk Treatment Plan, which should document the
decisions about how each of the identified risks should be handled. Mitigation of risks often
means selection of security controls, which should be documented in a Statement of
Applicability, which identifies which particular control objectives and controls from the
standard have been selected, and why.
4.1.4. Implementation
Implementation follows all of the planned methods for mitigating the effect of the risks.
Purchase insurance policies for the risks that have been decided to be transferred to an insurer,
avoid all risks that can be avoided without sacrificing the entity's goals, reduce others, and
retain the rest.
4.1.5. Review and evaluation of the plan
Initial risk management plans will never be perfect. Practice, experience, and actual loss results
will necessitate changes in the plan and contribute information to allow possible different
decisions to be made in dealing with the risks being faced.
Risk analysis results and management plans should be updated periodically. There are two
primary reasons for this:
1. to evaluate whether the previously selected security controls are still applicable and
effective
2. to evaluate the possible risk level changes in the business environment. For example,
information risks are a good example of rapidly changing business environment.
You dealt with all the significant hazards, taking into account potential users.
The precautions are reasonable, and the remaining risk is judged acceptable.
The recording of the assessment should be in a format which is easily read - dont write a book!
Risk assessments are not operating procedures -they inform and determine key aspects of the
operating procedures. At the campsite your risk assessment may have determined that no more
than 30 people may be admitted to the swimming pool at any one time due to the size of the pool
and the need to avoid overcrowding.
This assessment will then be reflected in the pools operating procedure and a requirement placed
on the lifeguard and those controlling bookings for the pool to count. A risk assessment for a day
in the hills or on water that you have not visited before cannot be formalized in exactly the same
way. In these cases, refer to the examples later in the fact sheet
.
4.2.5 Activity Five: Review your assessment and revise it if necessary:
In all cases, it is good practice to review your risk assessments from time to time, to ensure that
the precautions are still working effectively. If there are any significant changes, review and
revise the assessments to take account of the new hazard. For those risk assessments for a
Composite, and activities on site, it is important to ensure that when carrying out a risk
assessment the date is also set for the next review. Make sure that all relevant documentation is
changed.
CHAPTER-5
NEED AND ITS IMPORTANCE
IN FINANCE
The financial and accounting function represents a specialized activity within the organization
through which the measurement, evaluation, knowledge, management and control of assets,
liabilities and equity can be performed, as well as the outcomes obtained from the economic
activity of an organization. Financial and accounting activities ensure chronological and
systematic recording, processing, publication and preservation of information regarding financial
position, financial performance and cash flow for both the domestic needs of the
organization as well as for external users.
Information provided by the financial and accounting system refers to the performance of
income and expenditure budgets, budget execution outcomes, assets under management, asset
outcomes and cost of approved programs.
Also, financial and accounting operations present the situation concerning propriety and assets,
namely inventory, calculation, analysis and control of assets denominated in currency, it provides
control of operations, processing procedures as well as the accuracy of accounting data provided
to users.
The content and range of the financial and accounting activities include:
- the existence of material and financial means;
- movement and transformation of material and financial means within the economic operations
and processes
- determination of the final outcome of movements and transformations in a value expression.
Carrying out any economic activity by an organization or entity imposes the preparation and
existence of financial and book-keeping records which represent the consignment made in a
specific order, based on set principles, of any conducted economic activity or operation.
According to the nature of the data and the manner in which they are obtained, processed and
represented, financial and book-keeping records take three distinct forms: technical and
operational records, accounting records and statistical records, which reflect the overall situation
of the organization.
Activities carried out within the financial and accounting function can be grouped as followed:
- financial activities which refer to the establishment and use of financial resources;
- accounting activities, which relate to preparation of accounting records that reflect the
existence, movement and transformation of assets in a value expression. These ensure the
integrity of the assets and give a foundation to management decisions.
Finance and book-keeping performed within an organization is key because it reflects any asset
operation and in the same time provides a series of data which are used by the management in
decision making, as well as a series of users, depending on concerns.
Under these conditions ensuring effective management of financial and accounting hazards is
essential for limiting errors and fraud, waste and uneconomical activity. Implementation of an
effective risk management system on financial and accounting activities contributes to increasing
business performance and overall performance across the entire organization, given the
interfering of this function with all other functions within the organization .
CHAPTER-6
FRAMEWORK AND STRATEGIES
OF RISK MANAGEMENT
6.1 FRAMEWORK
Standard
Bank
Group board
Board
Committees
Management
committees
Group
executive
Group
audit
committee
Group risk
and
capital
managem
Group
credit
committe
SBSA
large
exposure
Group risk
oversight
committee
Intragr
oup
exposur
e
commit
tee
Group
Risk
compli
ance
commit
tee
Group
capita
l
mana
geme
nt
comm
ittee
Grou
p
asset
and
liabili
ty
comm
ittee
Group
opera
tional
risk
commi
ttee
Group
countr
y risk
manag
ement
commit
tee
Transacti
on
review
committ
ee
Global
Persona
l
&
Busines
s
Banking
credit
Global
Corporat
e
&
Investme
nt
Banking
credit
committe
1 The board has delegated authority to these committees to act as nominated designated
committees in respect of the regulations.4 Standard Bank Group risk management report for
the six months ended June 2010
approving
and monitoring the groups risk profile and risk tendency against risk appetite for
each risk type under normal and potential stress conditions.
Executive management oversight for all risk types at group level has been delegated by the group
executive committee to the group risk oversight committee (GROC). This committee considers
and, to the extent required, recommends for approval by the relevant board committees:
levels of risk appetite and tolerance;
risk governance standards for each risk type;
actions on the risk profile;
risk strategy and key risk controls across the group;
capital planning and capital funding activities;
utilisation of risk appetite; and
usage and allocation of economic capital parameters for modelling, stress testing and scenario
analysis.
The GRCMC, GCC, GAC and GROC meet at least quarterly, with additional meetings
conducted when necessary. The group risk management subcommittees set out in figure report
directly to GROC and through GROC to the GRCMC, the GCC and GAC.
6.1.2 Approach and structure
The groups approach to risk management is based on well established governance processes and
relies on both individual responsibility and collective oversight, supported by comprehensive
reporting. This approach balances strong corporate oversight at group level, beginning with
proactive participation by the group chief executive and the group executive committee in all
significant risk matters, with independent risk management structures within individual business
units.
Business unit heads are primarily responsible for managing risk within each of their businesses
and for ensuring that appropriate, adequately designed and effective risk management
frameworks are in place, and that these frameworks are compliant with the groups risk
governance standards.
To ensure independence and appropriate segregation of responsibilities between business and
risk management, business unit chief risk officers and chief credit risk officers report
operationally to their respective business unit heads and functionally to either the group chief
risk officer or the group chief credit officer.
6.1.3 Risk governance standards, policies and procedures
The group has developed a set of risk governance standards for each major risk type to which it
is exposed. The standards set out and ensure alignment and consistency in the way in which we
deal with major risk types across the group, from identification to reporting.
All standards are applied consistently across the group and are approved by the GRCMC or the
GCC. It is the responsibility of executive management in each business unit to ensure that the
risk governance standards, as well as supporting policies and procedures, are implemented and
independently monitored by the risk management team in that particular business unit.
Compliance with risk standards is controlled through annual self-assessments conducted by
business units and group risk and review independently by the group internal auditors.
6.2 RISK MANAGEMENT STRATEGIES
Once risks have been identified and assessed, all techniques to manage the risk fall into one or
more of these major categories:
Hedging
Combination
Ideal use of these strategies may not be possible. Some of them may involve trade-offs that are
not acceptable to the organization or person making the risk management decisions. Another
source, from the US Department of Defense , Defense Acquisition University, calls these
categories ACAT, for Avoid, Control, Accept, or Transfer. This use of the ACAT acronym is
reminiscent of another ACAT (for Acquisition Category) used in US Defense industry
procurements, in which Risk Management figures prominently in decision making and planning.
6.2.1 Risk avoidance
This includes not performing an activity that could carry risk. An example would be not buying a
property or business in order to not take on the legal liability that comes with it. Another would
be not flying in order not to take the risk that the airplane were to be hijacked. Avoidance may
seem the answer to all risks, but avoiding risks also means losing out on the potential gain that
accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss
also avoids the possibility of earning profits. Increasing risk regulation in hospitals has led to
avoidance of treating higher risk conditions, in favor of patients presenting with lower risk.
6.2.2 Hazard prevention
Hazard prevention refers to the prevention of risks in an emergency. The first and most effective
stage of hazard prevention is the elimination of hazards. If this takes too long, is too costly, or is
otherwise impractical, the second stage is mitigation.
6.2.3 Risk reduction
Risk reduction or "optimization" involves reducing the severity of the loss or the likelihood of
the loss from occurring. For example, sprinklers are designed to put out a fire to reduce the risk
of loss by fire. This method may cause a greater loss by water damage and therefore may not be
suitable. Hal on fire suppression systems may mitigate that risk, but the cost may be prohibitive
as a strategy.
Acknowledging that risks can be positive or negative, optimizing risks means finding a balance
between negative risk and the benefit of the operation or activity; and between risk reduction and
effort applied. By an offshore drilling contractor effectively applying HSE Management in its
organization, it can optimize risk to achieve levels of residual risk that are tolerable.
Modern software development methodologies reduce risk by developing and delivering software
incrementally. Early methodologies suffered from the fact that they only delivered software in
the final phase of development; any problems encountered in earlier phases meant costly rework
and often jeopardized the whole project. By developing in iterations, software projects can limit
effort wasted to a single iteration.
Outsourcing could be an example of risk reduction if the outsourcer can demonstrate higher
capability at managing or reducing risks. For example, a company may outsource only its
software development, the manufacturing of hard goods, or customer support needs to another
company, while handling the business management itself. This way, the company can
concentrate more on business development without having to worry as much about the
manufacturing process, managing the development team, or finding a physical location for a call
center.
6.2.4 Risk sharing
Briefly defined as "sharing with another party the burden of loss or the benefit of gain, from a
risk, and the measures to reduce a risk."
The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that you can
transfer a risk to a third party through insurance or outsourcing. In practice if the insurance
company or contractor go bankrupt or end up in court, the original risk is likely to still revert to
the first party. As such in the terminology of practitioners and scholars alike, the purchase of an
insurance contract is often described as a "transfer of risk." However, technically speaking, the
buyer of the contract generally retains legal responsibility for the losses "transferred", meaning
that insurance may be described more accurately as a post-event compensatory mechanism. For
example, a personal injuries insurance policy does not transfer the risk of a car accident to the
insurance company. The risk still lies with the policy holder namely the person who has been in
the accident. The insurance policy simply provides that if an accident (the event) occurs
involving the policy holder then some compensation may be payable to the policy holder that is
commensurate to the suffering/damage.
Some ways of managing risk fall into multiple categories. Risk retention pools are technically
retaining the risk for the group, but spreading it over the whole group involves transfer among
individual members of the group. This is different from traditional insurance, in that no premium
is exchanged between members of the group up front, but instead losses are assessed to all
members of the group.
6.2.5 Risk retention
Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self
insurance falls in this category. Risk retention is a viable strategy for small risks where the cost
of insuring against the risk would be greater over time than the total losses sustained. All risks
that are not avoided or transferred are retained by default. This includes risks that are so large or
catastrophic that they either cannot be insured against or the premiums would be
infeasible. War is an example since most property and risks are not insured against war, so the
loss attributed by war is retained by the insured. Also any amounts of potential loss (risk) over
the amount insured is retained risk. This may also be acceptable if the chance of a very large loss
is small or if the cost to insure for greater coverage amounts is so great it would hinder the goals
of the organization too much.
6.2.6 Risk Hedging
Hedging is the practice of taking a position in one market to offset and balance against the risk
adopted by assuming a position in a contrary or opposing market or investment. The word hedge
is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb
in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as
in a bet, is from 1670s.
The taking of an offsetting position in related assets so as to profit from relative price
movements. For example, an investor might purchase futures contracts on gold and sell futures
contracts on silver in the belief that gold will become relatively more valuable compared with
silver over the life of the contracts.
CHAPTER-7
TOOLS AVAILABLE
ii)
prioritize the contributors leading to the top event - Creating the Critical
Equipment/Parts/Events lists for different importance measures.
monitor and control the safety performance of the complex system (e.g., is a particular
aircraft safe to fly when fuel valve x malfunctions? For how long is it allowed to fly with the
valve malfunction?).
minimize and optimize resources.
assist in designing a system. The FTA can be used as a design tool that helps to create
(output / lower level) requirements.
function as a diagnostic tool to identify and correct causes of the top event. It can help
with the creation of diagnostic manuals / processes.
Basic event
Conditioning event
Intermediate event
Basic event - failure or error in a system component or element (example: switch stuck in
open position)
External event - normally expected to occur (not of itself a fault)
Conditioning event - conditions that restrict or affect logic gates (example: mode of
operation in effect)
An intermediate event gate can be used immediately above a primary event to provide more
room to type the event description. FTA is top to bottom approach.
Gate Symbols
Gate symbols describe the relationship between input and output events. The symbols are
derived from Boolean logic symbols:
OR gate
AND gate
Exclusive OR gate
Inhibit gate
AND gate - the output occurs only if all inputs occur (inputs are independent)
Priority AND gate - the output occurs if the inputs occur in a specific sequence specified
by a conditioning event
Inhibit gate - the output occurs if the input occurs under an enabling condition specified
by a conditioning event
Transfer Symbols
Transfer symbols are used to connect the inputs and outputs of related fault trees, such as the
fault tree of a subsystem to its system.
Transfer in
Transfer out
FMEA is a system for analyzing the design of a product or service system to identify potential
failures, then taking steps to counteract or at least minimize the risks from those failures.
The FMEA process begins by identifying failure modes, the ways in which a product, service
or process could fail. A project team examines every element of a service, starting from the
inputs and working through to the output delivered to the customer. At each step, the team asks
what could go wrong here?
A key element of FMEA is analyzing three characteristics of failures:
1.
2.
3.
ways to detect the problem, developing recommended actions, and assigning responsibility for
monitoring the process and taking action when warranted.
Probability (P)
In this step it is necessary to look at the cause of a failure mode and the likelihood of occurrence.
This can be done by analysis, calculations / FEM, looking at similar items or processes and the
failure modes that have been documented for them in the past. A failure cause is looked upon as
a design weakness. All the potential causes for a failure mode should be identified and
documented. This should be in technical terms. Examples of causes are: Human errors in
handling, Manufacturing induced faults, Fatigue, Creep, Abrasive wear, erroneous algorithms,
excessive voltage or improper operating conditions or use (depending on the used ground rules).
A failure mode is given an Probability Ranking.
Ratin
Meaning
g
Severity (S)
Determine the Severity for the worst case scenario adverse end effect (state). It is convenient to
write these effects down in terms of what the user might see or experience in terms of functional
failures. Examples of these end effects are: full loss of function x, degraded performance,
functions in reversed mode, too late functioning, erratic functioning, etc. Each end effect is given
a Severity number (S) from, say, I (no effect) to VI (catastrophic), based on cost and/or loss of
life or quality of life. These numbers prioritize the failure modes (together with probability and
detectability). Below a typical classification is given. Other classifications are possible. See
also hazard analysis.
Ratin
Meaning
g
II
Very minor, no damage, no injuries, only results in a maintenance action (only noticed
by discriminating customers)
III
Minor, low damage, light injuries (affects very little of the system, noticed by average
customer)
IV
Moderate, moderate damage, injuries possible (most customers are annoyed, mostly
financial damage)
Critical (causes a loss of primary function; Loss of all safety Margins, 1 failure away
from a catastrophe, severe damage, severe injuries, max 1 possible death )
VI
Catastrophic (product becomes inoperative; the failure may result complete unsafe
operation and possible multiple deaths)
Detection (D)
The means or method by which a failure is detected, isolated by operator and/or maintainer and
the time it may take. This is important for maintainability control (Availability of the system) and
it is specially important for multiple failure scenarios. This may involve dormant
failure modes (e.g. No direct system effect, while a redundant system / item automatic takes over
or when the failure only is problematic during specific mission or system states) or latent failures
(e.g. deterioration failure mechanisms, like a metal growing crack, but not a critical length). It
should be made clear how the failure mode or cause can be discovered by an operator under
normal system operation or if it can be discovered by the maintenance crew by some diagnostic
action or automatic built in system test. A dormancy and/or latency period may be entered.
Rating
Meaning
Almost certain
High
Moderate
Low
After these three basic steps the Risk level may be provided.
Risk level (P*S) and (D)
Risk is the combination of End Effect Probability And Severity. Where probability and severity
includes the effect on non-detectability (dormancy time). This may influence the end effect
probability of failure or the worst case effect Severity. The exact calculation may not be easy in
case multiple scenarios (with multiple events) are possible and detectability / dormancy plays a
crucial role (as for redundant systems). In that case Fault Tree Analysis and/or Event Trees may
be needed to determine exact probability and risk levels.
Preliminary Risk levels can be selected based on a Risk Matrix like shown below, based on Mil.
Std. 882.The higher the Risk level, the more justification and mitigation is needed to provide
evidence and lower the risk to an acceptable level. High risk should be indicated to higher level
management, who are responsible for final decision making.
Probability
Severity -->
II
III
IV
VI
Low
Low
Low
Low
Moderate
High
Low
Low
Low
Moderate
High
Unacceptabl
e
Low
Low
Moderat
Moderate
e
High
Unacceptabl
e
Low
Moderat Moderat
High
e
e
Moderat Moderat
High
e
e
Unacceptabl Unacceptabl
e
e
7.1.1.2 Uses
7.1.1.3 Advantages
Improve the quality, reliability and safety of a product/process
7.1.2 PDPC :
The process decision program chart (PDPC) systematically identifies what might go wrong in a
plan under development. Countermeasures are developed to prevent or offset those problems. By
using PDPC, you can either revise the plan to avoid the problems or be ready with the best
response when a problem occurs.
A useful way of planning is to break down tasks into a hierarchy, using a Tree Diagram. PDPC
simply extends this chart a couple of levels to identify risks and countermeasures for the bottom
level tasks, as in the diagram below. Different shaped boxes are used to highlight the risks and
and countermeasures (they are often shown as 'clouds' to indicate their uncertain nature).
5. Decide how practical each countermeasure is. Use criteria such as cost, time required, ease of
implementation and effectiveness. Mark impractical countermeasures with an X and practical
ones with an O.
7.1.3 Insurance - It is the most common risk management tool used in organizations. The
insurance can be applied to any physical property like equipment in the organization in order to
recover from the loss occurred due to damages. The risk management can prior analyse the risks
causing damages to the organization and formulates insurance policy during any losses to the
organization.
7.1.4 Risky calculations This method of managing risk includes the process of continuous
scanning of the risk at various phases in the business operations. It is the process of calculating
the most occurring risks. These are identified by the priorities given to the risks during their
occurrence with respect to its severity. Hence the risk management authority processes on the
high priority risk by calculating the risk exposure. This calculation is obtained by the following
methods:
o Risk exposure The probability of the risk occurrence and total loss to the organisation
provides the overall exposure of specific risk.
Risk Exposure, RE = Probability of occurring risk x Total loss due to risk
o Risk reduction leverage (RRL) The value of the return on investment for countermeasures is
obtained. The reduction in the risk exposure and cost of countermeasure helps in prioritising the
possible countermeasures.
RRL = Reduction in Risk Exposure Cost of countermeasure
o Managing Risk: Once the risks are identified and calculated the following processes are
performed to mitigate risk. This process is less in terms of cost and choosing the best plan can
avoid risk exposures and provides a better action to perform. It includes the stages of identifying
the risk and choosing plans to avoid, or reduce risk. If the method avoiding is considered, the
risk management chooses the alternative actions to counterpart the risk else if it is reduction
method, then it changes the current action by adding new action to reduce the risk. The
contingency planning depends upon the risk exposure and reduction leverage.
CHAPTER-8
ADVANCED TOPICS
IN
RISK MANAGEMENT
In financial mathematics and financial risk management, Value at Risk (VaR) is a widely
used risk measure of the risk of loss on a specific portfolio of financial assets. For a given
portfolio, probability and time horizon, VaR is defined as a threshold value such that the
probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this
value (assuming normal markets and no trading in the portfolio) is the given probability level.
For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 0.05
probability that the portfolio will fall in value by more than $1 million over a one day period if
there is no trading. Informally, a loss of $1 million or more on this portfolio is expected on 1 day
out of 20 days (because of 5% probability). A loss which exceeds the VaR threshold is termed a
VaR break. Thus, VaR is a piece of jargon favored in the financial world for a percentile of the
predictive probability distribution for the size of a future financial loss. In other words if you
have a record of portfolio value over time then the VaR is simply the negative quantile function
of those values.
The generality of value-at-risk poses a computational challenge. In order to measure market risk
in a portfolio using value-at-risk, some means must be found for determining the probability
distribution of that portfolios market value. Obviously, the more complex a portfolio isthe
more asset categories and sources of market risk it is exposed tothe more challenging that task
becomes.
A value-at-risk metric, such as one-day 90% USD VaR, is specified with three items:
A time horizon
A probability
A currency
For a given value-at-risk metric, measure time in units of the value-at-risk horizon. Let time 0 be
now, so time 1 represents the end of the horizon. We know a portfolios current market value 0p.
Its market value 1P at the end of the horizon is unknown. Define portfolio loss 1L as
L = 0p 1P
[1]
If 0p exceeds 1P, the loss will be positive. If 0p is less than 1P, the loss will be negative, which is
another way of saying the portfolio makes a profit.
Because we dont know the portfolios future value 1P, we dont know its loss 1L. Both are
random variables, and we can assign them probability distributions. That is exactly what a valueat-risk measure doesin assigns a distribution to 1P and/or 1L, so it can calculate the desired
quantile of 1L. Most typically, value-at-risk measures work directly with the distribution of
1
P and use that to infer the quantile of 1L. This is illustrated in Exhibit 1 for a 90% VaR metric.
Exhibit 1: . A 90% VaR metric can be valued from the distribution of 1P. The .90-quantile
of 1L (the portfolios value-at-risk) equals the .10-quantile of 1P minus the portfolios current
value 0p. Other value-at-risk metrics can be valued similarly
Exhibit 1 shows how the .90-quantile of 1L (the portfolios value-at-risk) can be obtained as the .
10-quantile of 1P minus the portfolios current value 0p. Other value-at-risk metrics can be valued
similarly. So if we know the distribution for 1P, calculating value-at-risk is easy. The challenge
for any value-at-risk measure is constructing that distribution of 1P. Value-at-risk measures do so
in various ways, but all practical value-at-risk measures share certain features described below.
Because value-at-risk measures are probabilistic, they deal with various random financial
variables. Three types are particularly significant and are given standard notation:
values 1S i; and
key factors 1R i.
We have portfolio value 1P, which is the portfolios market value at time 1the end of the valueat-risk horizon. It has current value 0p. Mathematically, a portfolio is defined as an ordered pair
(0p,1P).
Asset values 1Si represent the accumulated value at time 1 of individual assets held by the
portfolio. Individual assets might be stocks, bonds, futures, options or other instruments. Current
asset values are denoted 0si. Mathematically, we define an asset as an ordered pair
(0si,1Si). The m asset values 1Si comprise an ordered set (or vector) called the asset vector,
which we denote 1S. Its current value 0s is the ordered set of asset current values 0si.
[2]
Key factors 1Ri represent values at time 1 of financial variables that can be used to value the
assets. Depending on the composition of the portfolio, key factors might represent exchange
rates, interest rates, commodity prices, spreads, implied volatilities, etc. The n key
factors 1Ri comprise an ordered set called the key vector, which we denote 1R. Value-at-risk
measures utilize not only the current value 0r for the key vector but also other historical values
1
r, 2r, 3r, , r:
[3]
Where are we going with this? The quantities 1P, 1Si and 1Ri are all random. But the portfolios
value 1P is a function of the values 1Si of the assets it holds. Those in turn are a function of the
key factors 1Ri. For example, a bond portfolios value 1P is a function of the values 1Si of the
individual bonds it holds. Their values are in turn functions of applicable interest rates 1Ri.
Because a function of a function is a function, 1P is a function of 1R:
1
P = (1R)
[4]
Value-at-risk measures apply time series analysis to historical data 0r, 1r, 2r, , r to construct
a joint probability distribution for 1R. They then exploit the functional relationship
between 1P and 1R to convert that joint distribution into a distribution for 1P. From that
distribution for 1P, value-at-risk is calculated, as illustrated in Exhibit 1 above.
Lets formalize this. Exhibit 2 summarizes the components common to all practical value-at-risk
measures:
Exhibit 2: All practical value-at-risk measures accept portfolio holdings and historical market
data as inputs. They process these with a mapping procedure, inference procedure, and
transformation procedure. Output comprises the value of a value-at-risk metric. That value is the
value-at-risk measurement.
The portfolio holdings comprise a row vector whose components indicate the number of units
held of each asset. For example, if a portfolio holds 1000 shares of IBM stock, 5000 shares of
Google stock and a short position of 3000 shares of Microsoft stock, its holdings are
= (1000 5000 3000)
[5]
The two inputshistorical data and portfolio holdingsare processed separately by two
procedures within the value-at-risk measure:
An inference procedure applies methods of time series analysis to the historical data 0r, 1r,
2r, , --r to construct a joint distribution for 1R.
A mapping procedure uses the portfolios holdings to construct a function such that 1P =
(1R).
The mapping procedure uses a set of pricing functions i that value each asset 1Si in terms of 1R:
1
Si = i(1R)
[6]
For example, if asset 1S1 is a bond, pricing formula 1 will be a bond pricing formula.
If asset 1S2 is an equity option, pricing formula 2 will be an equity option pricing formula. A
functional relationship 1P = (1R) is then defined as a weighted sum of the pricing formulas i,
with the weights being the holdings i:
1
[7]
[8]
This is called a primary mapping. If a portfolio is large or holds complex instruments, such as
derivatives or mortgage-backed securities, a primary mapping may be computationally expensive
to value. Many mapping procedures replace a primary mapping with a simpler
approximation
. Such approximations are called remappings. They can take many forms.
Two common examples are remappings that are constructed, using the method of least squares,
as either a linear polynomial or quadratic polynomial approximation of . Such remappings are
called, respectively, linear remappings and quadratic remappings.
uncertainty
exposure
In the context of market risk, we are uncertain if we dont know what will happen in the markets.
We are exposed if we have holdings in instruments traded in those markets. A value-at-risk
measure characterizes uncertainty with the joint distribution for 1R constructed by its inference
procedure. It characterizes exposure with the portfolio mapping constructed by its mapping
procedure. A value-at-risk measure must combine those two components to measure a portolios
market risk, and it does so with a transformation procedure.
It uses these to construct a distribution for 1P from which it calculates the portfolios value-atrisk.
Transformation procedures take various forms, but there are essentially three types:
generate scenarios but instead construct them directly from historical data for 1R. These are
called historical transformation procedures.
Refers to the ability to invest money and earn income or interest over a period of time. Thus, the
point in time when the money will be paid becomes very important. The longer the delay in
making a payment, the more interest that can be earned. The time value of money is a function of
the interest rate paid and the amount of time the money is invested.
The time value of money is the premise that a fixed amount of money available today is more
valuable/desired than the same amount of money available in the future. This premise can be
generalized for economic resources (of which money is an embodiment by social contract). We
can state two reasons to justify the premise for all resources: 1) We prefer to have in our control a
resource today rather than in the future, because of the inherent uncertainty that characterizes any
future event. We cannot be certain that we will acquire the resource in the future. 2) We prefer to
have in our control a resource today rather than in the future, because we could use to our favor
this resource in the meantime (this is a temporal version of the notion of "opportunity cost").
Especially for money, there is a third reason, namely the existence of inflation: given inflation,
the same amount of money will buy tomorrow fewer goods than today. It must be noted however
that while Uncertainty of the Future and Opportunity Cost, are rooted in the very foundations of
human existence, inflation is a historical event that may change direction. In the case of
"negative inflation", ie where money increases rather than loses its value as time passes, then
"money tomorrow" tends to be more valuable than "money today" (or at least, it partially offsets
the pull of the other two fundamental reasons given above towards the opposite direction).
Nevertheless, in modern market economies, a consistent trend of negative inflation is absent for
almost a century.
A fourth reason is the belief that maybe the money might not be around in the future. The
borrower might not be around or the repayment contract could be lost. The currency could be
abolished or a catastrophy could occur rendering money valueless.
DISCOUNT RATE
The time value of money can be easily quantified at a personal level. A person can ask herself,
"What do I prefer, 100 euros today or XXX euros in a year from now?" When she finds the
amount that makes her "indifferent", then she can calculate easily her Personal Discount Rate.
Assume that given the question, "100 euros now or 120 euros in one year from now," a person
replies, "it's all the same to me". Then this person's Yearly Personal Discount Rate (YPDR) is
calculated as:
YDR = (120/100)-1 =1,2-1 =0,2 =20%
Note that YPDR quantifies together the effects of all the reasons given above that lead to
"money tomorrow" being worth less than "money today".
If a person has calculated his own YPDR honestly, carefully, and rationally, and has tested it over
a period of time for stability of preferences, he can then use it as a tool to assist him in taking
economic decisions than involve different amounts and timings of money (to be given or to be
received). Essentially, by using the discount rate, we can calculate what amount of money
received or given today is -for us- equivalent with an amount of money to be received (or to be
given) in the future.
Note that this series can be summed for a given value of n, or when n is .
Where i g :
To get the PV of a growing annuity due, multiply the above equation by (1 + i).
Where i = g :
Future value is the value of an asset or cash at a specified date in the future that is
equivalent in value to a specified sum today.
Future value of an annuity (FVA) is the future value of a stream of payments (annuity),
assuming the payments are invested at a given rate of interest.
The future value of an annuity (FVA) formula has four variables, each of which can be solved
for:
outflow of ` 1,00,000 in the zero year and cash inflows of ` 20,000 per year, for six years. In
order to decide, whether to accept or reject the project, it is necessary that the Present Value
of cash inflows received annually for six years is ascertained and compared with the initial
investment of ` 1,00,000.
The firm will accept the project only when the Present Value of cash inflows at the desired rate
of interest exceeds the initial investment or at least equals the initial investment of ` 1,00,000.
EXAMPLE 2: A firm has to choose between two projects. One involves an outlay of ` 10 lakhs
with a return of 12% from the first year onwards, for ten years. The other requires an investment
of ` 10 lakhs with a return of 14% per annum for 15 years commencing with the beginning of the
sixth year of the project. In order to make a choice between these two projects, it is necessary to
compare the cash outflows and the cash inflows resulting from the project. In order to make a
meaningful comparison, it is necessary that the two variables are strictly comparable. It is
possible only when the time element is incorporated in the relevant calculations. This reflects the
need for comparing the cash flows arising at different points of time in decision-making.
CHAPTER-9
LITERATURE SURVEY
The insurance market is "hard" when premiums are high and underwriting standards are
tight.
The insurance market is "soft" when premiums are low and underwriting standards are
loose.
Gold fluctuates in price just like other assets. There are periods of time when gold is
"expensive" in relation to the U.S. dollar. If an investor buys gold when it is selling at a high
price in relation to the dollar and then sells it at a lower price, the investor will, of course,
lose money.
There is an "opportunity cost" to owning gold as it does not pay interest as bonds, or
money market accounts or savings accounts do. Nor does gold pay a dividend the way many
stocks do. Instead, it just "sits there looking pretty" neither earning interest nor paying a
dividend. If an investor owns gold during a period of time when it is not gaining in value (or
worse is losing value), the investor will have lost out on the opportunity to earn income
from having invested in an alternative asset. This opportunity cost can be significant,
especially when the virtues of compound interest are considered.
When an investor purchases gold, attention needs to be given to how the gold will be
safely stored. Storing gold coins in one's house is the equivalent of putting money under
one's mattress: It is not a safe place to keep it. Some investors use safe deposit boxes
(available at some banks) to store gold. Other investors purchase gold in a manner that does
not require taking delivery on the gold. For instance, a gold exchange traded fund enables
the purchase of gold without having to take possession of it as the gold is collectively stored
for owners of the fund in some safe place, such as a bank vault.
While more a drawback than a risk, gold coins are considered "collectibles"; as such, the
long term federal capital gains rate for gold is higher than for stocks (about 28% for gold
coins versus 15% for stocks).
9.2.1 ANALYSIS:
MUMBAI, FEB. 5:
The steep rise in gold prices over the past few years indicates that the risk involved in investment
in gold has heightened, cautioned K. C. Chakrabarty, Deputy Governor, Reserve Bank of India.
This is a fact which is not recognized by people, he said at a Workshop on Financial Literacy.
Some basic concepts are not fully appreciated even by seemingly literate groups, resulting in
assumption of excessive risks.
One example that I often quote about the widespread financial illiteracy is the theory being
floated around by the so-called financial advisers about investment in gold being a hedge
against inflation and a safe asset, said the Deputy Governor.
Given that the price of the yellow metal has surged in the last few years, Chakrabarty flagged the
risks involved in investing in gold.
According to the RBIs Financial Stability Report, the price of gold carries an uncertainty
premium arising from risk aversion among investors in recent years. This has caused an abovenormal return that is not sustainable in the long term.
Since Indian households hold a significant quantity of gold, they face the risk of a correction in
gold prices.
There has been a reduction in the share of financial assets in household savings as households
preference for physical assets and valuables like gold seem to be rising, thereby adding to the
pressure on the current account deficit (CAD). This is a worrying factor, said the report.
CAD arises when a countrys total imports of goods, services and transfers is greater than
exports.
The deterioration in trade balance (with imports outstripping exports) has led to the CAD-GDP
ratio reaching a historical of 5.4 per cent in the August-September quarter of 2012-13.
Gold imports continue to account for a large part of Indias CAD. Also, the country accounts for
a quarter of the world demand for gold.
9.3 THE RISK OF INVESTING IN BONDS
Investing in bonds, whether they are public or private, also carries risks, especially the
insolvency risk (credit risk) and the interest rate risk. The credit risk of bonds is usually indicated
by its rating.
Ratings give a long-term view of the likelihood of companies being able to meet their
commitments, i.e. paying the interest and repaying the principal of the bonds they issue.
The three main international bond rating companies are Standard & Poors, Moodys and Fitch.
Although there are usually no major discrepancies between these companies scores, the methods
they use to analyse and rate bonds are different.
Bonds with ratings of BBB or higher are considered to be investment grade. Any bond rated
below this is considered to be high risk, i.e. a junk bond.
However, ratings can change as often as analysts review the company that issued the bonds.
Whenever there is a change in the company or in its economic environment, analysts review its
rating.
The table below shows the different bond ratings given by two of the main rating agencies,
Moodys and Standard & Poors
Moodys
Degree
Protection
of
Investor
Investment Grade
Aaa
Aa
A
AAA
AA
A
Baa
BBB
Extremely strong
Very strong
Strong but susceptible to
changes in certain economic
conditions
Adequate protection but these
protective components may
be deficient and likely to delay
repayments in the event of
changes
in economic circumstances
Junk Bond
BB
Ba
B
Caa
CCC
Ca
C
CC
C
In default
Lalita D. Gupte be continued before the city civil court at Ahmedabad. In June 2003, the
promoters of Mardia Chemicals in their capacity as guarantors of loans given by ICICI to Mardia
Chemicals filed a civil suit in the city civil court at Ahmedabad against ICICI Bank for an
amount of Rs. 20.8 billion (US$ 437 million) on the grounds of loss of investment and loss of
profit on investments. The pleadings in the matter are yet to be completed. Mardia Chemicals
had also filed a petition in the High Court, Delhi, challenging the constitutional validity of the
Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest
Ordinance, 2002. The matter has since been transferred to the Supreme Court of India, where it is
currently pending.
market contracts in August, 2011. Some market participants are concerned that increased price
limits will increase price volatility and in-turn margin call requirements. Some agricultural
producers may have difficulty in meeting increased margin call requirements while country
elevators are concerned about their ability to finance margin requirements. This could adversely
affect their ability to offer forward contracts to farmers. Hedging market risk using forward and
futures market contracts have been widely recommended as risk management tools. Risk
management education provides producers tools and knowledge to implement risk reducing
strategies that work to increase their long-term profitability.
Dr. J. Shannon Neibergs is the Director of the Western Center for Risk Management Education
with Washington State University Extension
CHAPTER-10
BENEFITS
AND
LIMITATIONS
10.1 BENEFITS
Risk management is a process which provides assurance that:
It is not a process for avoiding risk. The aim of risk management is not to eliminate risk, rather to
manage the risks involved
The potential benefits from risk management are :
reassuring stakeholders;
10.2 LIMITATIONS
Prioritizing the risk management processes too highly could keep an organization from ever
completing a project or even getting started. This is especially true if other work is suspended
until the risk management process is considered complete.
It is also important to keep in mind the distinction between risk and uncertainty. Risk can be
measured by impacts x probability.
If risks are improperly assessed and prioritized, time can be wasted in dealing with risk of losses
that are not likely to occur. Spending too much time assessing and managing unlikely risks can
divert resources that could be used more profitably. Unlikely events do occur but if the risk is
unlikely enough to occur it may be better to simply retain the risk and deal with the result if the
loss does in fact occur. Qualitative risk assessment is subjective and lacks consistency. The
primary justification for a formal risk assessment process is legal and bureaucratic.
CHAPTER-11
RECOMMENDATIONS
AND
CONCLUSION
There should be sound co-operation between industries, Government and other interested
stakeholders of the industry.
There should be transparency in the review and utilization of risk assessment data.
Consequences
Probability
Low Risk
Moderate Risk
High Risk
Insignificant cost,
schedule, or technical
impact
Affects program
objectives, cost, or
schedule; however
cost,
schedule,
performance are
achievable
Significant
impact,
requiring reserve or
alternate courses of
action to recover
High likelihood of
Occurrence
likelihood
Extent
Demonstration
of Full-scale, integrated
technology has been
demonstrated
previously
Has
been
demonstrated
but
design changes, tests
in
relevant
environments required
Significant design
changes required in
order to achieve
required/desired
results
Existence
Capability
of Capability exists in
known
products;
requires
integration
into new system
11.2 CONCLUSION
The essence of risk management is not avoiding or eliminating risk but deciding which risks to
exploit, which ones to let pass through to investors, and which ones to avoid or hedge. In this
chapter, we focused on exploitable risks by presenting evidence on the payoff to taking risk.
Although there is evidence that higher risk taking, in the aggregate, leads to higher returns, there
is also enough evidence to the contrary (that is, risk taking can be destructive) to suggest that
firms should be careful about which risk they expose themselves to.
Risk management underscores the fact that the survival of an organization depends heavily on its
capabilities to anticipate and prepare for the change rather than just waiting for the change and
react to it. The objective of risk management is not to prohibit or prevent risk taking activity, but
to ensure that the risks are consciously taken with full knowledge, clear purpose and
understanding so that it can be measured and mitigated. It also prevents an institution from
suffering unacceptable loss causing an institution to fail or materially damage its competitive
position. Functions of risk management should actually be bank specific dictated by the size and
quality of balance sheet, complexity of functions, technical/ professional manpower and the
status of MIS in place in that bank. There may not be one-size-fits-all risk management module
for all the banks to be made applicable uniformly. Balancing risk and return is not an easy task
as risk is subjective and not quantifiable where as return is objective and measurable. If there
exist a way of converting the subjectivity of the risk into a number then the balancing exercise
would be meaningful and much easier.
Banking is nothing but financial inter-mediation between the financial savers on the one hand
and the funds seeking business entrepreneurs on the other hand. As such, in the process of
providing financial services, commercial banks assume various kinds of risks both financial and
non-financial. Therefore, banking practices, which continue to be deep routed in the philosophy
of securities based lending and investment policies, need to change the approach and mindset,
rather radically, to manage and mitigate the perceived risks, so as to ultimately improve the
quality of the asset portfolio.
As in the international practice, a committee approach may be adopted to manage various risks.
Risk Management Committee, Credit Policy Committee, Asset Liability Committee, etc are such
committees that handle the risk management aspects. While a centralized department may be
made responsible for monitoring risk, risk control should actually take place at the functional
departments as it is generally fragmented across Credit, Funds, Investment and Operational
areas. Integration of systems that includes both transactions processing as well as risk systems is
critical for implementation.
In a scenario where majority of profits are derived from trade in the market, one can no longer
afford to avoid measuring risk and managing its implications thereof. Crossing the chasm will
involve systematic changes coupled with the characteristic uncertainty and also the pain it brings
and it may be worth the effort. The engine of the change is obviously the evolution of the market
economy abetted by unimaginable advances in technology, communication, transmission of
related uncontainable flow of information, capital and commerce through out the world. Like a
powerful river, the market economy is widening and breaking down barriers. Governments role
is not to block that flow, but to accommodate it and yet keep it sufficiently under control so that
it does not overflow its banks and drown us with the associated risks and undesirable side
effects.
To the extent the bank can take risk more consciously, anticipates adverse changes and hedges
accordingly, it becomes a source of competitive advantage, as it can offer its products at a better
price than its competitors. What can be measured can mitigation is more important than capital
allocation against inadequate risk management system. Basel proposal provides proper starting
point for forward-looking banks to start building process and systems attuned to risk
management practice. Given the data-intensive nature of risk management process, Indian Banks
have a long way to go before they comprehend and implement Basel II norms, in to-to.