Banking

and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Overview Of Risk Management

Risk management is about protecting the downside, that is, minimize the losses if the future
outcome turns out to be the opposite of the view taken by the decision maker. The world of
banking and financial markets is grounded in the concept of risk-return relationship: higher
the risk, higher the expected return; lower the risk, lower the expected return.
There are various types of risks encountered in the world of banking and financial markets.
These include:

Credit
Risk

O-BalanceSheet Risk

Foreign
Exchange
Risk

The failure of a borrower or an issuer of bonds to meet his contracted cash outflow
obligations on a loan he has taken or a bond he has issued
The risk associated with assets and liabilities that are contingent (i.e. could result
in claims in the future) on the financial institution and hence reported outside its
balance sheet ( as off- balance sheet items).

The gains or losses that arises due to fluctuations in the foreign exchange rates

The sensitivity of income and capital to volatilities in interest rates

Interest
Rate Risk

The potential adverse impact of factors that are exogenous to the firm, i.e., factors
outside the firm's control, largely a result of macroeconomic changes.
Market
Risk

Opera&onal
Risk

Liquidity
Risk

Solvency
Risk

Direct or indirect losses resulting from failed or inadequate internal processes,

people, break down of information technology, etc.

The potential inability of any financial institution to generate additional liabilities to
cope with the decline in its liabilities or increase in its assets

A financial institution not having adequate capital or networth to cope with a
sudden or steep decline in the mark-to-market value of its assets

The causes, consequences, measurement and management of each of these risks are dealt
with at great length in this course.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Risk Management Involves:

Iden3fying the Causes an Consequences of the Risk


Measuring the Poten3al Adverse Impact

Mi3ga3ng the Risk

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Overview of Liquidity and Solvency Risk

Liquidity and solvency issues impact the banks and financial market entities in very different ways.
While liquidity issues are more common, and in some cases cyclical in nature, solvency issues are,
most often, deep-rooted and if left unattended could result in the eventual liquidation of the firm
altogether. Liquidity issues that remain unresolved for an extended period of time could inevitably
translate into solvency issues for that financial institution.
A financial institution would face liquidity and/or solvency issues:

If a substantial number of its customers suddenly decide to withdraw a large part of their
deposits/investments from that institution
Due to a sudden and sharp impairement in the vlaue of its assets (or increase in its nonperforming assets, as they are popularly referred to in the world of banking & finance).

Financial institutions try to overcome the sudden liquidity crunch by one or more of the following
methods:
a) By drawing on its cash reserves
b) By borrowing in the short term money market or
c) By selling its holding in government securities and other liquid assets.
Important lessons in managing liquidity and solvency:
1. If a financial institution has ample cash reserve or has adequate liquid securities that can be
turned into cash quickly or has the credibility to borrow short-term in the money market, the
liquidity problem can be overcome quickly and will not have a serious impact on that institution
going forward.
2. If a financial institution maintains adequate capital (i.e. equity, retained earnings, etc.), it will
lessen the chance of bankruptcy/insolvency even when its assets are stressed i.e. increase in nonperforming assets that may have to be written off.
In summary, liquidity is managed through cash reserves and solvency is managed through capital
adequacy, both mandated by the regulator in every country.

Liquidity

Solvency

Cash Reserves

Capital Adequacy

Mandated by appropriate regulator

in each country

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Managing potential problems of liquidity in any financial system

Liquidity problems arise primarily for two reasons

Sudden unforeseen withdrawal of deposits by customers or

Sudden drawdown against loan commitments by customers

To meet this sudden outflow of funds and the consequent likely adverse impact on liquidity, financial
institutions (particularly banks) are mandated by the banking regulator in that country to maintain
sufficient liquid assets. Almost all Central Banks mandate a reserve ratio i.e. the amount of cash to
be maintained either as cash in the vault of the bank and/or as balances in its current account with
the Central Bank and/or as investments in liquid instruments such as government securities. These
reserve requirements reflect the amount of liquid assets to be maintained by the bank as a
percentage of customer deposits in the bank's books.
Customer deposits comprise:
(a) Demand deposits: balances held by customers in their savings and current accounts and/or
(b) Time deposits: fixed deposits and certificate of deposits held by the customers
In several countries, particularly where the reserve computation include time deposits as well,
regulators have implemented a two-tier structure for the reserve requirements:
(1) Cash reserve: Cash to be held in the vault or in the bank's current account with the Central
Bank
(2) Statutory liquidity reserve: Investments by the bank in government securities and such
other liquid instruments

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Reserve requirements for Banks: Indian financial system

Reserve requirements for banks in India are computed and maintained based on Net Demand and
Time Liabilities (NDTL).
NDTL comprise three components:

All forms of demand liabilities such as balances in the current accounts and savings accounts.
Time liabilities such as fixed deposits, certificate of deposits, etc.
Net Inter Bank Liabilities (NIBL), which is borrowings from the banking system minus lending
to the banking system

Important points to remember while computing NDTL:
(1) Liabilities that are long term in nature, such as equity capital, retained earnings, provisions
for bad loans, etc. as well as contingent liabilities should not be included in the NDTL
computation
(2) If NIBL is negative (i.e. the loans to the banking system is greater than the borrowings from
the banking system), it should not be considered in the NDTL calculation
(3) The time period considered for the daily average NDTL computation is one fortnight,
commencing Friday through Thursday after next

The Reserve Bank of India (the banking regulator in India) mandates that all regulated bank in the
country maintain:
(a) Cash Reserve Ratio (CRR): X% of the banks average NDTL as cash reserves, either as physical
cash in its vaults or as balances in its current account with the Reserve Bank of India. X%
could vary and will be notified from time to time by the Reserve Bank of India but can never
be less than 3%
(b) Statutory Liquidity Ratio (SLR): An additional Y% of NDTL as investment in government
securities. This Y%, which is referred to as the Statutory Liquidity Reserve, could vary over
time and is currently at 20%

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Reserve Bank of India, in its role as the monetary authority of the country, use CRR and/or SLR as a
tool to control money supply in the Indian financial system.

RBI

Money
Supply

CRR

or

Money supply can be

increased, by reducing the
percentage of Cash Reserve Ratio
and/or the Statutory Liquidity
Ratio to be maintained by the
banks.

SLR

Central Bank

Commercial Banks

RBI

Money
Supply

CRR

or

Money supply can be reduced
by increasing the percentage of
Cash Reserve Ratio and/or
Statutory Liquidity Ratio to be
maintained by the banks.

SLR

Central Bank

Commercial Banks

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Reserve requirements for Banks: US financial system

The reserve requirements to be maintained by banks, as mandated by the regulator in the United
States, comprise Cash Reserves, i.e. cash held in the bank vault and balance in the current account of
the bank with the Federal Reserve). It does not include the Banks investments in government
securities (equivalent to statutory liquidity ratio, as for instance, in India).
Cash Reserve computation covers only demand deposits or (transaction accounts), i.e. accounts
where customers are is allowed to make withdrawals and deposits at his/her discretion.

Step func5on

Cash
Reserves

Demand deposits
(Transac5on
accounts)

10%
3%
0%

$10 M to $50 M

Greater than
$50 M

Banks maintain Cash Reserves

as a step function as shown
in the diagram alongside. This
diagram is only indicative, the
reserves computation is based
on the directives from the
Federal Reserve.

Up to $10 M

The demand balances due from other banks and cash items under collection are subtracted from the
transaction account balances to determine the net transaction account balance on which the cash
reserve is to be computed.
Computing the cash reserve to be maintained is governed by two time periods: Reserve computation
period covers a two week period, always starting on a Tuesday and ending on the Monday after next
Reserve maintenance period consists of fourteen consecutive days, always starting on a Thursday
and ending on the Wednesday after next, with a lag of seventeen days after the end of a reserve
computation period (or thirty days
from the start of a reserve
Cash Reserves: Computa4on
computation period).
Reserve
Computa4on
Period

Reserve
Maintenance
Period

The computation of the reserve

amount is based on the average
balance of transaction accounts over
the reserve computation period. The
reserve amount so computed has to
be maintained on an average over the
reserve maintenance period.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Managing Solvency
Solvency is managed using a well-defined method called Capital Adequacy Ratio (CAR) also known
as Capital to Risk Assets Ratio (CRAR). It measures a bank's capital as a percentage of its risk
weighted assets.
There are two operating phrases here:

Capital: That involves classifying the Banks Capital as Tier-I Capital and Tier-II Capital
Risk-Weighted Assets: Recomputing the assets on the bank's balance sheet based on the
degree of risk associated with each class of assets.

Capital Adequacy Ratio = Tier-I Capital + Tier-II Capital
Risk Weighted Assets
Basel Committee on Banking Supervision (BCBS) set up by the Bank of International Settlements
(BIS) has recommended capital adequacy ratio of minimum 8% or higher, to be maintained by
regulated banks in all countries (commonly referred to as BASEL-I guidelines). Based on the BASEL-I
guidelines, the Banking Regulator in each country issues directives on Capital Adequacy that banks
under its jurisdiction will be required to comply with. Such directives should be (at least) same as or
more rigorous than the Basel I guidelines.

Computa+on of CAR
The Composi+on of Capital
Compu+ng Tier -1 Capital & Tier - II Capital
The Composi+on of Assets
Compu+ng the Risk Weight for each of
those Assets

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

2 Caveats
1. Total Tier- II Capital cannot exceed 100% of Tier - I Capital
2. Subordinated Debt cannot exceed 50% of Tier - I Capital

Composi'on of Assets
Perpetual Instruments:
Perpetual
Preference Capital
Capital raised
through Perpetual
Debt

Perpetual Debt
Perpetual Cumula've
Preference Shares

Tier I
Capital

Issued by Banks

Other Securi'es
(such as Bonds) that
are issued with
specic maturity
date and are Long-
term in nature

Tier II
Capital

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Risk Weighted Assets

Risk assets such as loans, investments, etc., carry a credit risk, i.e. a potential loss arising from the
risk of the borrowers or the issuers of the bond not meeting their repayment obligations on the loan
or the bond. Hence, risk assets are converted into risk weighted assets based on the risk weight
assigned to every class of asset.

The Risk weight to be used for each class of asset would be mandated by the Banking Regulator in
every country. Given below is a condensed version of such a classification:
Investments in treasury bonds or government securities = 0% risk weight
Unsecured corporate loans = 100% risk weight
Other asset classes = would vary between 0% and 100% risk (could vary from assest-class to
asset-class and country to country)

Guidelines issued by the Basel Committee on Banking Supervisions have necessarily to be complied
with and cannot be compromised or diluted by the Banking Regulators. However, the Banking
Regulator in every country could implement marginal variations (that are more stringent) in the
interpretation and classification of Tier-I, Tier-II capital and risk weighted assets, based on the
context prevailing in each country.
It is also important to note that most financial systems have grown in complexity over the last two
decades, i.e. since the mid-90s, when the Basel I Capital Adequacy Ratio was implemented. Hence,
the Capital Adequacy Ratio guidelines issued under Basel I have been superseded by the more
complex and contemporary Basel II Guidelines and more recently by the Basel III guidelines, which
will be discussed in a later week in this course.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

10

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Liquidity Risk Management

Liquidity Risk refers to the potential inability of a financial institution to generate fresh liabilities to
cope with any decline in liabilities or increase in assets.
Liquidity risk management, therefore, involves managing the two conflicting objectives of any
financial institution:
1. To eliminate liquidity risk
2. To maximise the return on its earning assets.
In other words, managing liquidity involves potential reduction in interest income.

Techniques to manage liquidity risk

1. Fundamental Approach: This requires a carefull analysis of cash inflows and outflows, and based
on the gap in the cash flow mismatch, source funds ahead of need

2. Technical Approach: This approach focuses on the liquidity in the short term through two
methods:
(i) Working funds approach: Segregating the sources of funds (i.e. liabilities) that are
coming up for maturity in the near term into the following three categories - Volatile
funds, Vulnerable funds and Stable funds
(ii) Cash flow approach: Laying down the planning horizon and estimating the cash inflows
as well as cash outflows, forecast for each period and determine the liquidity needs for
the planning horizon (with specific focus on the short term). This is also referred to as
the Maturity Ladder Model proposed by the Bank of International Settlements (BIS).

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

11

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Lquidity Risk Management

Fundamental Approach

Technical Approach

Cash Flow Approach

Inves&ng in assets that
can be turned into cash
easily and/or complying
with regulatory measures

On the liability
side of the balance
sheet, focus on
source of funds

Vola=le Funds

Carefully analyze
cash inows and
ou?lows; source
funds ahead of need

Working Funds Approach

Vulnerable Funds

(BIS)
Maturity
Ladder
Model

Stable Funds

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

12

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Operational Risk
Operational risk is the risk of direct or indirect losses resulting from inadequate or failed internal
processes, people, and systems or from external events. Another name for operational risk is catchall risk (In Football parlance, operations risk is also referred to as the goal-keeper risk).

Operational risks are pervasive, complex and dynamic as well as embedded virtually in all the
business processes of any financial institution, since they can be triggered by both exogenous and
endogenous factors.

A broad category of endogenous contributors to operational risk include:

ENDOGENOUS FACTORS
Internal Fraud

Financial transac+ons not reported

Forgery
Misappropria+on
Embezzlement, etc.

Employee Prac+ces and

Work Place Safety

Ac+ons originated by employees who have been terminated

or who have resigned
Organised ac+vi+es by employees unions
Personal accidents and injury to employees or customers
inside the ins+tu+ons premises

Failure of Informa+onal
Technology and Business
Disrup+ons

Disrup+on to the normal conduct of the business caused by

failure of computer hardware or soHware, data
communica+on network, power supply, etc.

Failures in Execu+on,
Delivery and Process
Management

Data entry and accoun+ng errors,

Access control viola+ons,
Poor collateral management, etc.

Clients, Products and

Business Prac+ces

Breach of customer privacy,

Insider trading,
Money laundering,
Wilful viola+on of guidelines, etc.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

13

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

A broad category of exogenous contributors to operational risk include:

EXOGENOUS FACTORS
Acts of forgery by the ins0tu0ons customers

External Fraud

Hacking of computers resources by

uniden0ed external en00es, etc.
Such as property, informa0on technology

Damage to

asset due to natural disasters, terrorist aAacks,

etc.

Physical Assets

Categorization of Operational Risks
All financial institutions around the world encounter operational risk events that can be categorized,
based on sound empirical analysis, into the following four quadrantsA, B, C, D.

High



Financial


Impact



Low
Low

High

Frequency/Probability

As you can see from the
quadrant diagram, X-axis
denotes the frequency or
probability of the risk events,
and the Y-axis denotes the
financial impact of such
operational risk events.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

14

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week One

Mitigating Operational Risks

Financial institutions, on their part, have taken several proactive measures to protect themselves
against losses from operational risk events. These include:

Banks and Financial Ins-tu-ons

Disasters recovery and Business con-nuity planning

with respect to their informa-on technology infrastructure
Seeking out insurance companies to underwrite poten-al
losses from risk events such as natural disasters,
outsourcing, etc.
Paying special aBen-on to security and access control;
including measures such as dual authen-ca-on, ethical
hacking, etc.
Cons-tu-ng organiza-onal structures and processes to
cri-cally examine opera-onal risks inherent in exis-ng
products & processes and in new products and processes
Collec-ng and analysing data on the ins-tu-ons historical
loss experience; develop/revamp policies and procedures
to prevent opera-onal risk events and to minimize losses

At the initiative of the Central Bank in several countries, financial institutions have started sharing
and learning from their mutual experience and collectively found ways to mitigate operational risk
events and minimize losses when such events occur.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Parspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

15