Beruflich Dokumente
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A PROJECT SUBMITTED IN
PART COMPLETION OF
BY
NAYAN THARVAL
1
CERTIFICATE
Management In Banking in
Mumbai University
___________________ _____________________
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Acknowledgement
We believe that behind the ascend of each and every student lie not
only the relentless urge to work hard but also the guidance and
inspiration of their guide, co-guide and other helpful people.
With a deep sense of gratitude I would like to thank each and every
person who has contributed towards the successful completion of the
project work.
Sincere thanks to the workforce of TIMSR, for their kind and timely
support & cooperation.
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Synopsis
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This report aims at:
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Table of Content
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10 Market Risk Management 52-57
10.1 Board and Senior Management Oversight 52-53
10.2 Organizational Structure for Market Risk 54-57
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Part - I
Risk In Banking – An Overview
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Chapter 1 Introduction
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An effective risk management framework includes:
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Chapter 2 Types of Risks
Banks are exposed to the various kinds of risk. For e.g. Market risk,
credit risk & operational risk.
Bank operations
Pre
settlement
settlement
The risks associated with the provision of banking services differ by the
type of service rendered. Three Broad categories of Risks faced by
banks are systematic or market risk, credit risk, and operational risk.
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such, systematic risk comes in many different forms. For the banking
sector, however, two are of greatest concern, namely variations in the
general level of interest rates and the relative value of currencies.
Because of the bank's dependence on these systematic factors, most
try to estimate the impact of these particular systematic risks on
performance, attempt to hedge against them and thus limit the
sensitivity to variations in undiversifiable factors. Accordingly, most will
track interest rate risk closely. They measure and manage the firm's
vulnerability to interest rate variation, even though they can not do so
perfectly. At the same time, international banks with large currency
positions closely monitor their foreign exchange risk and try to
manage, as well as limit, their exposure to it. In a similar fashion, some
institutions with significant investments in one commodity such as oil,
through their lending activity or geographical franchise, concern
themselves with commodity price risk. Others with high single-industry
concentrations may monitor specific industry concentration risk as well
as the forces that affect the fortunes of the industry involved.
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credit risk is not easily transferred, and accurate estimates of loss are
difficult to obtain.
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Chapter 3 Risk Management System and Procedure
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and much more frequent reporting intervals, with daily or weekly
reports substituting for the quarterly GAAP periodicity.
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In addition, securitization and even derivative activity are rapidly
growing techniques of position management open to participants
looking to reduce their exposure to be in line with management's
guidelines.
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Chapter 4 Risk Measurement – An Introduction
Until and unless risks are not assessed and measured it will not be
possible to control risks. Further a true assessment of risk gives
management a clear view of institution’s standing and helps in
deciding future action plan. To adequately capture institutions risk
exposure, risk measurement should represent aggregate exposure of
institution both risk type and business line and encompass short run as
well as long run impact on institution. To the maximum possible extent
institutions should establish systems / models that quantify their risk
profile, however, in some risk categories such as operational risk,
quantification is quite difficult and complex. Wherever it is not possible
to quantify risks, qualitative measures should be adopted to capture
those risks. Economic Capital gives a common framework for
quantifying the risk arising from many diverse sources. It also allows
calculating the amount of equity capital that the bank should hold.
RAROC has become industry standard way of measuring risk-adjusted
probability. It allows comparing the probability of different
transactions.
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4.2 .Risk Adjusted Performance
Economic capital is useful for identifying large risks and setting aside
the required amount of capital to be held by the bank to ensure
smooth functioning without defaulting. However, when deciding
whether to carry out a transaction, the bank is not only concerned
about the risk, it is also interested in probability relative to that risk. By
measuring risk- adjusted performance (RAP), a bank can integrate risk
measurement into the daily profitability management of the business.
Traditionally, the banking industry relied on measurements that gave
an incomplete picture and its relation to risk. The two most common
measurements were Return on Assets (ROA) and Return on Equity
(ROE). ROA is a profit divided by the rupee value of the portfolio. ROE
is the profitability divided by either book capital or Regulatory capital.
The book capital is the net value of the bank as measured by
accounting methods. The regulatory capital is the minimum amount of
capital that must be held by the bank according to regulators such as
the Bank of England and the Federal Reserve. The return on assets
takes no account of the risk of the assets. As an alternative, over the
last decade the industry has developed two metrics for risk-adjusted
performance that are based on Economic Capital: RAROC and SVA.
RAROC is the risk-adjusted return on capital, and SVA is shareholder
value added.
RAROC = ENP
EC
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4.2.2. Shareholder Value Added (SVA)
Shareholder value added (SVA) gives a dollar- based measure of
performance. It is simply the actual or expected probability minus the
required probability to meet the hurdle rate.
SVA = ENP – H x EC
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Part – II
Credit Risk
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Chapter 5 Introduction to Credit Risk
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Both firm credit risk and portfolio credit risk are impacted or triggered
by systematic and unsystematic risks.
Credit risk
Socio-political
Risks
Business Risks
Economic Risks
Other Exogenous
Financial Risks
Risks
External forces that affect all business and households in the country
or economic system are called systematic risks and are considered as
uncontrollable. The second type of credit risks is unsystematic risks
and is controllable risks. They do not affect the entire economy or all
business enterprises/households. Such risks are largely industry-
specific and /or firm specific. A creditor can diversify these risks by
extending credit to a range of customers.
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5.3. Sources of Credit Risk
Credit – related losses can occur in the following ways:
A customer fails to repay money that was lent by the bank
A customer enters into a derivative contract with the bank in
which the payments are based on market prices, and then the
market moves so that the customer owes money, but customer
fails to pay.
The bank holds a debt security (e.g. a bond or a loan) and the
credit quality of the security issuer falls, causing the value of the
security to fall. Here, a default has not occurred, but the
increased possibility of a default makes the security less
valuable.
The bank holds a debt security and the market’s price for risk
changes. For example, the price for all BB-rated bonds may fall
because the market is less wiling to take risks. In this case, there
is no credit event, just a change in market sentiment. This risk is
therefore typically treated as market risk
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Increase in bankruptcies: Recessionary phases are common
in the economy, although the timing and causes may be different
for different countries. In 2002/2003, the US economy went
through massive job losses and sluggish growth and was almost
on the verge of an economic slowdown. Given the fact that the
incidence of bankruptcies during recession is high, the role of
accurate credit analysis is very important
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may not quote even half the value of the credit extended during
boom periods.
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Default Risk: It is the probability of the event of default, i.e. missing a
payment obligation, breaking an agreement or economic default. A
payment default is declared when a scheduled payment is not made
within 90 days from the due date. Default Risk depends upon the credit
standing of the borrower and is measured by the probability that
default occurs during a given time period. Although this cannot be
measured directly, it can be observed from historical statistics or can
be collected internally from rating agencies.
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Given the risk and a fixed price, is the asset worth taking?
This is the type of decision made when dealing with a large volume of
retail customers. It is a more rigid approach where there is little
opportunity to modify the price, and therefore the decision becomes
“yes/no”
Given the risk, what price is required to make the asset worth
buying?
This approach is typically used in a flexible, liquid trading environment,
or in negotiating rates and fees for a corporate loan
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Chapter 6 Types of Credit Structure
Credit risk can arise in many ways, from granting loans to trading
derivatives. The amount of credit risk depends largely on the structure
of the agreement between the bank and its customers. An agreement
between a bank and a customer that creates credit exposure is often
called a credit structure or a credit facility
Credit Exposure To
1.Credit Exposure To Retail Customers
Large Corporations
Personal Loans
Commercial loans Credit cards
Commercial Lines Credit Car Loans
Letter Of Credit & Structure
Leases and hire-
Gurantees purchase agreements
Leases Mortgages
Credit derivatives Home-equity lines of
Credit Exposures In credit
Trading Operations
Bonds
Asset-backed securities
Securities lending and
repos
Margin accounts
Credit exposure for
derivatives
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6.1 Credit Exposure to Large Corporations:
Car Loans: Car loans are same as personal loans except that
they are for a specific purpose and have the car as collateral.
They tend to have a lower loss given default than personal loans
because of the collateral, and they have a lower probability of
default because the customer is unwilling to lose the car.
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Margin Accounts: A margin account is another form of
collateralized loan. In a margin account, a customer takes a loan
from the bank, and then with the loan and his own funds,
purchases a security. The security is then held by the bank as
collateral against the loan. The pledging of the security as
collateral by the customer to the bank is called hypothecation. It
is also possible for the bank to pledge the security to another
bank to get a loan. This is called rehypothecation.
Margin accounts are used by customers who want to leverage
their positions and increase their potential returns. As an
example, consider a customer who has %10000 and takes a loan
for $10000. Thus customer now has $20000 which he can use to
buy securities worth $20000. If the price rises by 10% to $22,000
and the customer sells these securities, then after paying back
the loan with interest, the customer has a little less than
$12,000, a nearly 20%gain, conversely , if the price falls by 10%,
the customer makes a 20% loss. Typically, retail customers are
allowed to borrow only up to half the value of the securities that
own. If the value of the securities falls, the bank will ask the
customer for more cash to maintain the 50% ratio; this is called a
margin call. If the customer does not respond, the bank will sell
all or part of the shares. After paying off the, any residual value
is given back to the customer. If the securities lost more than
50% of their value before they are liquidated, and the customer
failed to make up the difference, the bank would suffer credit
loss.
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Chapter 7 Credit Risk and Basel Accords
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Risk – Weighted Assets: Assets in the balance sheet of a bank have
been differentiated, based on the risks. While central
government/Central bank obligations carry nil (0%) risk, those of
the private business sector carry full risk (100%).The portfolio
approach is adopted to measure risk with assets classified into four
buckets(0%,20%,50%,and 100%). This distinction, depending upon
counter parties, gives a unique perspective to the capital adequacy
of a banking institution. If a bank has more counter parties having
nil (or lower) risk, it needs to hold less capital than a bank which has
parties with 100% risk weight.
The summarized weight scale is given below: Risk Weight of On –
B/S items
Risk 0% 20% 50% 100%
Weights
Counter Parties
Central Govt, Central Bank
exposure in National Currency
x
OECD Govt/ Central Banks &
claims guaranteed by them
x
Multi- Lateral development
banks(ADB, IBRD, etc )
X
Banks in OECD/ Claims
guaranteed by them
x
Residential mortgage backed
loans
x
Private sector entities
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7.2. Basel 2 (New) Accord:
The suggested form of new Accord was published in January 2001 to
obtain comments from the banking industry. The final Accord will be
effective from 2006 – 2007. The new Accord retains the same concepts
of EWA and Tier 1 and Tier 2 available capital, but it changes the
method for calculating RWA.
The new Accord has three pillars:
i) Minimum requirement of Capital
ii) Role of supervisory review process
iii) Market discipline
The measurement of minimum requirement of capital gives many
formulas to replace the simple calculations of the 1998 Accord. The
supervisory review pillar requires regulators to ensure that the
bank has effective risk management, and requires the regulators to
increase the required capital if they think that the risks are not being
adequately measured. The market discipline pillar requires banks to
disclose large amounts of information so that depositors and investors
can decide for themselves the risk of the bank and require
commensurately high interest-rates and return on capital.
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receive 100% weight. Generally all AAA and AA rated
companies require only 20% weight while credit exposures
rated B and below require 150% weight.
Risk Weights for Government and Banks under the new standardized
Approach
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ii. IRB Advanced, where all inputs to risk weighted asset
calculation – PD , LGD, and EAD – estimated by the bank
itself , subject to regulatory satisfaction
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Chapter 8 Credit Risk Measurement
P
R
O
B
A
Credit Risk Measured as B
Economic Capital I
L
I
T
Worst Case loss y
Credit Loss
EC = MPL – EL
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8.2. Calculation of EL & UL for Singe Facility/ Single Loan
UL = P – P2 x E x S
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8.3. Determining Losses Due to Both Default and Downgrades
When a company is downgraded, it means that the rating agency
believes that the probability of default has risen. A promise by this
downgraded company to make a future payment is no longer as
valuable as it was because there is an increased probability that the
company will not be able to fulfill its promise. Consequently, there is a
fall in the value of the bond or a loan.
To obtain the EL and UL for this risk, we require the probability of a
grade change and the loss if such a change occurs. The probability of a
grade change has been researched and published by the credit-rating
agencies.
End 6
BBB 8 49 519 892 667 46 93 0
Of
6
the BB 3 6 49 444 833 576 200 0
Year 1
B 0 9 20 81 747 841 1074 0
8
CCC 0 2 1 16 105 387 6395 0
Defau 0 1 4 22 98 530 2194 10000
lt
To understand how to read this table, let us use it to find the grade
migration probabilities for a company that is rated Single A at the start
of the year. Looking down the third column, we see that the company
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has a 7- basis point chance of becoming AAA rated by the end of the
year. It has a 2.25% chance of being rated AA, a 91.76% chance of
remaining single – A and a 5.19% chance of being downgraded to BBB.
Looking down to the bottom of the column, we see that it has a 4-
basis points chance of falling into default.
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8.4. Calculation of EL and UL of the Portfolio
The expected loss for the portfolio (ELP) is simply the sum of the
expected losses for the individual loans within the portfolio. The
unexpected loss for the portfolio (ULP) is the standard deviation
obtained from the sum of the variances for the individual loans.
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8.5. RAROC Over One Year:
RAROC = ENP
EC
Where for a loan, the expected net profit ENP is the interest income on
the loan, plus any fees (F), minus interest to be paid on debt, minus
operating costs (OC), and minus expected loss.
Thus Formula can be Re-written as:
RAROC = A0 rA + F – D0 rD – OC – EL
EC
Here: The interest income on the loan asset is the initial loan amount
Example:
A loan of $100 for 1 year to a company rated BBB with the following
assumptions:
1. the collateral is such that the LGD is 30%
2. The average default correlation with the rest of the portfolio is
3%
3. The capital multiplier for the portfolio is 6
4. The probability of default is 22 basis points i.e. 0.22%
5. The interbank rate for one-year debt is 5 (rD).
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Solution:
UL = P – P2 x E x S = 0.22% - 0.22% 2
x $100 x 30% = $1.41
Calculation of RAROC
RAROC =
A0 rA + F – D0 rD – OC – EL = $100 x 6.5% -($100-$1.46)x 5%- $1-
$0.066
EC $1.46
RAROC = 35%
Calculation of SVA
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Part – III
Market Risk
Banks are exposed to market risk via their trading activities and their
balance sheets. The measurement of trading risk is probably the most
advanced of the three main types of risks faced by banks.
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Chapter 9 Introduction to Market Risk
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Sources of interest rate risks:
Interest rate risk occurs due to
(1) Differences between the timing of rate changes and the timing of
cash flows (re-pricing risk);
(2) Changing rate relationships among different yield curves effecting
bank activities (basis risk);
(3) Changing rate relationships across the range of maturities (yield
curve risk);
(4) interest-related options embedded in bank products (options risk).
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3. Liquidity risk
Possible needs for the liquidity are manifold they can be classified into
4 broad categories
1. Funding risk: - the need to replace the outflows of the funds. e.g.
non renewal of the wholesale funds
2. Time risk: - the need to compensate for the no receipt of the
expected inflow of the funds e.g. when the borrower fails to meet
his commitment.
3. Call risk:- the need to find new funds when contingent liability
becomes due e.g. a sudden surge in the borrowing under ATMs
4. the need to undertake new transactions when desirable, e.g. a
request for the imp client
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Chapter 10 Market Risk Management
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10.2. Organizational Structure for Market Risk Management
The organizational structure used to manage market risk vary
depending upon the nature size and scope of business activities of the
institution, however, any structure does not absolve the directors of
their fiduciary responsibilities of ensuring safety and soundness of
institution. While the structure varies depending upon the size, scope
and complexity of business, at a minimum it should take into account
following aspect.
a) The structure should conform to the overall strategy and risk policy
set by the BOD.
b) Those who take risk (front office) must know the organization’s risk
profile, products that they are allowed to trade, and the approved
limits.
c) The risk management function should be independent, reporting
directly to senior management or BOD.
d) The structure should be reinforced by a strong MIS for controlling,
monitoring and reporting market risk, including transactions between
an institution and its affiliates.
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integrated risk management containing various risk exposures of the
bank including the market risk. The responsibilities of Risk
Management Committee with regard to market risk management
aspects include:
a) Devise policies and guidelines for identification, measurement,
monitoring and control for all major risk categories.
b) The committee also ensures that resources allocated for risk
management are adequate given the size nature and volume of the
business and the managers and staffs that take, monitor and control
risk possess sufficient knowledge and expertise.
c) The bank has clear, comprehensive and well-documented policies
and procedural guidelines relating to risk management and the
relevant staff fully understands those policies.
d) Reviewing and approving market risk limits, including triggers or
stop losses for traded and accrual portfolios.
e) Ensuring robustness of financial models and the effectiveness of all
systems used to calculate market risk.
f) The bank has robust Management information system relating to risk
reporting.
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up of MIS and related computerization. Major responsibilities of the
committee include:
a) To keep an eye on the structure /composition of bank’s assets and
liabilities and decide about product pricing for deposits and advances.
b) Decide on required maturity profile and mix of incremental assets
and liabilities.
c) Articulate interest rate view of the bank and deciding on the future
business strategy.
d) Review and articulate funding policy.
e) Decide the transfer pricing policy of the bank.
f) Evaluate market risk involved in launching of new products.
ALCO should ensure that risk management is not confined to collection
of data.
Rather, it will ensure that detailed analysis of assets and liabilities is
carried out so as to assess the overall balance sheet structure and risk
profile of the bank.
The ALCO should cover the entire balance sheet/business of the bank
while carrying out the periodic analysis.
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showing the effects of various possible changes in market conditions
related to risk exposures. Banks using VaR or modeling methodologies
should ensure that its
ALCO is aware of and understand the nature of the output, how it is
derived, assumptions and variables used in generating the outcome
and any shortcomings of the methodology employed. Segregation of
duties should be evident in the middle office, which must report to
ALCO independently of the treasury function. In respect of banks
without a formal Middle Office, it should be ensured that risk control
and analysis should rest with a department with clear reporting
independence from Treasury or risk taking units, until normal Middle
Office framework is established.
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Chapter 11 Market Risk Monitoring and Control
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functions they review. Key elements of internal control process include
internal audit and review and an effective risk limit structure.
Audit: Banks need to review and validate each step of market risk
measurement process. This review function can be performed by a
number of units in the organization including internal audit/control
department or ALCO support staff. In small banks, external auditors or
consultants can perform the function. The audit or review should take
into account.
a) The appropriateness of bank’s risk measurement system given the
nature, scope and complexity of bank’s activities
b) The accuracy or integrity of data being used in risk models.
c) The reasonableness of scenarios and assumptions
d) The validity of risk measurement calculations.
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Part IV
Operational Risk
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Chapter 12 Introduction to Operation Risk
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operational risk, including those that do not readily lend themselves to
measurement.
d) Operational risk policies and procedures that clearly define the way
in which all aspects of operational risk are managed should be
documented and communicated. These operational risk management
policies and procedures should be aligned to the overall business
strategy and should support the continuous improvement of risk
management.
e) All business and support functions should be an integral part of the
overall operational risk management framework in order to enable the
institution to manage effectively the key operational risks facing the
institution.
f) Line management should establish processes for the identification,
assessment, mitigation, monitoring and reporting of operational risks
that are appropriate to the needs of the institution, easy to implement,
operate consistently over time and support an organizational view of
operational risks and material failures.
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Chapter 13 Operational Risk Management and
Measurement
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13.2. Operational Risk Function
A separate function independent of internal audit should be
established for effective management of operational risks in the bank.
Such a functional set up would assist management to understand and
effectively manage operational risk. The function would assess,
monitor and report operational risks as a whole and ensure that the
management of operational risk in the bank is carried out as per
strategy and policy.
To accomplish the task the function would help establish policies and
standards and coordinate various risk management activities. Besides,
it should also provide guidance relating to various risk management
tools, monitors and handle incidents and prepare reports for
management and BOD.
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Bibliography
Reference Books:
Websites:
1. Google.com
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