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Risk Management is
the
process of measuring or
assessing the actual or
potential
dangers
of
a
particular situation.
RISK MANAGEMENT
Types of Risk
Operational
Market
Credit
OPERATIONAL RISK
The risk of loss resulting from
inadequate or failed internal
processes,
people
and
systems, or from external
events. This includes legal
risk but excludes strategic &
reputational risk.
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RISK
MANAGEMENT
OPERATIONAL
RISK
1. Internal Fraud.
Unauthorized Activity.
Transactions not reported.
Transaction type unauthorized.
Mismarking of position.
Theft and Fraud.
Fraud/credit fraud/worthless deposits.
Theft/extortion/embezzlement/robbery.
Misappropriation of assets.
Account take-over/impersonation.
Bribes/kickbacks.
Money laundering.
Willful blindness.
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OPERATIONAL RISK
2.External Fraud.
Theft and Fraud.
Theft / Robbery.
Forgery.
Check kiting.
Elder financial abuse.
Systems Security.
Hacking damage.
Theft of information (with monetary loss).
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OPERATIONAL RISK
3.Employment Practices and Workplace Safety :
Employee Relations.
Compensation, benefit, termination issues.
Organized labor issues.
Safe Environment.
General liability
Employee health and safety rules.
Workers compensation.
Diversity and Discrimination.
All discrimination types.
Harassment.
Equal Employment Opportunity (EEO).
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OPERATIONAL RISK
4.Clients, Products and Business Practices :
Suitability, Disclosure and Fiduciary.
OPERATIONAL RISK
4.Clients,
(CONTINUED).
Selection, Sponsorship and Exposure.
Failure to investigate client as per guidelines.
Exceeding client exposure limits.
Advisory Activities.
Disputes over performance or advisory
activities.
OPERATIONAL RISK
5. Damage to Physical Assets :
Disasters and Other Events.
Natural disaster losses.
Human losses from external sources
(terrorism, vandalism).
6.Business Disruption and System Failures
Systems.
Hardware.
Software.
Telecommunications.
Utility outage/disruptions.
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OPERATIONAL RISK
7. Execution, Delivery and Process Management.
Transaction Capture, Execution and Maintenance.
Miscommunication/Delivery Failure
Data entry, maintenance or loading errors.
Missed deadline or responsibility.
Accounting error
Record retention.
Documentation maintenance.
Collateral management failure.
Reference data maintenance.
contd.
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OPERATIONAL RISK
Monitoring and Reporting.
Failed mandatory reporting obligations.
Inaccurate external loss (loss incurred).
Customer Intake and Documentation.
Unapproved access given to accounts.
Incorrect client records (loss incurred).
Negligent loss or damage of client assets.
Trade Counterparties.
Non-client counterparty misperformance.
Vendors and Suppliers.
Outsourcing.
Vendor disputes.
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OPERATIONAL RISK
STEPS TO BE TAKEN BY BANKS :
To minimize operational risk & strengthen internal
control, the objective of the Bank is to develop an
appropriate
policy,
procedures,
strategy,
framework, and risk culture by adopting best
practices to achieve the goal set by the Bank.
To find out the extent of Banks Operational Risk
exposure and to allocate capital for operational
risk.
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OPERATIONAL RISK
The New Capital Adequacy Framework outlines
three methods for calculating operational risk
capital charges for increasing sophistication
and risk sensitivity:
(i) the Basic Indicator Approach (BIA) - Under
this Approach, banks must hold capital for
operational risk equal to the average over the
previous three years of a fixed percentage
(presently 15% by BCBS) of positive annual gross
income (Net interest + Net non-interest income).
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OPERATIONAL RISK
(ii) The Standardised Approach (TSA) : Banking
activities have been mapped into 8 business
lines: (on average gross income of last 3 yrs)
1.Corporate finance
2. Trading & Sales
3. Retail Banking
4. Commercial Banking
5. Asset Management
6. Retail brokerage
7. Agency service
8. Payment settlement . ( w.e.f. 30.09.2010)
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OPERATIONAL RISK
(iii) Advanced Measurement Approaches (AMA)
Basel II - Banks can use this approach only
subject to approval from their local regulators :
Its board of directors and senior management, are
actively involved in the oversight of the
operational risk management framework;
It has an operational risk management system
that is conceptually sound and is implemented
with integrity; and
It has sufficient resources for use of approach in
major business lines, control & audit areas.
(Implemented by 31.03.2014)
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OPERATIONAL RISK
Operational Risk Checklist :
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Employee training.
Close management vigil.
Segregation of duties.
Employee background checks.
Procedures and process.
Purchase of insurance.
Exit from certain businesses.
Capitalization of risks.
MARKET RISK
Market risk is, risk of losses in onbalance sheet and off balance-sheet
positions arising from movements in
market prices. The market risk
positions subject to capital charge
requirement are :
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MARKET RISK
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(i)
(ii)
Foreign
exchange risk
(including
open position in
precious metals) throughout the
bank (both banking
and trading*
books). [*Investment/securities]
MARKET RISK
RBI GUIDELINES :
Banks are required to manage the
market risks in their books on an
ongoing basis and ensure that the
capital requirements for market risks
are being maintained on a continuous
basis, i.e. at the close of each
business day.
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MARKET RISK
MEASURES :
1. Prudential gap limits are fixed and reviewed
periodically for the liquidity and interest rate
risk of the banks books.
2. The ALM solution would encompass the
Global operations of the bank.
3. Behavioral studies shall continue to be done
for assessing and apportioning volatile and
non-volatile portion of various non-maturity
products of both assets and liabilities.
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MARKET RISK
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MARKET RISK
5. The banks Foreign Exchange Risk position in
each currency should be calculated by
summing : net spot position, net forward position,
Guarantees, Net future income/ expenses
(capital charge for foreign exchange risk and gold
open position presently is 9 per cent).
6.Duration gap analysis (measure the percentage
change in the economic value of a position)
continue to be carried out at Monthly (since April
2012 earlier Qtly) intervals to assess the interest
rate risk of both banking book and trading book.
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MARKET RISK
7. Foreign Exchange risk be regularly monitored and
managed through exposure limits i.e. Day Light
Limit, Overnight Limit, Stop Loss limits, Inter Bank
Exposure Limits etc.
8. Maturity Position and Interest Sensitivity of Forex
Open positions are assessed on monthly basis and
put up to ALCO.
9. Bank may enter into Interest Rate Swaps (IRS) &
Forward Rate Agreement (FRA) selectively with the
objective of hedging actual balance sheet
exposures and to meet the requirements of
corporate clients.
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MARKET RISK
10.VaR (Value-at-risk) a measure of the worst
expected loss over a given time interval under
normal market conditions at a given confidence
level shall be computed on the trading book of the
Investment Portfolio on daily basis
11.Earnings at risk (EAR) measure the quantity by
which net income might change in the event of an
adverse change in interest rates.
VAR looks at the change in the entire value over
the forecast horizon, EAR looks at potential
changes in cash flows or earnings.
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MARKET RISK
12.RBI said : Banks should identify their major
sources of risk and carry out stress tests
appropriate to them, may be run daily or weekly,
monthly or at quarterly intervals. This stress testing
would also form a part of preparedness for Pillar 2
of the Basel II framework.
It is another modern risk management practice
which has found wide acceptability in Indian
Banking System, for determining the required
buffer size of capital is an important risk
management issue for banks
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CREDIT RISK
Credit Risk is defined as the possibility of
losses associated with diminution in the credit
quality of borrowers or counter-parties. In a
banks portfolio, losses stem from:
1. Outright default due to inability or unwillingness
of a customer or counter-party to meet
commitments in relation to lending, trading,
settlement and other financial transactions.
2. Reduction in portfolio value arising from actual
or perceived deterioration in credit quality.
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CREDIT RISK
Credit risk incorporates following three risks: Counterparty Risk: Risk to each party of a contract that
other party (or parties) will not live up to their obligations
under the contract. In most financial contracts,
counterparty risk is default risk i.e. failure to make
payments because of bankruptcy. To reduce the potential
of counterparty risk, margin is taken in the accounts.
Credit Spread Risk: It arises due to changes in the
credit quality of the obligor between a rating horizon.
Example - If credit quality of a borrower deteriorates after
last rating but before next rating becomes due, in that
case bank is not compensated for taking additional risk if
loan price is not revised. However, if the borrowers
credit quality improves between a rating horizon, it is
beneficial for the bank.
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CREDIT RISK
Concentration Risk: Refers to additional portfolio risk by
increased exposure to one obligor or groups of correlated
obligors (e.g., by industry, by location, etc.). It includes:
Significant exposures to an individual counterparty or
group of related counterparties;
Credit exposures to counterparties in the same economic
sector or geographic region;
Credit exposures to counterparties whose financial
performance is dependent on the same activity or
commodity; and
Indirect credit exposures arising from a banks Credit Risk
Mitigation (CRM) activities (e.g. exposure to a single
collateral type or to credit protection provided by a single
counterparty).
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Expected Loss
The Expected Loss (in absolute terms)
EL = PD * EAD * LGD
If expressed in percentage terms of the EAD
EL = PD * LGD.
The bank should incorporate an expected loss rate in the
estimation of the total spread to be charged on the loan.
Expected Loss is the banks cost of doing business.
Expected loss is not a measure of risk as it is anticipated.
Probability of Default (PD)
Loss given Default (LGD)
Exposure at Default (EAD)
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ADVANCED
INTERNAL RATING
BASED
APPROACH
FOUNDATION
INTERNAL
RATING BASED
APPROACH
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Risk Components
Probability of Default (PD)
Probability of default measures the likelihood that the
borrower will default over a given time-horizon i.e. What is
the likelihood that the counterparty will default on its
obligation either over the life of the obligation or over some
specified horizon, such as a year?
Calculated for a one-year horizon, this may be called the
expected default frequency.
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Risk Components
Loss Given Default (LGD)
Loss Given Default is the credit loss incurred if an obligor
of the bank defaults.
LGD = 1 Recovery Rate
where, Recovery = Present Value of { Cash flows
received from borrower after the date of default - Costs
incurred by the bank on recovery }
Recovery rate = Recovery (as
Exposure on the date of default
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calculated
above)/
Risk Components
Exposure at Default (EAD)
EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK
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Risk Components
Maturity (M)
It measures the remaining economic maturity of the
exposure.
Determines framework for comparing different exposures.
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BB
AAA
100
750
11.00
73.10
4.50
33.75
1.00
2.00
1.00
0.75
1.35
1.35
Total Cost
7.85
37.10
Return on Capital
3.15
36.00
It can be inferred from the above that lending to AAA assets at 9.75%
would be more remunerative vis--vis lending to BB at 11%.
Our natural choice for selection of borrowers would shift from BB &
upwards under Basel I to AAA & downwards under Basel II (SA).
In case sufficient number of AAA assets are not available at lease our
order of preference would be AA, A and then BB.
Manufacturing
Trading
Unlimited Up Side
Limited Up Side
Lending
GENERAL GUIDELINES
Latest Audited Financial Statements only (not more
than 1 Yr old).
Each parameter to be evaluated and no parameter
should be left un-assessed.
Careful analysis & evaluation of each parameter.
Subjective parameters need qualitative evaluation
and continuous updating knowledge about the
business & industry.
To improve information base about management
and conduct of the accounts - through regular visit
of the industry, interaction valuable insight
beyond financial data.
Basel I
Rating
AAA
BB
Exposure
ROI
RISK
WEIGHT
Capital
Charge
100
100
9%
11%
100%
100%
9
9
Exposure
ROI
RISK
WEIGHT
Capital
Charge
AAA
100
9%
20%
1.8
BB
100
11%
150%
13.5
Results :
It can be inferred from the above that lending
to AAA assets at 9% would be more
remunerative vis--vis lending to BB at 11%.
Our natural choice for selection of borrowers
would shift from BB & upwards under Basel I
to AAA & downwards under Basel II (SA).
In case sufficient number of AAA assets are
not available at lease our order of preference
would be AA, A and then BB.