Money and Banking

Course Instructor: Maam Bushra Zulfiqar

Risk Management in Commercial Banks

Group Members
Ali Jan (09-arid-877) Malik Ishfaq Balouch (09-arid-) M.Abdul Basit Gondal (09-arid-(923) Bilal Raza (09-arid-)

PMAS University of Arid Agriculture Rawalpindi University Institute of Management Sciences

Acknowledgement
Thanks to Almighty ALLAH who had made us able to complete this report with the true knowledge.

Special thanks are due to our respected teacher Maam Bushra Zulfiar who have shown us the right way to go for our report to success and enlightened our mind with the tips and guidance to think creatively. We are thankful to our friends, who help us a lot during this course of report.

Askari Bank:
History:
Askari Bank Ltd (formerly Askari Commercial Bank) was incorporated in Pakistan on October 9, 1991, as a Public Limited Company. It is the only bank in the world run by an army; serving Adjutant General of Pakistan Army being head of the Board of Governors. It started its operations on April 1, 1992. The bank principally deals with banking, as defined in the Banking Companies Ordinance, 1962. The Bank is listed on the Karachi, Lahore &Islamabad Stock Exchanges.

Defining Risk:
The variability of return from those that are expected while variability is directly proportional to risk Risks are usually defined by the adverse impact on profitability of several distinct sources of uncertainty. While the types and degree of risks an organization may be exposed to depend upon a number of factors such as its size, complexity business activities, volume etc.

Risk Management
Risk Management is a discipline at the core of every financial institution and measures all the activities that affect its risk profile. It involves identification, measurement, monitoring and controlling risks to ensure that The individuals who take risks is clearly understood and manage it.
Risk taking Decisions are in line with the business strategy and objectives set by BOD.

The expected payoffs compensate for the risks taken Risk taking decisions are understandable and clear. Sufficient capital as a buffer is available to take risk. Risk is inherent in business of banking and in banking roles.

In every financial institution, risk management activities broadly take place simultaneously at following different hierarchy levels.

Strategic level:
It measures risk management functions performed by senior management and BOD. It depends upon the senior management and BOD either they are risk taker or risk obverse. If they are risk taker then strategic level risks will be more and vice versa.

Macro level:
It encompasses risk management within a business area or across business lines. Generally this risk management activities are performed by middle level managers or unit devoted to perform this activity.

Micro level:
This is the risk management activities performed by individuals who take risk on organizations behalf such as front office and loan origination functions. A banks ability to measure, monitor, and steer risks comprehensively is becoming a decisive parameter for its strategic positioning. The risk management framework and sophistication of the process, and internal controls, used to manage risks, depends on the nature, size and complexity of institutions activities.

Risk Management in Commercial Banks:

For the management of risk all the commercial banks follow the rules and regulation defined by the SBP. Following are the guidelines for the management of different risks face by the commercial bank. Managing Market Risk

Managing Credit Risk

Managing Market Risk:

It is the risk that the value of on and off-balance sheet positions of a financial institution will be badly affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and commodity prices resulting in a loss to earnings and capital. Market risk may arises due to the change in Interest rate Foreign Exchange rate Equity prices

Interest Rate Risk:

Interest rate arises when there is difference between positions, which are subject to interest rate adjustment within a specified period. The banks lending. Funding and investment activities give rise to interest rate risk. The direct impact of variation in interest rate is on banks net interest income. While a long term impact is on banks net worth since the economic value of banks assets, liabilities and off-balance sheet exposure are affected. There are two common perspective for the evaluation of interest rate risk. 1. Earning Perspective 2. Economic Value Perspective Earning Perspective:

The focus of analysis is the impact of variation in interest rates on accrual/reported earnings. This is a traditional approach to interest rate risk estimation and obtained by measuring the

changes in the Net Interest Income (NII) or Net Interest Margin (NIM) means the difference between the total interest income and the total interest expense. Economic Value Perspective:

It reflects the impact of variation in the interest rates on economic value of a financial institution. Economic value of the bank can be viewed as the present value of future cash flows. In this respect economic value is affected both by changes in future cash flows and discount rate used for determining present value. Economic value perspective considers the potential longer-term impact of interest rates on an institution

Sources of Interest Rate Risk:

Interest rate risk occurs due to the following
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).

Foreign Exchange Rate Risk:

It is the prospective risk to earnings and capital arising from adverse movements in currency exchange rates. It means that the impact of adverse movement in currency exchange rates on the value of open foreign currency position.

The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses due to changes in discounts of the currencies concerned. In the foreign exchange business, banks also face the risk of default of the counter parties or settlement risk. While such type of risk crystallization does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements.

Equity Price Risk:

It is risk to capital that results from unfavorable changes in the value of equity related portfolios of a financial institution. Price risk associated with equities may be systematic or unsystematic. The earlier refers to sensitivity of portfolios value to changes in overall level of equity prices. While the later is associated with price instability that is determined by firm specific characteristics.

Fundamentals of Market Risk Management:

Board & Senior Management errors:
Similarly other risks, the concern for management of Market Risk must start from the top management. Effective board and senior management misunderstanding of the banks overall market risk experience is keystone of risk management process. For its part, the board of directors has following responsibilities: Outline banks overall risk acceptance in relation to market risk. Ensure that banks overall market risk contact is maintained at prudent levels and consistent with the available capital.

Ensure that top management as well as individuals responsible for market risk management have sound expertise and knowledge to accomplish the risk management function.

Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk. Ensure that sufficient resources (technical as well as human) are devoted to market risk management.

The first step in the management of the market risk is to determine the level of market risk. Once the level of market risk is determined, the institute should develop a strategy for the market risk either bank takes it or not. While articulate the market risk strategy the board needs to consider economic and market condition, and resulting effect on market risk. Finally the market risk strategy should be periodically reviewed and effectively communicated with the relevant staff. Only the top management is not involve in the management of Market Risk senior management is also have some responsibilities. These are following: Develop and implement procedures that translate business policy and strategic direction set by BOD into operating standards that are well understood by banks personnel. Ensure faithfulness to the lines of authority and responsibility that board has established for measuring, managing, and reporting market risk. Supervise the implementation and maintenance of Management Information System that identify, measure, monitor, and control banks market risk. Establish effective internal controls to monitor and control market risk.

The banks formulate the market risk management strategies which are approved by the board. The strategies should communicate with the line of authority and the responsibilities of BOD, senior management and the persons responsible for this. Besides the role of Board the typical organization set up for Market Risk Management includes: The Risk Management Committee

 The Asset Liability Management Committee The Middle Office

The Risk Management Committee:

It generally a board level subcommittee. The committee structure varies from organization to organization. It includes head of credit, Market and Operational Risk management committees. The responsibilities regarding the management of Market Risk includes:

Devise policies and guidelines for identification, measurement, monitoring and control for all major risk categories. The committee also ensures that resources allocated for risk management are sufficiently 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.

The bank has clear, comprehensive and well-documented policies and procedural guidelines relating to risk management and the relevant staff fully understands those policies.

Reviewing and approving market risk limits, including triggers or stop losses for traded and accrual portfolios. Ensuring robustness of financial models and the effectiveness of all systems used to calculate market risk. The bank has robust Management information system relating to risk reporting.

Asset Liability Committee:

It is also a senior level committee responsible for the management of market risk. It also has certain responsibilities regarding the management. Which are following:

To keep an eye on the composition of banks assets and liabilities and decide about product pricing for deposits and advances. Decide on required maturity profile and mix of incremental assets and liabilities. Articulate interest rate view of the bank and deciding on the future business strategy.

Review and articulate funding policy. Decide the transfer pricing policy of the bank. Evaluate market risk involved in launching of new products.

Middle Office:
The risk management functions relating to treasury operations are mostly performed by middle office. The concept of middle office has recently been introduced so as to independently monitor, measure and analyze risks inborn in treasury operations of banks. Basically the middle office performs risk review function of day-to-day activities. Being a highly specialized function, it should be staffed by people who have relevant expertise and knowledge. 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.

Risk Monitoring:
Risk monitoring processes are established to evaluate the policies that are formed for the management of the market risk in achieving the organizations goal. The Risk monitoring includes: Bank should have the information system that is accurate, informative and timely to ensure the flow of information from the BOD to the middle office. Reporting of risk measurements should be regular. The board on the regular basis should review these reports.

Following reports should prepare for the board and senior management, Summaries of banks aggregate market risk exposure. Reports demonstrating banks compliance with policies and limits.

Summaries of finding of risk reviews of market risk policies, procedures and the adequacy of risk measurement system including any findings of internal/external auditors or consultants.

Risk Control:
Banks internal control structure ensures the effectiveness of processes regarding the management of market risk. Key elements of internal control process include audit and review.

Managing Credit Risk:

Credit risk arises from the potential that an individual is either unwilling to perform on an obligation or its ability to perform such obligation is impaired resulting in economic loss to the bank.

Components of Managing Credit Risk:

A typical Credit management structure involves:
Boards and Senior Management Oversights

Organizational Structure System and procedures for identification, acceptance, monitoring and control risk

Boards and Senior Management Oversights:

It is the overall responsibility of the banks board to approve the strategy regarding the Credit Risk. The overall strategy of the bank is reviewed by the Boards of bank. Following are the responsibilities of the BOD regarding the management of credit risk. Outline banks overall risk acceptance in relation to market risk.

Ensure that banks overall market risk contact is maintained at prudent levels and consistent with the available capital. Ensure that top management as well as individuals responsible for market risk management have sound expertise and knowledge to accomplish the risk management function.

Ensure that the bank implements sound fundamental principles that facilitate the identification, measurement, monitoring and control of market risk. Ensure that sufficient resources (technical as well as human) are devoted to market risk management.

The senior management of the bank should develop the credit policies as a part of overall credit risk management framework and get approvals from the boards. Such policies and procedures shall provide guidelines to the staff on different types of lending includes corporate, SME, consumer, agriculture etc. the policy may includes:

Detailed and formal credit evaluation process. Credit approval authority at different hierarchy levels including authority for approving exceptions. Risk identification, measurement, monitoring and control. Risk acceptance criteria Roles and responsibilities of the staff involved in the management of the credit.

System and Procedures:

Credit Origination: Banks should operate in well defined criteria for new credits as well as the expansion of the existing credit. Before giving the credit facility, the make some assessment of risk profile of the customer. It includes: Credit assessment of the borrower and macro economic factors. The purpose of credit and source of repayment.

 \the repayment history of the borrower. Evaluate the repayment capacity of the borrower.

The proposed terms and conditions. Approval from appropriate authority. Limit Setting: An important element of credit risk management is to establish a certain limit for the individual and the group of individuals. Banks uses the limit which is established by the State Bank of Pakistan. The size of the limit is depends on the credit standing of the borrower. Banks may set a credit limit for a specific industry, economic sector or geographic regions to avoid from concentration risk. Credit Administration: Credit administration is basically a back office function that support and control the extension and maintenance of the credit. A credit administration unit performs the following duties: Documentation: It is the responsibility of the credit administration unit to ensure the completeness of the documentation in accordance with approved terms and conditions. Credit Disbursement. The credit administration function should ensure that the loan application has proper approval before entering facility limits into computer systems. Disbursement should be effected only after completion of covenants, and receipt of collateral holdings. In case of exceptions necessary approval should be obtained from competent authorities.

Credit monitoring. After the loan is approved and draw down allowed, the loan should be continuously watched over. These include keeping eyes on borrowers fulfillment with credit terms.

Loan Repayment. The individual should be communicated ahead of time as and when the principal/markup installment becomes due. Any exceptions such as non-payment or

late payment should be tagged and communicated to the management. Proper records and updates should also be made after receipt.

Data Collection Methods:

We collect data from the bank by personal visit and also from the internet. When we visit the bank we ask some questions to the person to whom we meet. He replied our some question and those questions are Q#1 What is the vision and mission of the bank? Q#2 How bank manage its different risks? Bank follows the rules and guidelines which are defined by the State Bank of Pakistan. Q#3 What are the requirements of providing loans to an individual? As Askari Bank is especially for the Army so our focus is on the armed forces. It is quit easier for an armed forces man to get loan from bank than a civilian. Q#4 What is your procedure of issuing loan? We use the procedure, which is defined by SBP. And mention in prudential regulation. Q#5 How you manage your Credit Risk? We manage our credit risk as guided by the State Bank of Pakistan. It is available on the internet. Q#6 What is your major strength? It is a bank which is controlled by Pakistan Army.

SOWT Analysis:
Strength:
Askari Bank has got a well-developed on-line system in most of its branches. Remittance Department is working very efficiently in transferring the funds of people due to this system.

The Bank has also started ATM facility in most of its branches. 24-hour Banking is new trend in Pakistan and Askari Bank has also taken apart in this trend.

One distinctive feature of the Bank is that it is the only Bank working for the welfare of army officers, which was established by Army Welfare Trust.

The productivity of the Bank is very good. Bank is providing a high quality service to its customers.

Askari Bank has strength that most of the imports which are done in Multan are handle by Askari Bank Multan.

Weakness:

Askari Bank has lesser number of branches as compared to many other branches. Due to this problem, army officers can not avail the benefits of their own Bank.

The human resource department is not performing the function of selection and recruitment very effectively.

Selection process is not on merit due to which competent persons cannot be selected.

Bank should boost the product development and increase the range of facilities offered for customers.

Bank is weak in its credit management. Bank should lend to very sound parties and increase its payment rate.

Opportunities:

Govt. is taking very bold steps to promote IT in Pakistan. Askari Bank has an opportunity to improve in technology.

Askari Bank is surrounded by many competitors. It has an opportunity to do aggressive marketing to increase its business.

Askari Bank may increase its branches in competitive areas.

Threats:

Askari Bank has many competitors, which are continuously increasing its products and marketing aggressively. It may cause its customers to shift to competitors. Some other Banks have competent taskforce, which is also a threat for Askari Bank. Because human resource is the most valuable resource. Due to the increased bad situation of Pakistan in which army is considered to be involved increase the frequency of withdrawals, which would decrease deposits.