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The Manager Evaluation
14, Intitutional Area
Lo!hi Roa!, Ne" #elhi
#ear $ir,
I have ent the %no&i an! it ha 'een a&&rove! 'ut I haven(t re)eive! the
)o&% o* the a&&roval %no&i, intea! ha )olle)te! the )ontrol nu+'er
*ro+ the #elhi O**i)e, The %no&i )ontrol nu+'er i -./0 an! !ate! .
A&ril 1212,
There*ore, I a+ en!ing the &ro3e)t re&ort along "ith a )o&% o* the
%no&i "ith the e4&e)tation o* earliet )oni!eration *ro+ %our i!e,
Than5ing %ou
A'hi3eet 6u+ar
Reg, No, /7281182/
#ate9 17 O)to'er, 1212
P%&'()* R(+&%*
Submitted By
A,-.'((* K/01%
R(2. N&. 70!21!07
D1*(3 2 O)*&,(% 2010
1, Na+e 9 A'hi3eet 6u+ar
1, Reg, No, 9 /7281182/
0, Na+e o* the Coure 9 P:#M
4, A!!re 9 1/;-, In!ra <i5a Colon%,
Mu5her3ee Nagar, Ne" #elhi
7, Title o* the &ro3e)t 9 Ri5 Manage+ent in =an5
8, Na+e o* the &ro3e)t $u&ervior 9 Ra5eh $ingh
$r, Manager >A))ount?
#ate9 17 O)to'er 1212 A,-.'((* K/01%
I here'% !e)lare that the &ro3e)t re&ort on @R.56 M1712(0(7* .7 B1768 u'+itte! to
A99 I7:.1 M1712(0(7* A55&).1*.&7 C(7*%( ;&% M1712(0(7* E:/)1*.&7, Ne" #elhi
in &artial *ul*ill+ent o* the reAuire+ent *or P&5* G%1:/1*( D.+9&01 .7 M1712(0(7*
)o+&lete! i +% original "or5 an! not u'+itte! *or the a"ar! o* an% other #egree;
#i&lo+a or other &riBe,
Pla)e9 #elhi
#ate9 17 O)to'er 1212
A,-.'((* K/01%
Thi i to )erti*% that the !iertation title! @R.56 M1712(0(7* .7 B1768 i a *aith*ull%
'ona*i!e "or5 !one '% Mr, A'hi3eet 6u+ar un!er +% gui!an)e an! ea)h )o+&lete! a
a &art o* training !one !uring 4
e+eter *or the *ul*ill+ent o* the reAuire+ent o* P&5*
G%1:/1*( D.+9&01 .7 M1712(0(7* #PGDM$,
R16(5- S.72-
S%. M1712(% #A))&/7*$
I have ha! )oni!era'le hel& an! u&&ort in +a5ing thi &ro3e)t re&ort a realit%,
I a+ than5*ul to ICICI =an5 *ro+ "here I got the relevant in*or+ation regar!ing +%
&ro3e)t, I a+ alo than5*ul to Mr, Ra5eh $ingh, $r, Manager >A))ount? "ho &rovi!e
u all the relevant in*or+ation regar!ing +% &ro3e)t, I "oul! alo li5e to than5 +%
*rien! an! *a+il% +e+'er,
Than5 are alo !ue to the ta** o* AIMACCME Li'rar% an! In*or+ation Centre,
In the en! I a+ than5*ul to that al+ight% go! "ho gave +e in&iration to )o+&lete thi
A,-.'((* K/01%
Reg, No, /7281182/
Ne" #elhi
17 O)to'er, 1212
Executive Summary 1
Chapter-1 -!
Introduction to risk management in banking 3
Problem in study 4
Objectives in study 4
Research methodology 4
Limitation 5
Scope o the Study 5
Chapter- "-#
!onceptual "rame#ork o $L% &
'uidelines or $sset Liability %anagement ($L%)
System in "inancial Institutions ("IS) *&
Revie# o e+isting literature summary ,-
Chapter-$ $%-$#
.istory and 'ro#th o the bank ,/
Risk %anagement at I!I!I 3&
Chapter-& &%-#$
Perormance evaluation o bank 4*
Risk %anagement 'uidelines or !ommercial 0anks 5,
Inter10ank 2+posure and !ountry Risk 3-
"oreign 2+change ("OR24) Risk -&
C'(c)u*i'( + ,ec'mme(-ati'( #&
.i/)i'0raphy #!
In normal course "is are e+pose to several major risk in the course o their
business1 'enerally classiied as credit risk5 market risk5 operational risk1 #hich
underlines the need o eective risk management system in "is6 7he "is needs
to address these risks in a structure manner by upgrading the 8uality o their
risk management and adopting more comprehensive $L% practices6
In order to give some giving to above lines #e have made a project report on
I!I!I bank6 7he project is divided into three phases in irst phase #e have
highlighted the introduction o risk management in banking sector5 the problem
and objective o the project6 Secondly #e have also sho#n the research
methodology o the #hole project6
Second phase consist o conceptual rame#ork o risk management and $L% it
is also include some e+isting literature revie# on risk management6 7hird phase
consist o history and gro#th o the bank also its include the perormance
evaluation o the bank6
Risk management is recognised in today9s business #orld as an integral part o
good management practice6 In its broadest sense5 it entails the systematic
application o management policies5 procedures and practices to the tasks o
identiying5 analysing5 assessing5 treating and monitoring risk6
7he past decade has also heralded enormous developments in ne# inancial
products6 %ortgages and residential mortgages have given institutional and
individual investors po#erul ne# tools #ith #hich to disperse risk both
domestically and internationally6 $dvances in comple+ inancial products5
together #ith improvements in technology5 have lo#ered the cost o and
e+panded opportunities or hedging risk6 :ith the raid gro#th in ne# tools5
8uantiying risk and interpreting risk measurements have never been more
7hese developments have enabled all companies to take a more proactive
vie# to#ards risk6 Instead o only associating risk as a potential do#nside o
their operations5 increasing numbers o irms are considering ho# risk can be
managed positively to enhance the irm9s value6
0ank in the process o inancial intermediation are conronted #ith various
kinds o inancial and non inancial risk vi;5credit risk5li8uidity risk5ore+ risk
etc67hese risk are highly interdependent and event that aect one area o risk
can have ramiication or a range o other risk categories so based on this
problem #e are going to do our research that ho# commercial banks monitor
such risk and controll the overall level o risk6
7o kno# the concept o risk management in banking6
7o kno# the guidelines setup by R606I or commercial banks
7o kno# #hether the banks are ollo#ing those guidelines or not6
7o kno# the banks perormance6
7o get the conclusion rom the undertaken project one should go through a
proper methodology6 .ere in this project our methodology is based on t#o
source5 primary and secondary source
Sec'(-ary *'urce
<nder secondary source #e have data collected rom outside the bank such as
internet5 stock e+change 5icci library6
7hrough eective and eicient asset1liability management5 the banks can
increase their productivity and reduce cost1ineiciency6
I ineicient banking irms have a tendency to remain ineicient5 it #ould be o
interest or the policy makers to investigate ho# these banks can remain
economically viable and not be driven out o the banking market and this can
be done through asset1liability management6
7he asset1liability management plays a very important role in the banks and
has a very vital scope in these institutions6
A( Overvie8
6i*t'rica) .ac90r'u(-
In the conte+t o present day9s rapidly changing business environment5 asset
liability management in the inancial sector especially banking reers to a
holistic approach to risk management5 concerning not only individual trading or
balance sheet positions but #ith overall balance sheet perspective6 It re8uires
assessing all available avenues or managing risks through natural methods5
diversiication5 pricing5 e+posure control5 and use o derivatives6
Risk can be categori;ed into credit and market risk6 .istorically5 credit risk
constituted the major challenge to the banking sector6 .o#ever5 during the last
t#o decades market risk has gained prominence and especially ater the 0asle
!ommittee $ccord o *=--5 #hich #as instrumental in raming broad guidelines
or determining the various risks associated #ith inancial sector6 $sset Liability
%anagement ($L%) encompasses the eects o market risk6
C'(cept ': ALM
$L% has gradually gained currency in Indian conditions in the #ake o the
inancial sector reorms during the last decade #ith particular emphasis on
interest rate deregulation6 7he techni8ue o managing both assets and liabilities
has come into being as a strategic response o banks to inlationary pressure5
volatility in interest rates and adverse business environments including the
recessionary trends in global economy5 i any6
Simply put5 asset1liability management is the management o total balance
sheet dynamics #ith regard to its si;e and 8uality6 It involves5
a) >uantiication o risk and
b) !onscious decision making #ith regard to asset1liability structure in order to
ma+imi;e interest earnings #ithin the rame#ork o perceived risk6 7he
proitable gro#th and at times survival o a inancial institution depends on
eective $L%6
Sc'pe a(- '/;ective* ': ALM
7he primary objectives o $L% is not to eliminate risk ? but to manage it in such
a #ay that volatility o net interest income is minimi;ed in the short term time
hori;on and net economic value o the organi;ation is protected in a long term
time hori;on6 In banking scenario5 this #ould controlling the volatility o net
income5 net interest margin5 capital ade8uacy5 and li8uidity risk and inally
ensuring an acceptable balance bet#een proitability5 gro#th5 and risk6
$ sound $L% system should ocus on
Revie# o interest rate outlook
"i+ation o interest@product pricing on both assets and liabilities
2+amining loan portolio
2+amining investment portolio
%easuring oreign e+change risk
%anaging li8uidity risk
Revie# o actual perormance vis1A1vis projections in respect o net
proit5 interest spread and other balance sheet ratios
0udgeting and strategic planning
2+amine the proitability o ne# products
ALM-A( Exerci*e :'r ,i*9 ,etur( Tra-e-O::
Risk is an inherent part o banking business and in simple #ords may be
deined as a proitability o loss or damage6 'iven the comple+ities o bank9s
balance sheets and rapidity o changes5 chances o loss or risks are only
comple+ in nature but also varied in dimension6 0roadly speaking5 banks are
e+posed to both categories o risk vi;6credit risk and market risk6 :hile credit
risk #hich is mainly on account o the counter party ailure in perorming the
repayment obligation on due date i6e6 loan deaults are managed by the credit
policy o the bank5 the market risk is related to the $sset Liability %anagement
process and is caused by changes in market variables5 involving one or more
o the ollo#ingB
Interest rate risk
"oreign e+change risk
!ommodity price risk
Stock market risk
$L% as a process not only encompasses market risk but also involves li8uidity
management5 unding and capital planning5 proitability gro#th and at times
management o certain credit risks #hich are caused by market risk variables
or e6g6 in a highly volatile interest rate environment5 loan deaults may increase
thereby deteriorating the credit 8uality6
I(tere*t ,ate ,i*9
7he 0asle !ommittee on 0anking Supervision #hose recommendations have
been accepted by the 0anking !ommunity throughout the #orld has called or
the 0anks to have a comprehensive risk management process in place that
eectively identiies5 measures5 monitors and control interest rate risk e+posure
and that is subject to appropriate board and senior management oversight
(source1###6bis6org? $mendment to the !apital $ccord to Incorporate %arket
Risks5 Canuary *==3)6
7raditionally5 interest rate risk means changes in the interest income due to
changes in the rate o interest6 :hile this ocus is not misplaced5 it is deinitely
incomplete in as much as it overlooks an important aspect1changes in interest
rate resulting in the value o assets@liabilities6 7hus5 interest rate risk may be
vie#ed rom t#o dierent complementary perspectives1 earning sensitivity to
rate luctuations and price sensitivity o instruments@products to changes in
interest rate6
!hanges in interest rates can aect banks #ith regard to changes in
a) %arket value o assets@liabilities and o balance sheet (O0S) items?
ultimately having impact on the value o net #orth6
b) Det interest income arising out o mismatch in the repricing terms o the
assets and liabilities?
c) Det income as a result o changes in interest income?
d) Det income margin o#ing to changes in interest income and sensitivity
o non1interest income to rate changes and
e) !apital1asset ratio due to changes in net margin6
7he supervisory capital re8uirements established by 0asle !ommittee rom the
end o *==& covers interest rate risks in the trading activities o banks6
$ccordingly5 interest
Rate risks in the trading activities o banks6 $ccordingly5 interest rate risk
management process has been constituted to include development o business
strategy5 the assumption o assets and liabilities in banking and trading
activities5 as #ell as a system o internal controls6 7he ocus has been on the
need or eective interest rate risk measurement5 monitoring5 and control
unctions #ithin the interest rate risk management process (Source1 Principles
or management o interest rate risk by 0IS)6
$ccording to the studies conducted by 0asle !ommittee based on #orking
e+perience o 0anks in more than *// countries5 the banks are normally
e+posed to ollo#ing orms o interest rate risk6
a) Repricing risk
b) Eield curve risk
c) 0asis risk
d) Optionally
,eprici(0 ri*9B arises rom timing dierences in the maturity (or i+ed rate)
and repricing (or loating rate) o bank9s assets 5 liabilities and o balance
sheet (O0S) positions #hile such repricing mismatches are undamental to the
business o banking 5 they can e+pose a bank9s income and underlying
economic value to unanticipated luctuations as interest rate varies6 "or
instance5 a bank that unded a long term i+ed
rate loan #ith a short term deposit could ace a decline in both the uture
income arising rom the position and its underlying value i the interest rate
increases6 7hese declines arises because the cash lo#s on the loan are i+ed
over its lietime 5 #hile the interest paid on the unding is variable5 and
increases ater the short term deposits matures6
3ie)- Curve ,i*9< arises #hen unanticipated shits o the yield curve have
adverse eects on a bank9s income or underlying economic value6 "or
e+ample5 the underlying economic value o a long position in */ yr government
bonds hedged by a short position in 5yr government notes could decline
sharply i the yield curve steepens5 even i the position is hedged against
parallel movements in the yield curve6
.a*i* ,i*9< arises rom imperect correlation in the adjustment o the rates
earned and paid on dierent instruments #ith other#ise similar repricing
characteristics6 :hen interest rates changes5 these dierences can give rise to
une+pected changes in the cash lo#s and earnings spread bet#een assets5
liabilities and O0S instruments o similar maturities or repricing re8uencies or
e+ample a strategy o unding one year loan that reprices monthly based on
one month LI0OR5 e+poses the institution to the risk that the spread bet#een
the t#o inde+ rates may change une+pectedly6
7he concept o basis risk is applicable or any set o t#o dierent interest rates6
"or e+ample5 basis risk bet#een thee ollo#ing the ollo#ing rates can be
7reasury 0ill@LI0OR
!ertiicate o deposits@LI0OR
LI0OR@!ommercial Paper
Prime@!ertiicate o Feposit
7he reasons or basis risk depend on particula4r set o rates5 or e+ample5
Prime@LI0OR basis risks are as ollo#sB
a) Prime is an administered rate #hile LI0OR is market rate6 7he LI0OR
changes everyday5 but the prime changes inre8uently6
b) In <S conte+t5 prime is a rate applicable or loans in the <SGLI0OR is
applicable or intermediated outside the <S6 7hus other things remaining
the same5 costs o certain types o regulation (e6g6 Feposit Insurance
Premium !hange) may impact prime only and not LI0OR6
c) Furing a declining rate environment5 Prime tends to lag changes in
LI0OR5 leading to #ider spread6 In an increasing rate environment5 there
is an urgency to increase Prime Rate5 resulting in declining spread6
7his kind o pricing is usual in products market also #hen costs are increasing5
prices go up 8uickly5 #hen costs are declining5 and prices go do#n slo#ly6 7he
rate o change is dierent in dierent environments6
Opti'(a)ityB option provides the holder the right but not the obligations to buy5
sell or in some manner alter the cash lo# o an instrument or inancial contract6
Options5 may be in the orm o standard alone instruments such as e+change
traded options or embedded #ithin an other#ise standard instrument like the
various type o bonds and notes #ith caller put provisions5 loans #hich give
borro#ers the right to repay balances and various type o non1maturity deposit
instruments #hich give depositors the right to #ithdra# unds at any time5 oten
#ithout any penalties6 I not ade8uately managed5 the asymmetrical pay o
characteristic o options held both e+plicit and embedded are generally
e+ercised to the advantage o the holder and disadvantage o seller6
E::ect* ': I(tere*t ,ate ,i*9B
Interest rate risk eects both on banks earning as #ell as its economic value6
2arnings5 comprising o net interest income i6e65 dierence bet#een total
interest income and total interest e+pense has been the ocus o main attention
traditionally5 and the impact o interest rate change on net interest income has
been accepted rom time to time6 .o#ever5 in the emerging ne# scenario
increasing ocus on ee1based income and other non1interest bearing income
and e+penses have led to changes in the dimension o the game6 7he non1
interest income arising rom many activities can also be highly sensitive to
market interest rates6 In international arena5 banks are providing the servicing
and loan1administration unction or mortgage loan pools in return or a ee1
based on the volume o assets it administers6 :hen interest rates all5 the
servicing bank may e+perience a decline in its ee income as the underlying
mortgages get prepared6 In addition5 even traditional sources o non1interest
income such as transaction processing ee are becoming more interest rate
sensitive6 7his increased sensitivity has led both bank management and
supervisors to take a broader vie# o potential eects o changes in market
interest rates on bank earnings and to actor these broader eects into their
estimated earnings under dierent interest rates environment6
7he economic value5 o a bank9s assets5 liabilities5 and O0S position can get
aected due to luctuation in interest rates6 7he economic value o a bank can
be vie#ed as the present value o banks e+pected net cash5 deined as the
e+pected cash lo# on liabilities plus the e+pected net cash lo#s on O0S
positions6 Since economic value considered the potential impacting interest
rate changes on the present value o all uture cash lo#s5 it provides a
comprehensive vie# o the potential long term eects o changes in interest
rates6 7han is oered by the earlier earnings perspectives6
:hile the above t#o perspectives ocus on the impact o changes in uture
interest rates on a banks uture perormances5 evaluation o impact past
interest rate changes may have on uture perormance is also o great
signiicance6 In particular instruments that are not marked to market may
already contain embedded gains or losses due to past rate movements and
may ultimately aect bank earnings6 "or e+ample5 a long term i+ed rate loan
entered into #hen interest rates #ere lo# and reunded more recently #ith
liabilities bearing a higher rate o interest #ill over its remaining5 represent a
drain on banks resources
7'rei0( Excha(0e ,i*9<
It reers to potential impact o movement in oreign e+change rates6 7he risk
here is that the adverse luctuations in e+change rates may result in a loss6
"oreign e+change risk arises #hen there are unhedged current mismatches in
an institution assets and liabilities6 7his risk persists until the open position is
covered by means o hedging transactions6 7he amount at risk is a unction o
the magnitude o the potential e+change rate changes and the si;e and
duration o the oreign currency e+posures6 Indian banks normally do not
undertake currency e+posure or unding operation (i6e6 unhedged conversion
o resources in one currency or unding assets in another currency)6 !urrency
position in Indian banks is concentrated in dealing rooms and these are
subjected to constant monitoring through separate daylight and overnight limits
and e+ception reporting6
C'mm'-ity ,i*9
It is a risk associated #ith trading in commodities6 !ommodity trading is not
practiced by 0anks and "inancial Institutions in India6
St'c9 Mar9et ,i*9
$rises primarily because o movement o portolio value5 #hich may have an
overall impact on 0anks inancial position in adverse condition6 7he li8uidation
o 0arings and Fai#a 0ank is related to the market related risk associated #ith
over e+posure to stock market to inluence their proitability and long term
In addition to market risk associated #ith $sset and Liability %anagement
process the t#o other important aspects #hich are also o importance #hile
discussing asset liability management include
a) Li8uidity Risk %anagement
b) !apital risk and capital planning
Li=ui-ity ,i*9
It is the potential inability to generate cash to cope #ith the decline in deposits
or increase in assets6 Li8uidity risk originates rom mismatches in the maturity
patterns o assets and liabilities since banks deal #ith assets and liabilities #ith
varied maturity patterns and risk proile5 they need to strike a trade1o bet#een
been overtly li8uid and relatively li8uid6 $n eective measurement and
monitoring process assessing all o banks cash inlo#s against its outlo# to
identiy the potential or any net shortalls going or#ard orms an essential
ingredient to overall li8uidity risk management6 7his includes unding
re8uirements or o balance sheet commitments6 $s all banks are aected by
changes in the economic climate and market conditions5 the monitoring o
economic and market trends is also a key to li8uidity risk management6
7raditionally5 banks have been relying on core deposits or their unding6
.o#ever5 in today9s environment5 banks have resorted to other means o
sources also or managing the li8uidity on ongoing basis6 !ash inlo#s arise
rom such things as maturing assets5 saleable non1maturing assets5 access to
deposit liabilities5 established credit lines that can be tapped and in developed
#orld through asset securiti;ation also6 7hese need to be matched against
cash lo#s stemming rom liabilities and contingent liabilities alling due5
especially committed lines o credit that can be dra#n do#n6 $ maturity ladder
is thereore a useul device to compare cash outlo#s and cash inlo#s both on
a day to day basis and over a period o time6 7he banks historical e+perience o
the patterns o lo#s and kno#ledge o market conventions can also guide a
bank9s decision on li8uidity risk management especially in a diicult scenario6
<se o H#hat iI analysis situations can also help in building dierent li8uidity
scenarios or practical applications6 $n eective system o internal control in
banks against li8uidity risk #ill involveB1
$ strong control environment
$n ade8uate process or identiying and evaluating li8uidity risk
2stablishment o policy and procedure or handling such risks
$n ade8uate inormation system
!ontrol revie# o adherence to established policies and procedures6
Capita) ,i*9
%aintaining ade8uate capital on a continuous basis is the sine 8uo1non or
sound banking practice6 In a business situation5 banks re8uire capital to
insulate themselves rom the risks o business that they undertake6 7he capital
accord o *=-- calls or detailed guidelines or maintaining ade8uate capital by
banks to mitigate themselves rom problems arising in business development
on account o inade8uate capital structure6
In the normal course5 "Is are e+posed to credit and market risks in vie# o the
asset1liability transormation6 :ith liberalisation in Indian inancial markets over
the last e# years and gro#ing integration o domestic markets #ith e+ternal
markets5 the risks5 particularly the market risks5 associated #ith "Is9 operations
have become comple+ and large5 re8uiring strategic management6 "Is are
operating in a airly deregulated environment and are re8uired to determine
interest rates on various products in their liabilities and assets portolios5 both in
domestic as #ell as oreign currencies5 on a dynamic basis6 Intense
competition or business involving both the assets and liabilities5 together #ith
increasing volatility in the domestic interest rates as also in oreign e+change
rates5 has brought pressure on the management o "Is to maintain a good
balance amongst spreads5 proitability and long1term viability6 7hese pressures
call or structured and comprehensive measures or institutionalising an
integrated risk management system and not just ad hoc action6 7he "Is are
e+posed to several major risks in the course o their business J generically
classiied as credit risk5 market risk and operational risk J #hich underlines the
need or eective risk management systems in "Is6 7he "Is need to address
these risks in a structured manner by upgrading the 8uality o their risk
management and adopting more comprehensive $L% practices than has been
done hitherto6
7he envisaged $L% system seeks to introduce a ormalised rame#ork or
management o market risks through measuring5 monitoring and managing
li8uidity5 e+change rate and interest rate risks o a "I that need to be closely
integrated #ith the "Is9 business strategy6 7his note lays do#n broad
guidelines or "Is in respect o li8uidity5 e+change rate and interest rate risk
management systems #hich orm part o the $L% unction6 7he initial ocus o
the $L% unction #ould be to enorce the discipline o market risk management
vi;6 managing business ater assessing the market risks involved6 7he objective
o a good risk management systems should be to evolve into a strategic tool or
eective management o "Is6
7he $L% process rests on three pillarsB
$L% Inormation System
%anagement Inormation System
Inormation availability5 accuracy5 ade8uacy and e+pediency
$L% Organisation
Structure and responsibilities
Level o top management involvement
$L% Process
Risk parameters
Risk identiication
Risk measurement
Risk management
Risk policies and tolerance levels6
ALM I(:'rmati'( Sy*tem
$L% has to be supported by a management philosophy #hich clearly speciies
the risk policies and tolerance limits6 7his rame#ork needs to be built on
sound methodology #ith necessary supporting inormation system as the
central element o the entire $L% e+ercise is the availability o ade8uate
and accurate inormation #ith e+pedience6 7hus5 inormation is the key to the
$L% process6 7here are various methods prevalent #orld1#ide or measuring
risks6 7hese range rom the simple 'ap Statement to e+tremely sophisticated
and data intensive Risk $djusted Proitability %easurement methods6 7he
present guidelines #ould re8uire comparatively simpler inormation system or
generating li8uidity gap and interest rate gap reports6
ALM Or0a(i*ati'(
Successul implementation o the risk management process #ould re8uire
strong commitment on the part o the senior management in the "I5 to integrate
basic operations and strategic decision making #ith risk management6 7he
0oard should have overall responsibility or management o market risks and
should decide the risk management policy o the "I and set limits or li8uidity5
interest rate5 e+change rate and e8uity price risks6
7he $L!O is a decision1making unit5 consisting o the "IKs senior management
including !2O5 responsible or integrated balance sheet management rom
risk1return perspective including the strategic management o interest rate and
li8uidity risks6 :hile each "I #ill have to decide the role o its $L!O5 its po#ers
and responsibilities as also the decisions to be taken by it5 its responsibilities
#ould normally includeB
monitoring the market risk levels o the "I by ensuring adherence to the
various risk1limits set by the 0oard?
articulating the current interest rate vie# and a vie# on uture direction o
interest rate movements and base its decisions or uture business strategy
on this vie# as also on other parameters considered relevant6
deciding the business strategy o the "I5 both 1 on the assets and liabilities
sides5 consistent #ith the "I9s interest rate vie#5 budget and pre1
determined risk management objectives6 7his #ould5 in turn5 includeB
determining the desired maturity proile and mi+ o the assets and liabilities
product pricing or both 1 assets as #ell as liabilities side?
deciding the unding strategy i6e6 the source and mi+ o liabilities or sale o
assets? the proportion o i+ed vs loating rate unds5 #holesale vs retail
unds5 money market vs capital market unding 5 domestic vs oreign
currency unding5 etc6
revie#ing the results o and progress in implementation o the decisions
made in the previous meetings
7he $L% Support 'roups consisting o operating sta should be responsible
or analysing5 monitoring and reporting the risk proiles to the $L!O6 7he sta
should also prepare orecasts (simulations) relecting the impact o various
possible changes in market conditions on the balance sheet and recommend
the action needed to adhere to "IKs internal limits6
C'mp'*iti'( ': ALCO
7he si;e (number o members) o $L!O #ould depend on the si;e o each
institution5 business mi+ and organisational comple+ity6 7o ensure commitment
o the 7op %anagement and timely response to market dynamics5 the
!2O@!%F@F%F or the 2F should head the !ommittee6 7hough the
composition o $L!O could vary across the "Is as per their respective set up
and business proile5 it #ould be useul to have the !hies o Investment5
!redit5 Resources %anagement or Planning5 "unds %anagement @ 7reasury
(ore+ and domestic)5 International 0usiness and 2conomic Research as the
members o the !ommittee6 In addition5 the .ead o the 7echnology Fivision
should also be an invitee or building up o %IS and related computerisation6
Some "Is may even have Sub1committees and Support 'roups6
C'mmittee ': Direct'r*
7he %anagement !ommittee o the 0oard or any other Speciic !ommittee
constituted by the 0oard should oversee the implementation o the $L% system
and revie# its unctioning periodically6
7he scope o $L% unction can be described as ollo#sB
Li8uidity risk management
%anagement o market risks
7rading risk management
"unding and capital planning
Proit planning and gro#th projection

7he guidelines contained in this note mainly address Li8uidity and Interest Rate
Li=ui-ity ,i*9 Ma(a0eme(t
%easuring and managing li8uidity needs are vital or eective operation o "Is6
0y assuring a "IKs ability to meet its liabilities as they become due5 li8uidity
management can reduce the probability o an adverse situation
developing6 7he importance o li8uidity transcends individual institutions5 as
li8uidity shortall in one institution can have repercussions on the entire
system6 "Is9 management should measure not only the li8uidity positions o "Is
on an ongoing basis but also e+amine ho# li8uidity re8uirements are likely to
evolve under dierent assumptions6 2+perience sho#s that assets commonly
considered to be li8uid5 such as 'overnment securities and other money
market instruments5 could also become illi8uid #hen the market and players
are unidirectional6 7hereore li8uidity has to be tracked through maturity or cash
lo# mismatches6 "or measuring and managing net unding re8uirements5 the
use o a maturity ladder and calculation o cumulative surplus or deicit o unds
at selected maturity dates is adopted as a standard tool6 7he ormat o the
Statement o Li8uidity is urnished in $nne+ure I6
7he %aturity Proile5 as detailed in $ppendi+ I5 could be used or measuring the
uture cash lo#s o "Is in dierent time buckets6 7he time buckets5 may be
distributed as underB
i) * to *4 days
ii) *5 to ,- days
iii) ,= days and upto 3 months
iv) Over 3 months and upto 3 months
v) Over 3 months and upto * year
vi) Over * year and upto 3 years
vii) Over 3 years and upto 5 years
viii) Over 5 years and upto & years
i+) Over & years andupto */ years
+) Over */ years6
7he investments are assumed as illi8uid due to lack o depth in the secondary
market and are5 thereore5 generally sho#n5 as per their residual maturity5
under respective time buckets6 .o#ever5 some o the "Is may be maintaining
securities in the L7rading 0ook95 #hich are kept distinct rom other investments
made or retaining relationship #ith customers6 Securities held in the K7rading
0ook9 should be subject to the ollo#ing preconditionsB
i)7he composition and volume o the 7rading 0ook should be clearly deined?
ii)%a+imum maturity@duration o the trading portolio should be restricted?
iii)7he holding period o the trading securities should not e+ceed =/ days?
iv)!ut1loss limit(s) should be prescribed?
v) Product1#ise deeasance periods (i6e6 the time taken to li8uidate the
on the basis o li8uidity in the secondary market) should be prescribed?
vi) Such securities should be marked1to1market on a daily@#eekly basis and
revaluation gain@loss should be charged to the proit and loss account?
"Is #hich maintain such L7rading 0ooks9 consisting o securities that comply
#ith the above standards5 are permitted to sho# the trading securities under *1
*4 days5 *51,- days and ,=1=/ days buckets on the basis o the deeasance
periods6 7he 0oard@$L!O o the banks should approve the volume5
composition5 ma+imum maturity@duration5 holding@deeasance period5 cut loss
limits5 etc65 o the L7rading 0ook9 6 "Is5 #hich are better e8uipped5 #ill have the
option o evolving #ith the approval o the 0oard @ $L!O5 an i(te0rate- 2a)ue
at ,i*9 >2a,? )imit or their entire balance sheet including the H0anking 0ookI
and the H7rading 0ookI5 or the rupee as #ell as oreign currency portolio6 $
copy o the approved policy note in this regard5 should be or#arded to the
Fepartment o 0anking Supervision5 "IF5 R0I6
:ithin each time bucket there could be mismatches depending on cash inlo#s
and outlo#s6 :hile the mismatches upto one year #ould be relevant since
these provide early #arning signals o impending li8uidity problems5 the main
ocus should be on the short1term mismatches vi;65 *1*4 days and *51,- days6
"Is ho#ever5 are e+pected to monitor their cumulative mismatches (running
total) across all time buckets by establishing internal prudential limits #ith the
approval o the 0oard @ $L!O6 7he (e0ative 0ap during *1*4 days and *51,-
days time1buckets5 in normal course5 should not e+ceed */ per cent and *5 per
cent respectively5 o the cash outlo#s in each time bucket6 I a "I in vie# o its
current asset1liability proile and the conse8uential structural mismatches needs
higher tolerance level5 it could operate #ith higher limit sanctioned by its
0oard @ $L!O giving speciic reasons on the need or such higher limit6 7he
discretion to allo# a higher tolerance level is intended or a temporary period5
i6e6 till March $1@ %%1A :hile determining the tolerance levels5 the "Is may
take into account all relevant actors based on their asset1liability base5 nature
o business5 uture strategy5 etc6 7he R0I is interested in ensuring that the
tolerance levels are determined keeping all necessary actors in vie# and
urther reined #ith e+perience gained in Li8uidity %anagement6
7he Statement o Li8uidity may be prepared by placing all cash inlo#s and
outlo#s in the maturity ladder according to the e+pected timing o cash lo#s6
$ maturing liability #ill be a cash outlo# #hile a maturing asset #ill be a cash
inlo#6 It #ould also be necessary to take into account the rupee inlo#s and
outlo#s on account o ore+ operations6 7hus5 the oreign currency resources
raised abroad but s#apped into rupees and deployed in rupee assets5 #ould be
relected in the rupee li8uidity statement6 Some o the "Is have the practice o
disbursing rupee loans to their e+porter clients but denominating such loans in
oreign currency in their books #hich are e+tinguished by the e+port proceeds6
Such oreign currency denominated loans too #ould be a part o rupee li8uidity
statement since such loans are created out o rupee resources6 $s regards the
oreign currency loans granted out o oreign currency resources on a back1to1
back basis5 a currency1#ise li8uidity statement or each o the oreign
currencies in #hich liabilities and assets have been created6
Curre(cy ,i*9

"loating e+change rate arrangement has brought in its #ake pronounced
volatility adding a ne# dimension to the risk proile o "Is9 balance sheets6
7he increased capital lo#s across ree economies ollo#ing deregulation have
contributed to increase in the volume o transactions6 Large cross border lo#s
together #ith the volatility has rendered the "IsK balance sheets vulnerable to
e+change rate movements6
Fealing in dierent currencies brings opportunities as also risks6 I the liabilities
in one currency e+ceed the level o assets in the same currency5 then the
currency mismatch can add value or erode value depending upon the currency
movements6 %ismatched currency position5 besides e+posing the balance
sheet to movements in e+change rate5 also e+poses it to country risk and
settlement risk6 "Is undertake operations in oreign e+change such as
borro#ings and making loans in oreign currency5 #hich e+poses them to
currency or e+change rate risk6 7he simplest #ay to avoid currency risk is to
ensure that mismatches5 i any5 are reduced to ;ero or near ;ero6 .o#ever5
irrespective o the strategies adopted5 it may not be possible to eliminate
currency mismatches altogether6
$t present5 only ive "Is (vi;6 24I% 0ank5 I!I!I5 IF0I5 I"!I and II0I) have been
granted by R0I (2!F) restricted authorisation to deal in oreign e+change
under "2R$ *=&3 #hile other "Is are not authorised to deal in oreign
e+change6 7he "Is are5 thereore5 unlike banks5 are not subject to the ull rigour
o the reporting re8uirements under 2+change !ontrol regulations6 .ence5 the
%$P and SIR statements prescribed or banks vide $F (%$ Series) circular no6
5, dated ,& Fecember *==& issued by R0I (2!F)5 are not applicable to "Is6 In
order5 ho#ever5 to capture the li8uidity and interest rate risk inherent in the
oreign currency portolio o the "Is5 it #ould be necessary to compile5 on an
ongoing basis5 curre(cy-8i*e Statement o Li8uidity and IRS Statement5
separately or each o the currencies in #hich the "Is have an e+posure6
I(tere*t ,ate ,i*9 >I,,?
Interest rate risk is the risk #here changes in market interest rates might
adversely aect a "IKs inancial condition6 7he immediate impact o changes in
interest rates is on "IKs earnings (i6e6 reported proits) by changing its Det
Interest Income (DII)6 $ long1term impact o changing interest rates is on "IKs
%arket Malue o 28uity (%M2) or Det :orth as the economic value o bank9s
assets5 liabilities and o1balance sheet positions get aected due to variation in
market interest rates6 7he interest rate risk #hen vie#ed rom these t#o
perspectives is kno#n as Learnings perspective9 and Leconomic value9
perspective5 respectively6 7he risk rom the earnings perspective can be
measured as changes in the Det Interest Income (DII) or Det Interest %argin
(DI%)6 7here are many analytical techni8ues or measurement and
management o Interest Rate Risk6 In the conte+t o poor %IS5 slo# pace o
computerisation in "Is5 the traditional 'ap analysis is considered to be a
suitable method to measure the Interest Rate Risk in the initial phase o the
$L% system6 .o#ever5 the "Is5 #hich are better e8uipped5 #ould have the
option o deploying
advanced IRR management techni8ues #ith the approval o their 0oard @
$L!O5 in addition to the 'ap $nalysis prescribed under the guidelines6 It is the
intention o R0I to move over to the modern techni8ues o Interest Rate Risk
measurement like Furation 'ap $nalysis5 Simulation and Malue at Risk over
time #hen "Is ac8uire suicient e+pertise and sophistication in ac8uiring and
handling %IS6
7he 'ap or %ismatch risk can be measured by calculating 'aps over dierent
time intervals as at a given date6 'ap analysis measures mismatches bet#een
rate sensitive liabilities and rate sensitive assets (including o1balance sheet
positions)6 $n asset or liability is normally classiied as rate sensitive iB
i) #ithin the time interval under consideration5 there is a cash lo#?
ii) the interest rate resets@reprices contractually during the interval?
iii) it is contractually pre1payable or #ithdra#able beore the stated maturities?
iv) It is dependent on the changes in the 0ank Rate by R0I6
7he 'ap Report should be generated by grouping rate sensitive liabilities5
assets and o1balance sheet positions into time buckets according to residual
maturity or ne+t re1pricing period5 #hichever is earlier6 $ll investments5
advances5 deposits5 borro#ings5 purchased unds5 etc6 that mature@re1price
#ithin a speciied timerame are interest rate sensitive6 Similarly5 any principal
repayment o loan is also rate sensitive i the "I e+pects to receive it #ithin the
time hori;on6 7his includes inal principal repayment and interim instalments6
!ertain assets and liabilities carry loating rates o interest that vary #ith a
reerence rate and hence5 these items get re1priced at pre1determined intervals6
Such assets and liabilities are rate sensitive at the time o re1pricing6 :hile the
interest rates on term deposits and bonds are generally i+ed during their
currency5 the interest rates on advances could be re1priced any number o
occasions5 on the pre1determined reset @ re1pricing dates and the ne# rate
#ould normally correspond to the changes in PLR6
7he interest rate gaps may be identiied in the ollo#ing time bucketsB
i) *1,- days
ii) ,= days and upto 3 months
iii) Over 3 months and upto 3 months
iv) Over 3 months and upto * year
v) Over * year and upto 3 years
vi) Over 3 years and upto 5 years
vii) Over 5 years and upto & years
viii) Over & years and upto */ years
i+) Over */ years
+) Don1sensitive
7he various items o rate sensitive assets and liabilities and o1balance sheet
items may be classiied into various time1buckets5
7he 'ap is the dierence bet#een Rate Sensitive $ssets (RS$) and Rate
Sensitive Liabilities (RSL) or each time bucket6 7he positive 'ap indicates that
it has more RS$s than RSLs #hereas the negative 'ap indicates that it has
more RSLs6 7he 'ap reports indicate #hether the institution is in a position to
beneit rom rising interest rates by having a positive 'ap (RS$ N RSL) or
#hether it is in a position to beneit rom declining interest rates by a negative
'ap (RSL N RS$)6 7he 'ap can5 thereore5 be used as a measure o interest
rate sensitivity6
2ach "I should set prudential limits on interest rate gaps in various time
buckets #ith the approval o the 0oard@$L!O6 Such prudential limits should
have a relationship #ith the T'ta) A**et*@ Ear(i(0 A**et* 'r E=uityA In
addition to the interest rate gap limits5 the "Is #hich are better e8uipped #ould
have the option o setting the prudential limits in terms o 2arnings at Risk
(2aR) or Det Interest %argin (DI%) based on their vie#s on interest rate
movements #ith the approval o the 0oard@$L!O6
7he classiication o various components o assets and liabilities into dierent
time buckets or preparation o 'ap reports (Li8uidity and Interest Rate
Sensitivity) as indicated in $ppendices I O II is the /e(chmar96 "Is #hich are
better e8uipped to reasonably estimate the behavioural pattern5 embedded
options5 rolls1in and rolls1out5 etc o various components o assets and liabilities
on the basis o past data @ empirical studies could classiy them in the
appropriate time buckets5 subject to approval rom the $L!O @ 0oard6 $ copy o
the note approved by the $L!O @ 0oard may be sent to the Fepartment o
0anking Supervision5 "inancial Institutions Fivision6
7he impact o embedded options (i6e6 the customers e+ercising their options or
premature closure o term deposits5 premature encashment o bonds and pre1
payment o loans and advances) on the li8uidity and interest rate risks proile o
"Is and the magnitude o embedded option risk during the periods o volatility in
market interest rates5 is 8uite substantial6 "Is should thereore evolve suitable
mechanism5 supported by empirical studies and behavioural analysis5 to
estimate the uture behaviour o assets5 liabilities and o1balance sheet items
to changes in market variables and estimate the impact o embedded options6
In the absence o ade8uate historical database5 the entire amount payable
under the embedded options should be slotted as per the residual period to the
earliest e+ercise date6
$ scientiically evolved internal transer pricing model by assigning values on
the basis o current market rates to unds provided and unds used is an
important component or eective implementation o $L% System6 7he transer
price mechanism can enhance the management o margin i6e6 lending or credit
spread5 the unding or liability spread and mismatch spread6 It also helps
centralising interest rate risk at one place #hich acilitate eective control and
management o interest rate risk6 $ #ell deined transer pricing system also
provide a rational rame#ork or pricing o assets and liabilities6
7he article is remark rom :lliam C %cFonough on risk management5
supervision and the ne# 0asel $ccord6 $ccording to the article in recent times
the are ail to develop the commitment to manage risk appropriately to avoid
this recent past re8uires a clear and consisted message5 as #ell as transparent
pattern o behaviour6 $lso according to #illiam the #ork o inancial
supervision is moving a#ay rom a purely retrospective5rules based
approach6this is particularly in banking #orld60anks supervisor in many
countries around the #orld are assessing the saety and soundness o banks
based les on the strength o the balance sheet today5 and more on the strength
o controls that #ill saeguard bank inancial health tomorro# but :illiam C
believed that evaluating the strength o control is5 in itsel5 not enough in deed
inancial sector re8uired innovation in the good and services oered6 $lso the
member o basel committee believes that public policy can best support the
enhancement o risk management by building incentives directly to their system
o supervision6 $ccording to :illiam C the #hole article based on ho#
supervisor have #orked to embrace and encourage the developments5 ho#
enhancement in banks risk management processes5 driven by business
imperatives5 have concurrently led supervisor to move to a more process1
oriented5 risk ocused approach to supervision6 Secondly ho# provision in De#
0asel $ccord support urther changes in there supervisory approach5 and
promote urther enhancement in risk management o market risk and thirdly
ho# those development #ill be coming together in there supervisory approach
going or#ard1particularly in terms o there supervisory e+pections or
management o market risk5 credit risk and operational risk by large banking
Summary ': artic)e
7he ollo#ing article has been delivered by Fr Rakesh %ohan5 Feputy
'overner o the Reserve 0ank o India6 7he article highlight the need to #ork
to#ard reducing the real lending rates o banks6 $lso it ocused on the need to
increase credit to S%2s as also look into aspects o creating an enabling
environment or long term inancing6 7he article also state about the DP$s level
5the absolute amount o DP$s continues to be a major drag on the perormance
o banks6 7he large volume o DP$s relects both an overhang o past dues and
on1going problems o resh accretion6 7hereore reducing in DP$ level and
appropriate risk management by banks #ould go a long #ay in improving
eiciency o banks and inculcating a sound credit culture
I!I!I 0ank Ltd6 #as ormed in *==4 as a ne# private sector bank6 Its initial
e8uity capital o Rs *5/ crores #as ully subscribed by I!I!I5 and as a result5
I!I!I 0ank became a #holly o#ned subsidiary o I!I!I6
In %ay *==45 #hen I!I!I obtained its commercial banking license to establish
I!I!I 0ank5 the Reserve 0ank o India (R0I) imposed a condition regarding
dilution o promoter9s holding in the bank6 7his condition re8uired I!I!I to
reduce its shareholding in I!I!I 0ank in stages5 irst to not more than &5P o its
e8uity share capital5 and ultimately to not more than 4/P6 7his took place in the
ollo#ing #aysB
>73? Eve(t
,ai*e- >,*A? 6')-i(0 ': ICICI
IPO o *5 million e8uity shares
o Rs6 */ each at a price o
Rs6 35 per share 5,65 crores &46-/P
$FR issue on DES2 or
<SQ*&5 million &3364 crores 3,6,/P
,//* $c8uisition o 0ank o %adura
(0O%)B , e8uity shares in lieu
o every * share o 0O%
,33 crores 5563/P
Fisinvestment o shares by
I!I!I *=63= crores 4364/P
Fisinvestment o shares by
I!I!I /6-- crores
43P(on $ugust
Furing ,//*5 the senior managements o I!I!I and I!I!I 0ank e+plored the
possibility amalgamation o I!I!I #ith I!I!I 0ank6 $s a bank5 I!I!I #ould have
the ability to accept lo#1cost demand deposits and oer #ider range on
products and services6 In vie# o such beneits and R0I9s guidelines on
universal banking5 I!I!I e+plored various corporate restructuring alternatives
or its transormation into a universal bank6 Subse8uently5 the shareholders o
both the institutions approved such amalgamation and the e+change ratio
determined #as * ully paid1up e8uity share o I!I!I 0ank in lieu o , ully paid1
up e8uity shares o I!I!I6 $s a result o such amalgamation5 #hich #as
approved by R0I on $pril ,35 ,//,5 the paid1up capital increased to Rs6 3*3
crores6 7he scheme o amalgamation became eective on %ay 35 ,//,6
R0I approved the merger subject to the ollo#ing major conditionsB
!ompliance #ith Reserve Re8uirementsB I!I!I 0ank #ould comply #ith
the !ash Reserve Re8uirements (!RR) and Statutory Li8uidity Reserve
(SLR) Re8uirements as applicable to banks on the net demand and time
liabilities o the bank5 inclusive o the liabilities pertaining to I!I!I rom
the date o merger6
Other Prudential DormsB I!I!I 0ank #ill continue to comply #ith all
prudential re8uirements and other instructions as applicable to banks
issued by R0I rom time to time on the entire portolio o assets and
liabilities o the bank ater the merger6
Priority Sector LendingB considering that the advances o I!I!I #ere not
subject to the re8uirement applicable to banks in respect o priority
sector lending5 I!I!I 0ank #ould ater merger5 maintain an additional
*/P over and above the re8uirement o 4/P5 i6e65 a total o 5/P o the
net bank credit on the residual portion o the bank9s advances6 7his
additional */P #ill apply until such time as the aggregate priority sector
advances reaches a level o 4/P o the total net bank credit6
28uity 2+posure !eiling o 5PB 7he investments o I!I!I ac8uired by
#ay o project inance as on the date o merger #ould be kept outside
the e+posure ceiling o 5P o advances to#ards e+posure to e8uity and
e8uity1linked instruments or a period o 5 years6 I!I!I 0ank should5
ho#ever5 mark1to1market the above instruments and provide or any loss
in their value in the manner prescribed or investments6
"ollo#ing the amalgamation5 I!I!I 0ank has become the second largest
among all scheduled commercial banks (S!0s) in India5 ranked on the basis o
their total assets5 coming ater the State 0ank o India6
$t end1"E,//,5 I!I!I 0ank had a net#ork o 35= branches and 44 e+tension
counters in ,5* centers across several India states6 Dearly 5*P (*-3
branches) o I!I!I9s branches are in urban@metropolitan areas6 7he balance is
in rural@semi1urban areas6 7ill this time I!I!I 0ank had also installed *5///
$t end1"E,//*5 I!I!I 0ank had no subsidiaries6 !onse8uent to the merger5
I!I!I9s subsidiary companies have become subsidiaries o I!I!I 0ank6 $t end1
"E,//,5 I!I!I 0ank had ** subsidiaries6 7he major subsidiaries are described
*6 I!I!I Securities and "inance !o6 Ltd6 1 perorms key merchant baking
activities including under#riting5 placement o debt and e8uity5 issue
management and corporate advisory services6
,6 I!I!I 0rokerage Services Ltd6 J engaged in security brokerage activities
on DS2 and 0S26
36 I!I!I Securities .oldings Inc6 J incorporated in the <S5 this arm has
been set up to provide investment banking services to investors in the
<S #ho #ish to enter the Indian inancial market and to investors in
India #ho #ish to enter the inancial markets in the <S6
46 I!I!I Securities Inc6 J incorporated in the <S5 this subsidiary has been
set up to provide brokerage5 research and investment banking services
to investors in the <S #ho #ish to enter the Indian inancial markets6
56 I!I!I Menture "unds %anagement !o6 Ltd6 J provides venture capital
unding to a #ide spectrum o industrial sectors6
36 I!I!I Prudential Lie Insurance !o6 Ltd6 J carries out the business o Lie
Insurance6 7his subsidiary has entered into an %o< #ith I!I!I 0ank or
distribution o its lie insurance policies through the bank9s branch
&6 I!I!I Lombard 'eneral Insurance !o6 Ltd6 J carries out the business o
general insurance6
-6 I!I!I .ome "inance !o6 Ltd6 J provides inance or housing6
7he management team o I!I!I 0ank consists o the ollo#ing individuals #ho
are very #ell 8ualiied5 possess rich e+perience and are competent
proessionals rom their ield6
Name De*i0(ati'(
%r6 R6M6 Ramath %anaging Firector O !2O
%r6 .6D6 Sinor Coint %anaging Firector? In charge o domestic banking
%s6 Lalita F6 'upte
Coint %anaging Firector? In charge o international
%s6 Ralpana %orparia 2+ecutive Firector? In charge o legal department
%r6 S6 %ukherji 2+ecutive Firector? In charge project inance
%s6 !handa F6
Rochhar 2+ecutive Firector5 In charge o retail banking
Fr6 Dachiket %or 2+ecutive Firector5 In charge o #holesale banking
I!I!I 0ank9s asset base o Rs6 *5/4* billion (at end "E,//,) places it as the
second largest scheduled commercial bank in India J behind only State 0ank o
India (S0I)6 I!I!I 0ank9s asset base is nearly 464 times larger than the second1
largest ne# private sector bank in India J .F"! 0ank (assets o Rs6 ,3- billion
as end1"E,//,)6
I!I!I 0ank9s principal activities include corporate banking5 retail banking and
treasury operations6
7he 'oI has never directly held any shares o I!I!I 0ank6 .o#ever5 'oI9s
controlled institutions held a ,/6-P stake in I!I!I 0ank at end $ugust ,//,6
7hese include the LI! (-63P)5 the 'I! and it9s subsidiaries (&63P)5 <7I (363P)5
and others (*63P)6 <nder the terms o the loan and guarantee acilities
provided by the 'oI to I!I!I that have been transerred to I!I!I 0ank5 the 'oI
is entitled to appoint and has appointed one representative to the 0oF o I!I!I
0ank6 !omparison o key ratios is done on the basis o previous year and the
current year6
Risk is an inherent part o I!I!I 0ank9s business5 and eective Risk
!ompliance O $udit 'roup is critical to achieving inancial soundness and
proitability6 I!I!I 0ank has identiied Risk !ompliance O $udit 'roup as one o
the core competencies or the ne+t millennium6 7he Risk !ompliance O $udit
'roup 'roup (R! O $') at I!I!I 0ank benchmarks itsel to international best
practices so as to optimise capital utilisation and ma+imise shareholder value6
:ith #ell deined policies and procedures in place5 I!I!I 0ank identiies5
assesses5 monitors and manages the principal risksB
!redit risk (the possibility o loss due to changes in the 8uality o
%arket Risk (the possibility o loss due to changes in market prices and
rates o securities and their levels o volatility)
Operational risk (the potential or loss arising rom breakdo#ns in
policies and controls5 human error5 contracts5 systems and acilities)
7he ability to implement analytical and statistical models is the true test o a risk
methodology6 In addition to three departments #ithin the Risk !ompliance O
$udit 'roup handling the above risks5 an $nalytics <nit develops 8uantitative
techni8ues and models or risk measurement6
!redit risk5 the most signiicant risk aced by I!I!I 0ank5 is managed by the
!redit Risk !ompliance O $udit Fepartment (!R! O $F) #hich evaluates risk
at the transaction level as #ell as in the portolio conte+t6 7he industry analysts
o the department monitor all major sectors and evolve a sectoral outlook5
#hich is an important input to the portolio planning process6 7he department
has done detailed studies on deault patterns o loans and prediction o deaults
in the Indian conte+t6 Risk1based pricing o loans has been introduced6
7he unctions o this department includeB
Revie# o !redit Origination O %onitoring
!redit rating o companies@structures
Feault risk O loan pricing
Revie# o industry sectors
Revie# o large e+posures in industries@ corporate groups@
2nsure %onitoring and ollo#1up by building appropriate systems
such as !$S
Fesign appropriate credit processes5 operating policies O procedures
Portolio monitoring
%ethodology to measure portolio risk
!redit Risk Inormation System (!RIS)
"ocussed attention to structured inancing deals
Pricing5 De# Product $pproval Policy5 %onitoring
%onitor adherence to credit policies o R0I
Furing the year5 the department has been instrumental in reorienting the credit
processes5 including delegation o po#ers and creation o suitable control
points in the credit delivery process #ith the objective o improving customer
response time and enhancing the eectiveness o the asset creation and
monitoring activities6
$vailability o inormation on a real time basis is an important re8uisite or
sound risk management6 7o aid its interaction #ith the strategic business units5
and provide real time inormation on credit risk5 the !R! O $F has
implemented a sophisticated inormation system5 namely the !redit Risk
Inormation System6 In addition5 the !R! O $F has designed a #eb1based
system to render inormation on various aspects o the credit portolio o I!I!I
I!I!I 0ank is e+posed to all categories o %arket Risk5 vi;65
Interest Rate Risk (risk due to changes in interest rates)
2+change Rate Risk (risk due to changes in e+change rates)
28uity Risk (risk due to change in e8uity prices)
Li8uidity Risk (risk due to deterioration in market li8uidity or tradable
7he %arket Risk !ompliance O $udit Fepartment evaluates5 tests and
approves market risk methodologies developed by the 7reasury6 It also
participates in the ne# product approval process on a irm1#ide basis and
evaluates all ne# products rom a market risk perspective
I!I!I 0ank5 like all large banks5 is e+posed to many types o operational risks6
7hese include potential losses caused by events such as breakdo#n in
inormation5 communication5 transaction processing and settlement systems@
7he $udit Fepartment5 an integral part o the Risk !ompliance O $udit 'roup5
ocusses on the operational risks #ithin the organisation6 In recent times5 there
has been a shit in the audit ocus rom transactions to controls6 Some
e+amples o this paradigm shit areB $dherence to internal policies5 procedures
and documented processes Risk 0ased $udit Plan :idening o 7reasury
operations audit coverage <se o !omputer $ssisted $udit 7echni8ues (!$$7s)
Inormation Systems $udit Plans to develop@ buy sot#are to capture the
#orklo# o the $udit Fepartment
7he $udit Fepartment conceptualised and put into operation a Risk 0ased
$udit Plan during the year *==-1==6 7he Risk 0ased $udit Plan envisages
allocation o audit resources in accordance #ith the risk constituents o I!I!I
0ank9s business6
*) !redit1Feposit (P)B 7his ratio is compared as underB
:e notice that in the year *==& credit deposit ratio is 3=6-P #hich ell to
,*63&P in the year *==-6 In *=== it urther drop to **6,,P6 In ,/// it drop
to *6/3P6 In the year ,//* it rose to 4655P6 In the year ,//, it rose to
,) Investment@Feposit (P)B 7his ratio is compared as underB
:e notice that in the year *==& investment ratio is 33634P it rose to 36/4P
in the year *==-6 In the year *=== again it rose to &6=3P6 In the year ,/// it
rose to *6/,P6 In the year ,//* it rose to ,633P6In the year ,//, it rose to
4,6=3P #hich is a signiicant increase6
3) !ash @Feposit(P) B 7his ratio is compared as underB
:e notice that in the year *==& !ash @deposit ratio is *,6,&P #hich ell to
/63=P in the year *==-6 In the year *=== it again ell to ,633P6 In the year
,/// it ell to *64&P6In the year ,//* it again ell to /6/*P6In the year ,//,
it ell to *6,4P6
4) Interest 2+pended@Interest 2arned(P)B this ratio is compared as under B
:e notice that In the year *==& interest earned(P) is 346*P #hich rose
to&6&-P6in the year *==-6 again it rose to 3633P6 in the year *===6 in the
year ,/// it ell to /6/*P6 in the year ,//* again it ell to */6&3P6 in the
year ,//, it ell to 5P6
5) Other Income@7otal Income(P) B this ratio is compared as underB
:e notice that in the year *==& percentage o other income@total income is
*-6=3P #hich rose to 56&5P in the year *==-6 In the year *=== it ell to
*/63P6 In the year ,/// there is a signiicant increase o 464&P6 in the year
,//* it ell to 36*P6 in the year ,//, It rose to 365P6
3) Operating 2+penses@7otal Income(P) B 7his ratio is compared as under B
:e notice that the percentage o operating e+penses in the year *==& is
*&6=-P #hich ell to *6,3P in the year *==-6In the year *=== again it ell to
363P6In the year ,/// it rose to /65=P6in the year ,//* it rose to -633P6in
the year ,//, it rose to /6&*P6
&) Interest Income@7otal unds(P)B this ratio is compared as underB
:e notice that percentage o interest income in the year *==& is *,643P
#hich ell to ,6*&P in the year *==-6In the year *=== it rose to /634P6in the
year ,/// it ell to *635P6in the year ,//* it ell to *6*4P6in the year ,//, it
urther ell to 4633P6
-) Interest 2+pended@7otal "unds(P) B this ratio is compared as under
*==&B1 &6=&P
*===B /6=*P(increase)
=) Det interest income@7otal unds(P) B 7his ratio is compared as under
*==& B 4643P
*==- B *65&P(decrease #hich take it to ,6-=P)
*=== B /65-P(decrease #hich take it to ,63*P)
,/// B /633P( decrease)
,//* B /65=P(increase)
,//, B *65-P(decrease)
*/) Don interest income@total unds(P) B this ratio is compared as under
*==& B,6=P
,///B /63P(increase)
,//* B/63*P(decrease)
**6 Operating e+pense@7otal unds(P) B this ratio is compared as under B
*==& B,6&3P
*==- B/64-P(decrease)
*===B/633P(decrease urther)
*,6) Proit beore provisions@total unds(P) B comparison o this I s done as
*==& B 463*P
*==- B/634P(decrease)
*36) Det Proit@7otal unds(P)B comparison o this is given as underB
*==&B ,6&3P
*==- B/6&5P(decrease)
*46) ROD:(P) B !omparison o this is done as under B
Out:)'8 1-1&
"-1 year 1-$ year $-! year A/'ve ! T'ta)
Dep'*it* 3*5,/3 =,*&& 4-*&/3 ,&&=/3 5&=-55 *,-=35= 4/3*- *44,* 3/=/=4-
.'rr'8i(0* ==34= *4==&* 44*5,/ 3,,=3, -=4,-3 *4*3,53 3=5*3/ ,-4-,3 4//453&
T'ta) 4*4-55 ,4,*4- =,3,,3 3//-3- *4&4*4* ,&/53*5 43544- ,==,44 &/=55*5
L'a(*Ca-vA -,534 353=, ,55,=4 ,33*5/ 3&*/-& *3,,53, &33&33 *3&//3= 44,4*5*
I(ve*tCSectA *3*==- 3-3,4 ,-=/*- ,3&53/ 5,*-&& &335&3 44&43* **55&/3 33*-&=/
T'ta) ,*453, */43*3 5443*, 5//3-/ -=,=34 ,/5=*3- *,***=4 ,5,5&&5 -/5,=4*
1,//,=3 1*3&-3, 13&-=*4 1*//*5- 15-**&& 13434&& &&5&43 ,,,353* *3/3=/3
'ap report indicates that there is a mismatch in the maturity buckets o *1*4
days to *13 years6 .o#ever this means RSLNRS$ this sho#s the bank in a
position to beneit rom declining interest rate by a negative gap6
%%-%$ %%1-%$ %%%-%$ 1###-%$ 1##B-%$ 1##D-%$
28uity Paid <p ,,/633 *=36-, *=36-, *35 *35 *5/
Det#orth 5-556= *,-=6/- **4=65* 3/-633 ,336&5 *-*6--
!apital 2mployed */4*/=6=, *=&3365= *,/&,633 3=-*63- 3,&=643 *&-*6-&
'ross 0lock 44=46,= 5-=63& 3*56*4 ,3*65& ,*-6=& **/65-
Sales ,*5*6=3 *,4,6*3 -5,6-& 5446/5 ,5=6& *-,63-
P0IF7 *=*,63* **//65& -,3634 53364* ,&*63& *&-6-3
P0F7 35363= ,3,6= *5363= **/6-= -46== 3*6&&
P0I7 *-4-6,, */336-, &=-6-5 5*-6-- ,5&6, *&/63,
P07 ,-=63 ,,36*5 *3*6= =3633 &/65, 53653
P$7 ,5-63 *3*6* */563 33633 5/6,, 4/6*3
!P 3,,63= *=&6-5 *3/6/= -/6-= 3463= 4-63&
Revenue earnings
in ore+
/ / / / / /
Revenue e+penses
in ore+
/ / / / / /
0ook Malue (<nit
,356&4 3565 5-64 *-63= *36*& *,6*3
,&3,643 3,5564 5**&63, 45,6* &556& /
!2PS (annualised)
(<nit !urr)
*4643 =6-, 364& 46&- 36-, 36,,
2PS (annualised)
(<nit !urr)
**65, &6=3 56,* 36&, ,6=5 ,63-
,/ ,/ *5 *, */ */
Payout (P) *&633 ,-6*4 ,46*3 3,6,3 3364 3&63-
!ash "lo# "rom
Operating $ctivities
,,4*6, 13=46/, */=*65& 33,6= 53-63& ,-*6-
!ash "lo# "rom
Investing $ctivities
1,363- 1&-63= 1536/3 14&63= 1*/56= 13/6**
!ash "lo# "rom
"inancing $ctivities
*3*64 1,&64& &4*63& *5/6*5 3&65 1**6&3
Rate o 'ro#th (P)
Det :orth (P) 3546,& *,6*4 ,&,6-, *565= 43633 *36/3
!apital 2mployed
4,&65 3364- &,6=, **,6-= -46/4 536=&
'ross 0lock (P) 33,6*& -&6** ,/64- *=645 =-6/, **/6&5
Sales (P) &36,5 45634 536&3 */=64= 4,6*3 5&63*
P0IF7 (P) &36&3 3363, 53655 =&645 5*6-= 3-6-3
P0F7 (P) 3464, 3&6&- 4*63 3/64& 3&65= *=36-3
P0I7 (P) &36&3 336*& 536=3 */*6&4 5/6&4 3-6,*
P07 (P) ,&6=, &*643 4*6,- 3,63= 3*6&4 ,,46,3
P$7 (P) 3/634 5,6== 336*= ,36*3 ,56*4 *436/3
!P (P) 3,6=5 5,6/= 3/6-, ,56/4 336&4 *3/6**
Revenue earnings / / / / / /
in ore+ (P)
Revenue e+penses
in ore+ (P)
/ / / / / /
!apitalisation (P)
1*36/3 13363- */3*6= 14/6*& / /
Rey Ratios
!redit1Feposit(P) ***653 4/6&3 336*- 3&6,* 4-643 3=6-
Investment @
Feposit (P)
=/6=5 4-6/, 45633 44634 3363- 33634
!ash @ Feposit (P) 36, &644 &645 -6=, **65- *,6,&
Interest 2+pended @
Interest 2arned (P)
&,644 3&644 &-6, &-6,* &*6-- 346*
Other Income @
7otal Income (P)
,*6=5 *5645 *-655 *46/- ,463- *-6=3
2+penses @ 7otal
Income (P)
,,6&- ,,6/& *36&* *36*, *36&, *&6=-
Interest Income @
7otal "unds (P)
364- &6-* -6=5 */63 */6,3 *,643
Interest 2+pended @
7otal "unds (P)
,65, 56,& & -6,= &63- &6=&
Det Interest
Income @ 7otal
"unds (P)
/6=3 ,654 *6=5 ,63* ,6-= 4643
Don Interest
Income @ 7otal
"unds (P)
/6=- *643 ,6/4 *6&4 3633 ,6=
2+penses @ 7otal
"unds (P)
*6/* ,6/4 *65* *63, ,6,- ,6&3
Proit beore
Provisions @ 7otal
"unds (P)
/6=, *6=3 ,64- ,643 36=& 463*
Det Proit @ 7otal
unds (P)
/64, *6/* *6** *6,3 *6=- ,6&3
ROD: (P) &6,3 *36,* *4645 ,,6/4 ,,63= ,36&
,//,/3 ,//*/3 ,////3 *===/3 *==-/3 *==&/3
!$PI7$L $DF
!apital S ,,/633 *=36-, *=36-, *35 *35 *5/
Reserves and
Surplus S
5335654 */=,6,3 =5,63= *43633 */*6&5 3*6--
Feposits S 3,/-56** *33&-6,* =-336/, 3/&,6=4 ,3,=6/, *34&63
0orro#ings S 4-3-*6,* */3,6&= 4=*64& *==6-= *=,6,3 =,6==
Other Liabilities O
Provisions S
*&4-&6& */3365* 535633 4//65, *=*643 *5=64
7O7$L */4*/=6=, *=&3365= *,/&,633 3=-*63- 3,&=643 *&-*6-&
!ash O 0alances
#ith R0I
*&&464& *,3*633 &,*6-= 4356-* 3*/6/= *5/634
0alances #ith
0anks O money at
!all O Short Dotice
**/**6-- ,33,6/3 ,3=36,& **&,644 53,6&= ,,,65-
Investments S 35-=*6/- -*-36-3 44*363- ,-3*6,3 */,363= 435635
$dvances S 4&/346-& &/3*643 335&635 ,**/6*, **,&6-& &=-
"i+ed $ssets S 4,3=634 3-46&5 ,,,6*, *==634 *-36& =363&
Other $ssets S 4*5-6,- 53=6-3 33*63, *&,644 &*65= &=6,3
7O7$L */4*/=6=, *=&3365= *,/&,633 3=-*63- 3,&=643 *&-*6-&
Liabilities S
3=44365= *3-4-6/* =&-/64& 5/*36=& ,=/36,4 *4=56&3
0ills or collection *3,364, *,,=6- &3*644 43-643 ,*-6*= *,36/*
,//,/3 (*,) ,//*/3 (*,) ,////3 (*,) *===/3 (*,) *==-/3 (*,) *==&/3 (*,)
I6 ID!O%2 B
Interest 2arned S ,*5*6=3 *,4,6*3 -5,6-& 5446/5 ,5=6& *-,63-
Other Income S 3/56/, ,,36=3 *=46*= -=6*4 -56/= 4,635
7O7$L ,&536=5 *43=6/= */4&6/3 3336*= 3446&= ,,5633
24P2DFI7<R2 B
Interest e+pended
*55-6=, -3&63& 3336=5 4,565, *-363- **&6/=
2+penses S
3,-6/= 3,46,- *43654 -36/- 5&635 4/65*
Provisions O
!ontingencies S
3**634 *436/4 *3*6,& 3*6,3 5/6,4 ,&63
7O7$L ,4=-635 *3/&6== =4*6&3 53=6-3 ,=465& *-56,
Det Proit or the
,5-63 *3*6* */563 33633 5/6,, 4/6*3
Prior Eear
$djustments S
/ / / / / /
Proit brought
/6-3 /6- /6*3 /63= /6/, /63=
7O7$L ,5=6*3 *3*6= */5643 336&5 5/6,4 4/65,
7ranser to Statutory
35 -/ ,5 ,/ ,& ,565
7ranser to Other
Reserves S
*,3 3,65 5,6-, ,*6-4 5 /
Proposed Fividend @
7ranser to
'overnment S
4-65& 4-65& ,&64& ,*6&- *&6-5 *5
0alance c@ to
0alance Sheet
*=653 /6-3 /6*4 /6*3 /63= /6/,
7O7$L ,5=6*3 *3*6= */5643 336&5 5/6,4 4/65,
28uity Fividend 446/& 446/& ,46&5 *=6- *36,3 *5
!orporate Fividend
465 465 ,6&, *6=- *63, /
28uity Fividend (P) ,/ ,/ *5 *, */ */
2arning Per Share
(Rs6)(<nit !urr6)
**65, &6=3 56,* 36&, ,6=5 ,63-
0ook Malue(<nit
,356&4 3565 5-64 *-63= *36*& *,6*3
2+traordinary Items
1/6/3 1/6/= 1/6* 1/6/& 1/6/3 1/6/3
,//,/3 ,//*/3 ,////3 *===/3 *==-/3 *==&/3
!$PI7$L $DF
28uity $uthorised 3// 3// 3// 3// 3// 3//
Preerence !apital
/ / / / / /
/ / / / / /
28uity Issued ,,/633 *=36-, *=36-, *35 *35 *5/
28uity Subscribed ,,/633 *=36-, *=36-, *35 *35 *5/
28uity !alled <p ,,/633 *=36-, *=36-, *35 *35 *5/
Less B 28uity !alls
in $rrears
/ / / / / /
28uity "oreited / / / / / /
28uity Suspense 3=,63& ,3654 / / / /
$djustments to
/ / / / / /
28uity Paid <p ,,/633 *=36-, *=36-, *35 *35 *5/
Preerence !apital
Paid <p
/ / / / / /
<nclassiied Shares
paid 1up
/ / / / / /
7O7$L !$PI7$L ,,/633 *=36-, *=36-, *35 *35 *5/
28uity converted
during the year
/ / / / / /
'FRs Issued
Furing the Eear
/ / / / / /
0onus in 28uity / / / / / /
Reserves and
/ / / / / /
Other Statutory
,4=643 *-4643 */36-3 &-6-3 5-6-3 3*6-3
!apital Reserves / / / / / /
!apital Redemption
/ / / / / /
Febt Redemption / / / / / /
*/ / / / / /
luctuation Reserve
/ / / / / /
/ / / / / /
Share Premium -/4654 -/4654 &3=6/3 3&65 3&65 /
Revenue O other
45,463& =*6*, &=633 ,36-4 5 /
Other Reserves ,&634 **634 / / / /
Proit O Loss $@c *=653 /6-3 /6*4 /6*3 /63= /6/,
7O7$L R2S2RM2S
5335654 */=,6,3 =5,63= *43633 */*6&5 3*6--
/ / / / / /
7O7$L R2S2RM2S
5335654 */=,6,3 =5,63= *43633 */*6&5 3*6--
Femand Feposits ,&336*5 ,3,*6-3 *5-&64& 5&363, 3336*& 3*3633
Saving Feposits ,4=& *--/634 5336,3 ,,&6*, */36&4 4=63&
7erm O Other
,3-5*6=3 **-&56&* &&456,= 5,3=6, ,*3,6** =-*63
7O7$L F2POSI7S 3,/-56** *33&-6,* =-336/, 3/&,6=4 ,3,=6/, *34&63
0orro#ings in India
1 R0I
*4/6-= 3/*6,4 ,*-63& *4-64- / /
0orro#ings in India
1Other 0anks
,3-&63 3=&6- *=,6*- 4*6&& ,=6,= -/6/4
0orro#ings in India
1Other agencies
=,356/= 3336&5 -/63, =634 *3,6=4 *,6=5
0orro#ings outside
,,&/=6=& / / / / /
/ / / / / /
Don !onvertible
*3&4464& / / / / /
Partly !onvertible
*336*= / / / / /
Less B Febentures
!alls in arrears
/ / / / / /
4-3-*6,* */3,6&= 4=*64& *==6-= *=,6,3 =,6==
Secured 0orro#ings
included above
/ / / / / /
Other Liabilities O
0ills Payable -*&633 3-/653 *4,6, **,6*= */&6-* 3-6&=
Inter Oice
$djustment (Det)
336/5 / / / / /
Interest $ccrued ,,-=65* 55635 3365, ,364= *&653 563&
Share $pplication *,-/6*, ,3654 / / / /
<nclaimed Fividend / / / / / /
Other Liabilities
*3/3&63= 5&36&3 3-=6=* ,346-4 336/3 -46=4
7O7$L O7.2R
*&4-&6& */3365* 535633 4//65, *=*643 *5=64
7O7$L */4*/=6=, *=&3365= *,/&,633 3=-*63- 3,&=643 *&-*6-&
!ash O 0alances
#ith R0I
*&&464& *,3*633 &,*6-= 4356-* 3*/6/= *5/634
0alances #ith 0anks O
money at !all O Short
**/**6-- ,33,6/3 ,3=36,& **&,644 53,6&= ,,,65-
>uoted 'overnment
,,&,,63* 4/&/644 ,-*46=4 *5,&633 &/463& 3*3633
Other $pproved
&/643 4*64= / / / /
Shares *=/-635 *,56*, *3/6=5 *3- 4&6/3 */64&
Febentures O
3433633 3/&/6/- **3&6,, 33363* ,*365* 3=634
Investment in
3/-6*- / / / / /
<nits / / / / / /
Other Investments 4*456*, -&=6&3 3/365& 5,=6,3 556*- 4,6*-
35-=*6/- -*-36-3 44*363- ,-3*6,3 */,363= 435635
%arket Malue o
>uoted Investments
/ / / / / /
0ills Purchased O
,4-46& */-&6/4 &/*63 4546=3 *4/6=, &364
!ash !redits5
Overdrat O Loans
Repayable on
,4/,65* 4=&/6=* ,5&&63& *3-365 -4*65= 33,6*
7erm Loans 4,*4&633 =&365* 3&-63- ,&*633 *45633 -=65
7O7$L $FM$D!2S 4&/346-& &/3*643 335&635 ,**/6*, **,&6-& &=-
"i+ed $ssets
Premises *4436*& ,/36/= *446&4 *3/6,* */363, ,-6-,
Other "i+ed $ssets 3/5*6*, 3-365- *&/64 *3*633 **,635 -*6&3
'ross 0lock 44=46,= 5-=63& 3*56*4 ,3*65& ,*-6=& **/65-
,546=5 ,/46=, =36/, 3*6=3 356,& *46,*
Det 0lock 4,3=634 3-46&5 ,,,6*, *==634 *-36& =363&
!apital :ork1in1 / / / / / /
7O7$L "I42F
4,3=634 3-46&5 ,,,6*, *==634 *-36& =363&
0anks in the process o inancial intermediation are conronted #ith various
kinds o inancial and non1inancial risks vi;65 credit5 interest rate5 oreign
e+change rate5 li8uidity5 e8uity price5 commodity price5 legal5 regulatory5
reputational5 operational5 etc6 7hese risks are highly interdependent and events
that aect one area o risk can have ramiications or a range o other risk
categories6 7hus5 top management o banks should attach considerable
importance to improve the ability to identiy5 measure5 monitor and control the
overall level o risks undertaken6
7he broad parameters o risk management unction should encompassB
i) organi;ational structure?
ii) comprehensive risk measurement approach?
iii) risk management policies approved by the 0oard #hich should be
consistent #ith the broader business strategies5 capital strength5
management e+pertise and overall #illingness to assume risk?
iv) guidelines and other parameters used to govern risk taking including
detailed structure o prudential limits?
v) strong %IS or reporting5 monitoring and controlling risks?
vi) #ell laid out procedures5 eective control and comprehensive risk
reporting rame#ork?
vii) separate risk management rame#ork independent o operational
Fepartments and #ith clear delineation o levels o responsibility or
management o risk? and
viii) periodical revie# and evaluation6
$ major issue in establishing an appropriate risk management organisation
structure is choosing bet#een a centralised and decentralised structure6 7he
global trend is to#ards centralising risk management #ith integrated treasury
management unction to beneit rom inormation on aggregate e+posure5
natural netting o e+posures5 economies o scale and easier reporting to top
management6 7he primary responsibility o understanding the risks run by the
bank and ensuring that the risks are appropriately managed should clearly be
vested #ith the 0oard o Firectors6 7he 0oard should set risk limits by
assessing the bank9s risk and risk1bearing capacity6 $t organisational level5
overall risk management should be assigned to an independent Risk
%anagement !ommittee or 2+ecutive !ommittee o the top 2+ecutives that
reports directly to the 0oard o Firectors6 7he purpose o this top level
committee is to empo#er one group #ith ull responsibility o evaluating overall
risks aced by the bank and determining the level o risks #hich #ill be in the
best interest o the bank6 $t the same time5 the !ommittee should hold the line
management more accountable or the risks under their control5 and the
perormance o the bank in that area6 7he unctions o Risk %anagement
!ommittee should essentially be to identiy5 monitor and measure the risk
proile o the bank6 7he !ommittee should also develop policies and
procedures5 veriy the models that are used or pricing comple+ products5
revie# the risk models as development takes place in the markets and also
identiy ne# risks6 7he risk policies should clearly spell out the 8uantitative
prudential limits on various segments o banks9 operations6 Internationally5 the
trend is to#ards assigning risk limits in terms o portolio standards or !redit at
Risk (credit risk) and 2arnings at Risk and Malue at Risk (market risk)6 7he
!ommittee should design stress scenarios to measure the impact o unusual
market conditions and monitor variance bet#een the actual volatility o portolio
value and that predicted by the risk measures6 7he !ommittee should also
monitor compliance o various risk parameters by operating Fepartments6
$ prere8uisite or establishment o an eective risk management system is the
e+istence o a robust %IS5 consistent in 8uality6 7he e+isting %IS5 ho#ever5
re8uires substantial upgradation and strengthening o the data collection
machinery to ensure the integrity and reliability o data6
7he risk management is a comple+ unction and it re8uires specialised skills
and e+pertise6 0anks have been moving to#ards the use o sophisticated
models or measuring and managing risks6 Large banks and those operating in
international markets should develop internal risk management models to be
able to compete eectively #ith their competitors6 $s the domestic market
integrates #ith the international markets5 the banks should have necessary
e+pertise and skill in managing various types o risks in a scientiic manner6 $t a
more sophisticated level5 the core sta at .ead Oices should be trained in risk
modelling and analytical tools6 It should5 thereore5 be the endeavour o all
banks to upgrade the skills o sta6
'iven the diversity o balance sheet proile5 it is diicult to adopt a uniorm
rame#ork or management o risks in India6 7he design o risk management
unctions should be bank speciic5 dictated by the si;e5 comple+ity o unctions5
the level o technical e+pertise and the 8uality o %IS6 7he proposed guidelines
only provide broad parameters and each bank may evolve their o#n systems
compatible to their risk management architecture and e+pertise6
Internationally5 a committee approach to risk management is being adopted6
:hile the $sset 1 Liability %anagement !ommittee ($L!O) deal #ith dierent
types o market risk5 the !redit Policy !ommittee (!P!) oversees the credit
@counterparty risk and country risk6 7hus5 market and credit risks are managed
in a parallel t#o1track approach in banks6 0anks could also set1up a single
!ommittee or integrated management o credit and market risks6 'enerally5
the policies and procedures or market risk are articulated in the $L% policies
and credit risk is addressed in Loan Policies and Procedures6
!urrently5 #hile market variables are held constant or 8uantiying credit risk5
credit variables are held constant in estimating market risk6 7he economic
crises in some o the countries have revealed a strong correlation bet#een
unhedged market risk and credit risk6 "ore+ e+posures5 assumed by
corporates #ho have no natural hedges5 #ill increase the credit risk #hich
banks run vis1A1vis their counterparties6 7he volatility in the prices o collateral
also signiicantly aects the 8uality o the loan book6 7hus5 there is a need or
integration o the activities o both the $L!O and the !P! and consultation
process should be established to evaluate the impact o market and credit risks
on the inancial strength o banks6 0anks may also consider integrating market
risk elements into their credit risk assessment process6

Lending involves a number o risks6 In addition to the risks related to
credit#orthiness o the counter party5 the banks are also e+posed to
interest rate5 ore+ and country risks6
!redit risk or deault risk involves inability or un#illingness o a customer or
counter party to meet commitments in relation to lending5 trading5 hedging5
settlement and other inancial transactions6 7he !redit Risk is generally made
up o transaction risk or deault risk and portolio risk6 7he portolio risk in turn
comprises intrinsic and concentration risk6 7he credit risk o a bank9s portolio
depends on both e+ternal and internal actors6 7he e+ternal actors are the
state o the economy5 #ide s#ings in commodity@e8uity prices5 oreign
e+change rates and interest rates5 trade restrictions5 economic sanctions5
'overnment policies5 etc6 7he internal actors are deiciencies in loan
policies@administration5 absence o prudential credit concentration limits5
inade8uately deined lending limits or Loan Oicers@!redit !ommittees5
deiciencies in appraisal o borro#ers9 inancial position5 e+cessive dependence
on collateral9s and inade8uate risk pricing5 absence o loan revie# mechanism
and post sanction surveillance5 etc6
$nother variant o credit risk is counter party risk6 7he counter party risk arises
rom non1perormance o the trading partners6 7he non1perormance may arise
rom counter party9s reusal@inability to perorm due to adverse price
movements or rom e+ternal constraints that #ere not anticipated by the
principal6 7he counter party risk is generally vie#ed as a transient inancial risk
associated #ith trading rather than standard credit risk6
7he management o credit risk should receive the top management9s attention
and the process should encompassB
a) %easurement o risk through credit rating@scoring?
b) >uantiying the risk through estimating e+pected loan losses i6e6 the amount
o loan losses that bank #ould e+perience over a chosen time hori;on
(through tracking portolio behaviour over 5 or more years) and une+pected
loan losses i6e6 the amount by #hich actual losses e+ceed the e+pected loss
(through standard deviation o losses or the dierence bet#een e+pected
loan losses and some selected target credit loss 8uantile)?
c) Risk pricing on a scientiic basis? and
d) !ontrolling the risk through eective Loan Revie# %echanism and portolio
7he credit risk management process should be articulated in the bank9s L'a(
4')icy@ duly approved by the 0oard6 2ach bank should constitute a high level
Cre-it 4')icy C'mmittee5 also called !redit Risk %anagement !ommittee or
!redit !ontrol !ommittee etc6 to deal #ith issues relating to credit policy and
procedures and to analyse5 manage and control credit risk on a bank #ide
basis6 7he !ommittee should be headed by the !hairman@!2O@2F5 and should
comprise heads o !redit Fepartment5 7reasury5 !redit Risk %anagement
Fepartment (!R%F) and the !hie 2conomist6 7he !ommittee should5 inter
alia, ormulate clear policies on standards or presentation o credit proposals5
inancial covenants5 rating standards and benchmarks5 delegation o credit
approving po#ers5 prudential limits on large credit e+posures5 asset
concentrations5 standards or loan collateral5 portolio management5 loan revie#
mechanism5 risk concentrations5 risk monitoring and evaluation5 pricing o
loans5 provisioning5 regulatory@legal compliance5 etc6 !oncurrently5 each bank
should also set up !redit Risk %anagement Fepartment (!R%F)5 independent
o the !redit $dministration Fepartment6 7he !R%F should enorce and
monitor compliance o the risk parameters and prudential limits set by the !P!6
7he !R%F should also lay do#n risk assessment systems5 monitor 8uality o
loan portolio5 identiy problems and correct deiciencies5 develop %IS and
undertake loan revie#@audit6 Large banks may consider separate set up or
loan revie#@audit6 7he !R%F should also be made accountable or protecting
the 8uality o the entire loan portolio6 7he Fepartment should undertake
portolio evaluations and conduct comprehensive studies on the environment to
test the resilience o the loan portolio6
I(*trume(t* ': Cre-it ,i*9 Ma(a0eme(t
!redit Risk %anagement encompasses a host o management techni8ues5
#hich help the banks in mitigating the adverse impacts o credit risk6
Cre-it Appr'vi(0 Auth'rity
2ach bank should have a careully ormulated scheme o delegation o po#ers6
7he banks should also evolve multi1tier credit approving system #here the loan
proposals are approved by an L$pproval 'rid9 or a L!ommittee96 7he credit
acilities above a speciied limit may be approved by the L'rid9 or L!ommittee95
comprising at least 3 or 4 oicers and invariably one oicer should represent
the !R%F5 #ho has no volume and proit targets6 0anks can also consider
credit approving committees at various operating levels i6e6 large branches
(#here considered necessary)5 Regional Oices5 Tonal Oices5 .ead Oices5
etc6 0anks could consider delegating po#ers or sanction o higher limits to the
L$pproval 'rid9 or the L!ommittee9 or better rated @ 8uality customers6 7he
spirit o the credit approving system may be that no credit proposals should be
approved or recommended to higher authorities5 i majority members o the
L$pproval 'rid9 or L!ommittee9 do not agree on the credit#orthiness o the
borro#er6 In case o disagreement5 the speciic vie#s o the dissenting
member@s should be recorded6
7he banks should also evolve suitable rame#ork or reporting and evaluating
the 8uality o credit decisions taken by various unctional groups6 7he 8uality o
credit decisions should be evaluated #ithin a reasonable time5 say 3 J 3
months5 through a #ell1deined Loan Revie# %echanism6
4ru-e(tia) Limit*
In order to limit the magnitude o credit risk5 prudential limits should be laid
do#n on various aspects o creditB
a) stipulate benchmark current@debt e8uity and proitability ratios5 debt
service coverage ratio or other ratios5 #ith le+ibility or deviations6 7he
conditions subject to #hich deviations are permitted and the authority
thereor should also be clearly spelt out in the Loan Policy?
b) single@group borro#er limits5 #hich may be lo#er than the limits
prescribed by Reserve 0ank to provide a iltering mechanism?
c) substantial e+posure limit i6e6 sum total o e+posures assumed in respect
o those single borro#ers enjoying credit acilities in e+cess o a threshold
limit5 say */P or *5P o capital unds6 7he substantial e+posure limit
may be i+ed at "%%E 'r B%%E o capital unds5 depending upon the
degree o concentration risk the bank is e+posed?
d) ma+imum e+posure limits to industry5 sector5 etc6 should be set up6 7here
must also be systems in place to evaluate the e+posures at reasonable
intervals and the limits should be adjusted especially #hen a particular
sector or industry aces slo#do#n or other sector@industry speciic
problems6 7he e+posure limits to sensitive sectors5 such as5 advances
against e8uity shares5 real estate5 etc65 #hich are subject to a high degree
o asset price volatility and to speciic industries5 #hich are subject to
re8uent business cycles5 may necessarily be restricted6 Similarly5 high1
risk industries5 as perceived by the bank5 should also be placed under
lo#er portolio limit6 $ny e+cess e+posure should be ully backed by
ade8uate collaterals or strategic considerations? and
e) banks may consider maturity proile o the loan book5 keeping in vie# the
market risks inherent in the balance sheet5 risk evaluation capability5
li8uidity5 etc6
,i*9 ,ati(0
0anks should have a comprehensive risk scoring @ rating system that serves as
a single point indicator o diverse risk actors o a counterparty and or taking
credit decisions in a consistent manner6 7o acilitate this5 a substantial degree
o standardisation is re8uired in ratings across borro#ers6 7he risk rating
system should be designed to reveal the overall risk o lending5 critical input or
setting pricing and non1price terms o loans as also present meaningul
inormation or revie# and management o loan portolio6 7he risk rating5 in
short5 should relect the underlying credit risk o the loan book6 7he rating
e+ercise should also acilitate the credit granting authorities some comort in its
kno#ledge o loan 8uality at any moment o time6
7he risk rating system should be dra#n up in a structured manner5
incorporating5 inter alia5 inancial analysis5 projections and sensitivity5 industrial
and management risks6 7he banks may use any number o inancial ratios and
operational parameters and collaterals as also 8ualitative aspects o
management and industry characteristics that have bearings on the
credit#orthiness o borro#ers6 0anks can also #eigh the ratios on the basis o
the years to #hich they represent or giving importance to near term
developments6 :ithin the rating rame#ork5 banks can also prescribe certain
level o standards or critical parameters5 beyond #hich no proposals should be
entertained6 0anks may also consider separate rating rame#ork or large
corporate @ small borro#ers5 traders5 etc6 that e+hibit varying nature and degree
o risk6 "ore+ e+posures assumed by corporates #ho have no natural hedges
have signiicantly altered the risk proile o banks6 0anks should5 thereore5
actor the unhedged market risk e+posures o borro#ers also in the rating
rame#ork6 7he overall score or risk is to be placed on a numerical scale
ranging bet#een *135 *1-5 etc6 on the basis o credit 8uality6 "or each
numerical category5 a 8uantitative deinition o the borro#er5 the loan9s
underlying 8uality5 and an analytic representation o the underlying inancials o
the borro#er should be presented6 "urther5 as a prudent risk management
policy5 each bank should prescribe the minimum rating belo# #hich no
e+posures #ould be undertaken6 $ny le+ibility in the minimum standards and
conditions or rela+ation and authority thereor should be clearly articulated in
the Loan Policy6
7he credit risk assessment e+ercise should be repeated biannually (or even at
shorter intervals or lo# 8uality customers) and should be delinked invariably
rom the regular rene#al e+ercise6 7he updating o the credit ratings should be
undertaken normally at 8uarterly intervals or at least at hal1yearly intervals5 in
order to gauge the 8uality o the portolio at periodic intervals6 Mariations in the
ratings o borro#ers over time indicate changes in credit 8uality and e+pected
loan losses rom the credit portolio6 7hus5 i the rating system is to be
meaningul5 the credit 8uality reports should signal changes in e+pected loan
losses6 In order to ensure the consistency and accuracy o internal ratings5 the
responsibility or setting or conirming such ratings should vest #ith the Loan
Revie# unction and e+amined by an independent Loan Revie# 'roup6 7he
banks should undertake comprehensive study on migration (up#ard J lo#er to
higher and do#n#ard J higher to lo#er) o borro#ers in the ratings to add
accuracy in e+pected loan loss calculations6
,i*9 4rici(0
Risk1return pricing is a undamental tenet o risk management6 In a risk1return
setting5 borro#ers #ith #eak inancial position and hence placed in high credit
risk category should be priced high6 7hus5 banks should evolve scientiic
systems to price the credit risk5 #hich should have a bearing on the e+pected
probability o deault6 7he pricing o loans normally should be linked to risk
rating or credit 8uality6 7he probability o deault could be derived rom the past
behaviour o the loan portolio5 #hich is the unction o loan loss
provision@charge os or the last ive years or so6 0anks should build historical
database on the portolio 8uality and provisioning @ charge o to e8uip
themselves to price the risk6 0ut value o collateral5 market orces5 perceived
value o accounts5 uture business potential5 portolio@industry e+posure and
strategic reasons may also play important role in pricing6 "le+ibility should also
be made or revising the price (risk premia) due to changes in rating @ value o
collaterals over time6 Large si;ed banks across the #orld have already put in
place Risk $djusted Return on !apital (R$RO!) rame#ork or pricing o loans5
#hich calls or data on portolio behaviour and allocation o capital
commensurate #ith credit risk inherent in loan proposals6 <nder R$RO!
rame#ork5 lender begins by charging an interest mark1up to cover the
e+pected loss J e+pected deault rate o the rating category o the borro#er6
7he lender then allocates enough capital to the prospective loan to cover some
amount o une+pected loss1 variability o deault rates6 'enerally5 international
banks allocate enough capital so that the e+pected loan loss reserve or
provision plus allocated capital covers ==P o the loan loss outcomes6
7here is5 ho#ever5 a need or comparing the prices 8uoted by competitors or
borro#ers perched on the same rating @8uality6 7hus5 any attempt at price1
cutting or market share #ould result in mispricing o risk and L$dverse
4'rt:')i' Ma(a0eme(t
7he e+isting rame#ork o tracking the Don Perorming Loans around the
balance sheet date does not signal the 8uality o the entire Loan 0ook6 0anks
should evolve proper systems or identiication o credit #eaknesses #ell in
advance6 %ost o international banks have adopted various portolio
management techni8ues or gauging asset 8uality6 7he !R%F5 set up at .ead
Oice should be assigned the responsibility o periodic monitoring o the
portolio6 7he portolio 8uality could be evaluated by tracking the migration
(up#ard or do#n#ard) o borro#ers rom one rating scale to another6 7his
process #ould be meaningul only i the borro#er1#ise ratings are updated at
8uarterly @ hal1yearly intervals6 Fata on movements #ithin grading categories
provide a useul insight into the nature and composition o loan book6
7he banks could also consider the ollo#ing measures to maintain the portolio
*) stipulate 8uantitative ceiling on aggregate e+posure in speciied rating
categories5 i6e6 certain percentage o total advances should be in the rating
category o * to , or * to 35 , to 4 or 4 to 55 etc6?
,) evaluate the rating1#ise distribution o borro#ers in various industry5
business segments5 etc6?
3) e+posure to one industry@sector should be evaluated on the basis o overall
rating distribution o borro#ers in the sector@group6 In this conte+t5 banks
should #eigh the pros and cons o specialisation and concentration by
industry group6 In cases #here portolio e+posure to a single industry is
badly perorming5 the banks may increase the 8uality standards or that
speciic industry?
4) target rating1#ise volume o loans5 probable deaults and provisioning
re8uirements as a prudent planning e+ercise6 "or any deviation@s rom the
e+pected parameters5 an e+ercise or restructuring o the portolio should
immediately be undertaken and i necessary5 the entry1level criteria could be
enhanced to insulate the portolio rom urther deterioration?
5) undertake rapid portolio revie#s5 stress tests and scenario analysis #hen
e+ternal environment undergoes rapid changes (e6g6 volatility in the ore+
market5 economic sanctions5 changes in the iscal@monetary policies5
general slo#do#n o the economy5 market risk events5 e+treme li8uidity
conditions5 etc6)6 7he stress tests #ould reveal undetected areas o
potential credit risk e+posure and linkages bet#een dierent categories o
risk6 In adverse circumstances5 there may be substantial correlation o
various risks5 especially credit and market risks6 Stress testing can range
rom relatively simple alterations in assumptions about one or more
inancial5 structural or economic variables to the use o highly sophisticated
models6 7he output o such portolio1#ide stress tests should be revie#ed
by the 0oard and suitable changes may be made in prudential risk limits or
protecting the 8uality6 Stress tests could also include contingency plans5
detailing management responses to stressul situations6
3) introduce discriminatory time schedules or rene#al o borro#er limits6
Lo#er rated borro#ers #hose inancials sho# signs o problems should be
subjected to rene#al control t#ice@thrice an year6
0anks should evolve suitable rame#ork or monitoring the market risks
especially ore+ risk e+posure o corporates #ho have no natural hedges on a
regular basis6 0anks should also appoint Portolio %anagers to #atch the loan
portolio9s degree o concentrations and e+posure to counterparties6 "or
comprehensive evaluation o customer e+posure5 banks may consider
appointing Relationship %anagers to ensure that overall e+posure to a single
borro#er is monitored5 captured and controlled6 7he Relationship %anagers
have to #ork in coordination #ith the 7reasury and "ore+ Fepartments6 7he
Relationship %anagers may service mainly high value loans so that a
substantial share o the loan portolio5 #hich can alter the risk proile5 #ould be
under constant surveillance6 "urther5 transactions #ith ailiated
companies@groups need to be aggregated and maintained close to real time6
7he banks should also put in place ormalised systems or identiication o
accounts sho#ing pronounced credit #eaknesses #ell in advance and also
prepare internal guidelines or such an e+ercise and set time rame or deciding
courses o action6
%any o the international banks have adopted credit risk models or evaluation
o credit portolio6 7he credit risk models oer banks rame#ork or e+amining
credit risk e+posures5 across geographical locations and product lines in a
timely manner5 centralising data and analysing marginal and absolute
contributions to risk6 7he models also provide estimates o credit risk
(une+pected loss) #hich relect individual portolio composition6 7he $ltman9s T
Score orecasts the probability o a company entering bankruptcy #ithin a *,1
month period6 7he model combines ive inancial ratios using reported
accounting inormation and e8uity values to produce an objective measure o
borro#er9s inancial health6 C6 P6 %organ has developed a portolio model
LCreditMetrics or evaluating credit risk6 7he model basically ocus on
estimating the volatility in the value o assets caused by variations in the 8uality
o assets6 7he volatility is computed by tracking the probability that the
borro#er might migrate rom one rating category to another (do#ngrade or
upgrade)6 7hus5 the value o loans can change over time5 relecting migration
o the borro#ers to a dierent risk1rating grade6 7he model can be used or
promoting transparency in credit risk5 establishing benchmark or credit risk
measurement and estimating economic capital or credit risk under R$RO!
rame#ork6 !redit Suisse developed a statistical method or measuring and
accounting or credit risk #hich is kno#n as Cre-it,i*9FA 7he model is based
on actuarial calculation o e+pected deault rates and une+pected losses rom
7he banks may evaluate the utility o these models #ith suitable modiications
to Indian environment or ine1tuning the credit risk management6 7he success
o credit risk models impinges on time series data on historical loan loss rates
and other model variables5 spanning multiple credit cycles6 0anks may5
thereore5 endeavour building ade8uate database or s#itching over to credit
risk modelling ater a speciied period o time6
L'a( ,evie8 Mecha(i*m >L,M?
LR% is an eective tool or constantly evaluating the 8uality o loan book and to
bring about 8ualitative improvements in credit administration6 0anks should5
thereore5 put in place proper Loan Revie# %echanism or large value accounts
#ith responsibilities assigned in various areas such as5 evaluating the
eectiveness o loan administration5 maintaining the integrity o credit grading
process5 assessing the loan loss provision5 portolio 8uality5 etc6 7he
comple+ity and scope o LR% normally vary based on banks9 si;e5 type o
operations and management practices6 It may be independent o the !R%F or
even separate Fepartment in large banks6
7he main objectives o LR% could beB
to identiy promptly loans #hich develop credit #eaknesses and initiate
timely corrective action?
to evaluate portolio 8uality and isolate potential problem areas?
to provide inormation or determining ade8uacy o loan loss provision?
to assess the ade8uacy o and adherence to5 loan policies and procedures5
and to monitor compliance #ith relevant la#s and regulations? and
to provide top management #ith inormation on credit administration5
including credit sanction process5 risk evaluation and post1sanction ollo#1
$ccurate and timely credit grading is one o the basic components o an
eective LR%6 !redit grading involves assessment o credit 8uality5
identiication o problem loans5 and assignment o risk ratings6 $ proper !redit
'rading System should support evaluating the portolio 8uality and establishing
loan loss provisions6 'iven the importance and subjective nature o credit
rating5 the credit ratings a#arded by !redit $dministration Fepartment should
be subjected to revie# by Loan Revie# Oicers #ho are independent o loan
0anks should ormulate Loan Revie# Policy and it should be revie#ed annually
by the 0oard6 7he Policy should5 inter alia5 addressB
Gua)i:icati'( a(- I(-epe(-e(ce
7he Loan Revie# Oicers should have sound kno#ledge in credit appraisal5
lending practices and loan policies o the bank6 7hey should also be #ell
versed in the relevant la#s@regulations that aect lending activities6 7he
independence o Loan Revie# Oicers should be ensured and the indings o
the revie#s should also be reported directly to the 0oard or !ommittee o the
7re=ue(cy a(- Sc'pe ': ,evie8*
7he Loan Revie#s are designed to provide eedback on eectiveness o credit
sanction and to identiy incipient deterioration in portolio 8uality6 Revie#s o
high value loans should be undertaken usually #ithin three months o
sanction@rene#al or more re8uently #hen actors indicate a potential or
deterioration in the credit 8uality6 7he scope o the revie# should cover all
loans above a cut1o limit6 In addition5 banks should also target other accounts
that present elevated risk characteristics6 $t least 3/14/P o the portolio
should be subjected to LR% in a year to provide reasonable assurance that all
the major credit risks embedded in the balance sheet have been tracked6
Depth ': ,evie8*
7he loan revie#s should ocus onB
$pproval process?
$ccuracy and timeliness o credit ratings assigned by loan oicers?
$dherence to internal policies and procedures5 and applicable la#s @
!ompliance #ith loan covenants?
Post1sanction ollo#1up?
Suiciency o loan documentation?
Portolio 8uality? and
Recommendations or improving portolio 8uality
7he indings o Revie#s should be discussed #ith line %anagers and the
corrective actions should be elicited or all deiciencies6 Feiciencies that
remain unresolved should be reported to top management6
7he Risk %anagement 'roup o the 0asle !ommittee on 0anking Supervision
has released a consultative paper on Principles or the %anagement o !redit
Risk6 7he Paper deals #ith various aspects relating to credit risk management6
7he Paper is enclosed or inormation o banks6
Cre-it ,i*9 a(- I(ve*tme(t .a(9i(0
Signiicant magnitude o credit risk5 in addition to market risk5 is inherent in
investment banking6 7he proposals or investments should also be subjected
to the same degree o credit risk analysis5 as any loan proposals6 7he
proposals should be subjected to detailed appraisal and rating rame#ork that
actors in inancial and non1inancial parameters o issuers5 sensitivity to
e+ternal developments5 etc6 7he ma+imum e+posure to a customer should be
bank1#ide and include all e+posures assumed by the !redit and 7reasury
Fepartments6 7he coupon on non1sovereign papers should be commensurate
#ith their risk proile6 7he banks should e+ercise due caution5 particularly in
investment proposals5 #hich are not rated and should ensure comprehensive
risk evaluation6 7here should be greater interaction bet#een !redit and
7reasury Fepartments and the portolio analysis should also cover the total
e+posures5 including investments6 7he rating migration o the issuers and the
conse8uent diminution in the portolio 8uality should also be tracked at periodic
$s a matter o prudence5 banks should stipulate entry level minimum
ratings@8uality standards5 industry5 maturity5 duration5 issuer1#ise5 etc6 limits in
investment proposals as #ell to mitigate the adverse impacts o concentration
and the risk o li8uidity6
Cre-it ,i*9 i( O::-/a)a(ce Sheet Exp'*ure
0anks should evolve ade8uate rame#ork or managing their e+posure in o1
balance sheet products like ore+ or#ard contracts5 s#aps5 options5 etc6 as a
part o overall credit to individual customer relationship and subject to the same
credit appraisal5 limits and monitoring procedures6 0anks should classiy their
o1balance sheet e+posures into three broad categories 1 :u)) ri*9 (credit
substitutes) 1 standby letters o credit5 money guarantees5 etc5 me-ium ri*9
(not direct credit substitutes5 #hich do not support e+isting inancial obligations)
1 bid bonds5 letters o credit5 indemnities and #arranties and )'8 ri*9 1 reverse
repos5 currency s#aps5 options5 utures5 etc6
7he trading credit e+posure to counter parties can be measured on static
(constant percentage o the notional principal over the lie o the transaction)
and on a dynamic basis6 7he total e+posures to the counter parties on a
dynamic basis should be the sum total oB
*) the current replacement cost (unreali;ed loss to the counter party)? and
,) the potential increase in replacement cost (estimated #ith the help o MaR
or other methods to capture uture volatility9s in the value o the outstanding
contracts@ obligations)6
7he current and potential credit e+posures may be measured on a daily basis
to evaluate the impact o potential changes in market conditions on the value o
counter party positions6 7he potential e+posures also may be 8uantiied by
subjecting the position to market movements involving normal and abnormal
movements in interest rates5 oreign e+change rates5 e8uity prices5 li8uidity
conditions5 etc6
$ suitable rame#ork should be evolved to provide a centralised overvie# on
the aggregate e+posure on other banks6 0ank1#ise e+posure limits could be
set on the basis o assessment o inancial perormance5 operating eiciency5
management 8uality5 past e+perience5 etc6 Like corporate clients5 banks should
also be rated and placed in range o *155 *1-5 as the case may be5 on the basis
o their credit 8uality6 7he limits so arrived at should be allocated to various
operating centres and ollo#ed up and hal1yearly@annual revie#s undertaken at
a single point6 Regarding e+posure on overseas banks5 banks can use the
country ratings o international rating agencies and classiy the countries into
lo# risk5 moderate risk and high risk6 0anks should endeavour or developing
an internal matri+ that reckons the counter party and country risks6 7he
ma+imum e+posure should be subjected to adherence o country and bank
e+posure limits already in place6 :hile the e+posure should at least be
monitored on a #eekly basis till the banks are e8uipped to monitor e+posures
on a real time basis5 all e+posures to problem countries should be evaluated on
a real time basis6
Mar9et ,i*9
7raditionally5 credit risk management #as the primary challenge or banks6
:ith progressive deregulation5 market risk arising rom adverse changes in
market variables5 such as interest rate5 oreign e+change rate5 e8uity price and
commodity price has become relatively more important6 2ven a small change
in market variables causes substantial changes in income and economic value
o banks6 %arket risk takes the orm oB
*) Li8uidity Risk
,) Interest Rate Risk
3) "oreign 2+change Rate ("ore+) Risk
4) !ommodity Price Risk and
5) 28uity Price Risk
Mar9et ,i*9 Ma(a0eme(t
%anagement o market risk should be the major concern o top management o
banks6 7he 0oards should clearly articulate market risk management policies5
procedures5 prudential risk limits5 revie# mechanisms and reporting and
auditing systems6 7he policies should address the bank9s e+posure on a
consolidated basis and clearly articulate the risk measurement systems that
capture all material sources o market risk and assess the eects on the bank6
7he operating prudential limits and the accountability o the line management
should also be clearly deined6 7he $sset1Liability %anagement !ommittee
($L!O) should unction as the top operational unit or managing the balance
sheet #ithin the perormance@risk parameters laid do#n by the 0oard6 7he
banks should also set up an independent Mi--)e O::ice to track the magnitude
o market risk on a real time basis6 7he %iddle Oice should comprise o
e+perts in market risk management5 economists5 statisticians and general
bankers and may be unctionally placed directly under the $L!O6 7he %iddle
Oice should also be separated rom 7reasury Fepartment and should not be
involved in the day to day management o 7reasury6 7he %iddle Oice should
apprise the top management @ $L!O @ 7reasury about adherence to prudential @
risk parameters and also aggregate the total market risk e+posures assumed
by the bank at any point o time6
Li=ui-ity ,i*9
Li8uidity Planning is an important acet o risk management rame#ork in
banks6 Li8uidity is the ability to eiciently accommodate deposit and other
liability decreases5 as #ell as5 und loan portolio gro#th and the possible
unding o o1balance sheet claims6 $ bank has ade8uate li8uidity #hen
suicient unds can be raised5 either by increasing liabilities or converting
assets5 promptly and at a reasonable cost6 It encompasses the potential sale
o li8uid assets and borro#ings rom money5 capital and ore+ markets6 7hus5
li8uidity should be considered as a deence mechanism rom losses on ire sale
o assets6
7he li8uidity risk o banks arises rom unding o long1term assets by short1term
liabilities5 thereby making the liabilities subject to rollover or reinancing risk6
7he li8uidity risk in banks maniest in dierent dimensionsB
i) 7u(-i(0 ,i*9 J need to replace net outlo#s due to unanticipated
#ithdra#al@non1rene#al o deposits (#holesale and retail)?
ii) Time ,i*9 1 need to compensate or non1receipt o e+pected inlo#s o
unds5 i6e6 perorming assets turning into non1perorming assets? and
iii) Ca)) ,i*9 1 due to crystallisation o contingent liabilities and unable to
undertake proitable business opportunities #hen desirable6
7he irst step to#ards li8uidity management is to put in place an eective
li8uidity management policy5 #hich5 inter alia5 should spell out the unding
strategies5 li8uidity planning under alternative scenarios5 prudential limits5
li8uidity reporting @ revie#ing5 etc6
Li8uidity measurement is 8uite a diicult task and can be measured through
stock or cash lo# approaches6 7he key ratios5 adopted across the banking
system areB
i) Loans to 7otal $ssets
ii) Loans to !ore Feposits
iii) Lar0e Lia/i)itie* >minus? Temp'rary I(ve*tme(t* t' Ear(i(0 A**et*
>minus? Temp'rary I(ve*tme(t*5 #here large liabilities represent
#holesale deposits #hich are market sensitive and temporary
Investments are those maturing #ithin one year and those investments
#hich are held in the trading book and are readily sold in the market?
iv) 4urcha*e- 7u(-* t' T'ta) A**et*5 #here purchased unds include the
entire inter1bank and other money market borro#ings5 including
!ertiicate o Feposits and institutional deposits? and
v) L'a( L'**e*CNet L'a(*6
:hile the li8uidity ratios are the ideal indicator o li8uidity o banks operating in
developed inancial markets5 the ratios do not reveal the intrinsic li8uidity proile
o Indian banks #hich are operating generally in an illi8uid market6
2+periences sho# that assets commonly considered as li8uid like 'overnment
securities5 other money market instruments5 etc6 have limited li8uidity as the
market and players are unidirectional6 7hus5 analysis o li8uidity involves
tracking o cash lo# mismatches6 "or measuring and managing net unding
re8uirements5 the use o maturity ladder and calculation o cumulative surplus
or deicit o unds at selected maturity dates is recommended as a standard
tool6 7he ormat prescribed by R0I in this regard under $L% System should be
adopted or measuring cash lo# mismatches at dierent time bands6 7he cash
lo#s should be placed in dierent time bands based on uture behaviour o
assets5 liabilities and o1balance sheet items6 In other #ords5 banks should
have to analy;e the behavioural maturity proile o various components o on @
o1balance sheet items on the basis o assumptions and trend analysis
supported by time series analysis6 0anks should also undertake variance
analysis5 at least5 once in si+ months to validate the assumptions6 7he
assumptions should be ine1tuned over a period #hich acilitate near reality
predictions about uture behaviour o on @ o1balance sheet items6 $part rom
the above cash lo#s5 banks should also track the impact o prepayments o
loans5 premature closure o deposits and e+ercise o options built in certain
instruments #hich oer put@call options ater speciied times6 7hus5 cash
outlo#s can be ranked by the date on #hich liabilities all due5 the earliest date
a liability holder could e+ercise an early repayment option or the earliest date
contingencies could be crystallised6
7he dierence bet#een cash inlo#s and outlo#s in each time period5 the
e+cess or deicit o unds5 becomes a starting point or a measure o a bank9s
uture li8uidity surplus or deicit5 at a series o points o time6 7he banks should
also consider putting in place certain prudential limits to avoid li8uidity crisisB
*6 !ap on inter1bank borro#ings5 especially call borro#ings?
,6 Purchased unds vis1A1vis li8uid assets?
36 !ore deposits vis1A1vis !ore $ssets i6e6 !ash Reserve Ratio5 Li8uidity
Reserve Ratio and Loans?
46 Furation o liabilities and investment portolio?
56 %a+imum !umulative Outlo#s6 0anks should i+ cumulative mismatches
across all time bands?
36 !ommitment Ratio J track the total commitments given to corporates@banks
and other inancial institutions to limit the o1balance sheet e+posure?
&6 S#apped "unds Ratio5 i6e6 e+tent o Indian Rupees raised out o oreign
currency sources6
0anks should also evolve a system or monitoring high value deposits (other
than inter1bank deposits) say Rs6* crore or more to track the volatile liabilities6
"urther the cash lo#s arising out o contingent liabilities in normal situation and
the scope or an increase in cash lo#s during periods o stress should also be
estimated6 It is 8uite possible that market crisis can trigger substantial increase
in the amount o dra# do#ns rom cash credit@overdrat accounts5 contingent
liabilities like letters o credit5 etc6
7he li8uidity proile o the banks could be analysed on a static basis5 #herein
the assets and liabilities and o1balance sheet items are pegged on a particular
day and the behavioural pattern and the sensitivity o these items to changes in
market interest rates and environment are duly accounted or6 7he banks can
also estimate the li8uidity proile on a dynamic #ay by giving due importance
*) Seasonal pattern o deposits@loans?
,) Potential li8uidity needs or meeting ne# loan demands5 unavailed credit
limits5 loan policy5 potential deposit losses5 investment obligations5 statutory
obligations5 etc6
7he li8uidity proile o banks depends on the market conditions5 #hich inluence
the cash lo# behaviour6 7hus5 banks should evaluate li8uidity proile under
dierent conditions5 vi;6 normal situation5 bank speciic crisis and market crisis
scenario6 7he banks should establish benchmark or ('rma) *ituati'(5 cash
lo# proile o on @ o balance sheet items and manages net unding
2stimating li8uidity under /a(9 *peci:ic cri*i* should provide a #orst1case
benchmark6 It should be assumed that the purchased unds could not be easily
rolled over? some o the core deposits could be prematurely closed? a
substantial share o assets have turned into non1perorming and thus become
totally illi8uid6 7hese developments #ould lead to rating do#n grades and high
cost o li8uidity6 7he banks should evolve contingency plans to overcome such
7he mar9et cri*i* *ce(ari' analyses cases o e+treme tightening o li8uidity
conditions arising out o monetary policy stance o Reserve 0ank5 general
perception about risk proile o the banking system5 severe market disruptions5
ailure o one or more o major players in the market5 inancial crisis5 contagion5
etc6 <nder this scenario5 the rollover o high value customer deposits and
purchased unds could e+tremely be diicult besides light o volatile deposits @
liabilities6 7he banks could also sell their investment #ith huge discounts5
entailing severe capital loss6
C'(ti(0e(cy 4)a(
0anks should prepare !ontingency Plans to measure their ability to #ithstand
bank1speciic or market crisis scenario6 7he blue1print or asset sales5 market
access5 capacity to restructure the maturity and composition o assets and
liabilities should be clearly documented and alternative options o unding in the
event o bank9s ailure to raise li8uidity rom e+isting source@s could be clearly
articulated6 Li8uidity rom the Reserve 0ank5 arising out o its reinance #indo#
and interim li8uidity adjustment acility or as lender o last resort should not be
reckoned or contingency plans6 $vailability o back1up li8uidity support in the
orm o committed lines o credit5 reciprocal arrangements5 li8uidity support
rom other e+ternal sources5 li8uidity o assets5 etc6 should also be clearly
I(tere*t ,ate ,i*9 >I,,?
7he management o Interest Rate Risk should be one o the critical
components o market risk management in banks6 7he regulatory restrictions in
the past had greatly reduced many o the risks in the banking system6
Feregulation o interest rates has5 ho#ever5 e+posed them to the adverse
impacts o interest rate risk6 7he Det Interest Income (DII) or Det Interest
%argin (DI%) o banks is dependent on the movements o interest rates6 $ny
mismatches in the cash lo#s (i+ed assets or liabilities) or repricing dates
(loating assets or liabilities)5 e+pose banks9 DII or DI% to variations6 7he
earning o assets and the cost o liabilities are no# closely related to market
interest rate volatility6
Interest Rate Risk (IRR) reers to potential impact on DII or DI% or %arket
Malue o 28uity (%M2)5 caused by une+pected changes in market interest rates6
Interest Rate Risk can take dierent ormsB
Type* ': I(tere*t ,ate ,i*9
Gap 'r Mi*match ,i*9<
$ gap or mismatch risk arises rom holding assets and liabilities and o1balance
sheet items #ith dierent principal amounts5 maturity dates or repricing dates5
thereby creating e+posure to une+pected changes in the level o market
interest rates6
.a*i* ,i*9
%arket interest rates o various instruments seldom change by the same
degree during a given period o time6 7he risk that the interest rate o dierent
assets5 liabilities and o1balance sheet items may change in dierent
magnitude is termed as basis risk6 7he degree o basis risk is airly high in
respect o banks that create composite assets out o composite liabilities6 7he
Loan book in India is unded out o a composite liability portolio and is e+posed
to a considerable degree o basis risk6 7he basis risk is 8uite visible in volatile
interest rate scenarios6 :hen the variation in market interest rate causes the
DII to e+pand5 the banks have e+perienced avourable basis shits and i the
interest rate movement causes the DII to contract5 the basis has moved against
the banks6
Em/e--e- Opti'( ,i*9
Signiicant changes in market interest rates create another source o risk to
banks9 proitability by encouraging prepayment o cash credit@demand
loans@term loans and e+ercise o call@put options on bonds@debentures and@or
premature #ithdra#al o term deposits beore their stated maturities6 7he
embedded option risk is becoming a reality in India and is e+perienced in
volatile situations6 7he aster and higher the magnitude o changes in interest
rate5 the greater #ill be the embedded option risk to the banks9 DII6 7hus5
banks should evolve scientiic techni8ues to estimate the probable embedded
options and adjust the 'ap statements (Li8uidity and Interest Rate Sensitivity)
to realistically estimate the risk proiles in their balance sheet6 0anks should
also endeavour or stipulating appropriate penalties based on opportunity costs
to stem the e+ercise o options5 #hich is al#ays to the disadvantage o banks6
3ie)- Curve ,i*9
In a loating interest rate scenario5 banks may price their assets and liabilities
based on dierent benchmarks5 i6e6 70s yields5 i+ed deposit rates5 call money
rates5 %I0OR5 etc6 In case the banks use t#o dierent instruments maturing at
dierent time hori;on or pricing their assets and liabilities5 any non1parallel
movements in yield curves #ould aect the DII6 7he movements in yield curve
are rather re8uent #hen the economy moves through business cycles6 7hus5
banks should evaluate the movement in yield curves and the impact o that on
the portolio values and income6
4rice ,i*9
Price risk occurs #hen assets are sold beore their stated maturities6 In the
inancial market5 bond prices and yields are inversely related6 7he price risk is
closely associated #ith the trading book5 #hich is created or making proit out
o short1term movements in interest rates6 0anks #hich have an active trading
book should5 thereore5 ormulate policies to limit the portolio si;e5 holding
period5 duration5 deeasance period5 stop loss limits5 marking to market5 etc6/
,ei(ve*tme(t ,i*9
<ncertainty #ith regard to interest rate at #hich the uture cash lo#s could be
reinvested is called reinvestment risk6 $ny mismatches in cash lo#s #ould
e+pose the banks to variations in DII as the market interest rates move in
dierent directions6
Net I(tere*t 4'*iti'( ,i*9
7he si;e o nonpaying liabilities is one o the signiicant actors contributing
to#ards proitability o banks6 :hen banks have more earning assets than
paying liabilities5 interest rate risk arises #hen the market interest rates adjust
do#n#ards6 7hus5 banks #ith positive net interest positions #ill e+perience a
reduction in DII as the market interest rate declines and increases #hen
interest rate rises6 7hus5 large loat is a natural hedge against the variations in
interest rates6
Mea*uri(0 I(tere*t ,ate ,i*9
0eore interest rate risk could be managed5 they should be identiied and
8uantiied6 <nless the 8uantum o IRR inherent in the balance sheet is
identiied5 it is impossible to measure the degree o risks to #hich banks are
e+posed6 It is also e8ually impossible to develop eective risk management
strategies@hedging techni8ues #ithout being able to understand the correct risk
position o banks6 7he IRR measurement system should address all material
sources o interest rate risk including gap or mismatch5 basis5 embedded
option5 yield curve5 price5 reinvestment and net interest position risks
e+posures6 7he IRR measurement system should also take into account the
speciic characteristics o each individual interest rate sensitive position and
should capture in detail the ull range o potential movements in interest rates6
7here are dierent techni8ues or measurement o interest rate risk5 ranging
rom the traditional %aturity 'ap $nalysis (to measure the interest rate
sensitivity o earnings)5 Furation (to measure interest rate sensitivity o capital)5
Simulation and Malue at Risk6 :hile these methods highlight dierent acets o
interest rate risk5 many banks use them in combination5 or use hybrid methods
that combine eatures o all the techni8ues6
'enerally5 the approach to#ards measurement and hedging o IRR varies #ith
the segmentation o the balance sheet6 In a #ell unctioning risk management
system5 banks broadly position their balance sheet into 7rading and Investment
or 0anking 0ooks6 :hile the assets in the trading book are held primarily or
generating proit on short1term dierences in prices@yields5 the banking book
comprises assets and liabilities5 #hich are contracted basically on account o
relationship or or steady income and statutory obligations and are generally
held till maturity6 7hus5 #hile the price risk is the prime concern o banks in
trading book5 the earnings or economic value changes are the main ocus o
banking book6
Tra-i(0 .''9
7he top management o banks should lay do#n policies #ith regard to volume5
ma+imum maturity5 holding period5 duration5 stop loss5 deeasance period5
rating standards5 etc6 or classiying securities in the trading book6 :hile the
securities held in the trading book should ideally be marked to market on a
daily basis5 the potential price risk to changes in market risk actors should be
estimated through internally developed Malue at Risk (MaR) models6 7he MaR
method is employed to assess potential loss that could crystalise on trading
position or portolio due to variations in market interest rates and prices5 using a
given conidence level5 usually =5P to ==P5 #ithin a deined period o time6
7he MaR method should incorporate the market actors against #hich the
market value o the trading position is e+posed6 7he top management should
put in place bank1#ide MaR e+posure limits to the trading portolio (including
ore+ and gold positions5 derivative products5 etc6) #hich is then disaggregated
across dierent desks and departments6 7he loss making tolerance level
should also be stipulated to ensure that potential impact on earnings is
managed #ithin acceptable limits6 7he potential loss in Present Malue 0asis
Points should be matched by the %iddle Oice on a daily basis vis1A1vis the
prudential limits set by the 0oard6 7he advantage o using MaR is that it is
comparable across products5 desks and Fepartments and it can be validated
through Lback testing96 .o#ever5 MaR models re8uire the use o e+tensive
historical data to estimate uture volatility6 MaR model also may not give good
results in e+treme volatile conditions or outlier events and stress test has to be
employed to complement MaR6 7he stress tests provide management a vie#
on the potential impact o large si;e market movements and also attempt to
estimate the si;e o potential losses due to stress events5 #hich occur in the
Htai)*H o the loss distribution6 0anks may also undertake scenario analysis #ith
speciic possible stress situations (recently e+perienced in some countries) by
linking hypothetical5 simultaneous and related changes in multiple risk actors
present in the trading portolio to determine the impact o moves on the rest o
the portolio6 MaR models could also be modiied to relect li8uidity risk
dierences observed across assets over time6 International banks are no#
estimating Li8uidity adjusted Malue at Risk (LaMaR) by assuming variable time
hori;ons based on position si;e and relative turnover6 In an environment #here
MaR is diicult to estimate or lack o data5 non1statistical concepts such as stop
loss and gross@net positions can be used6
.a(9i(0 .''9
7he changes in market interest rates have earnings and economic value
impacts on the banks9 banking book6 7hus5 given the comple+ity and range o
balance sheet products5 banks should have IRR measurement systems that
assess the eects o the rate changes on both earnings and economic value6
7he variety o techni8ues ranges rom simple maturity (i+ed rate) and repricing
(loating rate) to static simulation5 based on current on1and1o1balance sheet
positions5 to highly sophisticated dynamic modelling techni8ues that
incorporate assumptions on behavioural pattern o assets5 liabilities and o1
balance sheet items and can easily capture the ull range o e+posures against
basis risk5 embedded option risk5 yield curve risk5 etc6
Maturity Gap A(a)y*i*
7he simplest analytical techni8ues or calculation o IRR e+posure begins #ith
maturity 'ap analysis that distributes interest rate sensitive assets5 liabilities
and o1balance sheet positions into a certain number o pre1deined time1bands
according to their maturity (i+ed rate) or time remaining or their ne+t repricing
(loating rate)6 7hose assets and liabilities lacking deinite repricing intervals
(savings bank5 cash credit5 overdrat5 loans5 e+port inance5 reinance rom R0I
etc6) or actual maturities vary rom contractual maturities (embedded option in
bonds #ith put@call options5 loans5 cash credit@overdrat5 time deposits5 etc6) are
assigned time1bands according to the judgement5 empirical studies and past
e+periences o banks6
$ number o time bands can be used #hile constructing a gap report6
'enerally5 most o the banks ocus their attention on near1term periods5 vi;6
monthly5 8uarterly5 hal1yearly or one year6 It is very diicult to take a vie# on
interest rate movements beyond a year6 0anks #ith large e+posures in the
short1term should test the sensitivity o their assets and liabilities even at
shorter intervals like overnight5 *1& days5 -1*4 days5 etc6
In order to evaluate the earnings e+posure5 interest Rate Sensitive $ssets
(RS$s) in each time band are netted #ith the interest Rate Sensitive Liabilities
(RSLs) to produce a repricing L'ap9 or that time band6 7he positive 'ap
indicates that banks have more RS$s than RSLs6 $ positive or asset sensitive
'ap means that an increase in market interest rates could cause an increase in
DII6 !onversely5 a negative or liability sensitive 'ap implies that the banks9 DII
could decline as a result o increase in market interest rates6 7he negative gap
indicates that banks have more RSLs than RS$s6 7he 'ap is used as a
measure o interest rate sensitivity6 7he Positive or Degative 'ap is multiplied
by the assumed interest rate changes to derive the 2arnings at Risk (2aR)6
7he 2aR method acilitates to estimate ho# much the earnings might be
impacted by an adverse movement in interest rates6 7he changes in interest
rate could be estimated on the basis o past trends5 orecasting o interest
rates5 etc6 7he banks should i+ 2aR #hich could be based on last@current
year9s income and a trigger point at #hich the line management should adopt
on1or o1balance sheet hedging strategies may be clearly deined6
7he 'ap calculations can be augmented by inormation on the average coupon
on assets and liabilities in each time band and the same could be used to
calculate estimates o the level o DII rom positions maturing or due or
repricing #ithin a given time1band5 #hich #ould then provide a scale to assess
the changes in income implied by the gap analysis6
7he periodic gap analysis indicates the interest rate risk e+posure o banks
over distinct maturities and suggests magnitude o portolio changes necessary
to alter the risk proile6 .o#ever5 the 'ap report 8uantiies only the time
dierence bet#een repricing dates o assets and liabilities but ails to measure
the impact o basis and embedded option risks6 7he 'ap report also ails to
measure the entire impact o a change in interest rate ('ap report assumes
that all assets and liabilities are matured or repriced simultaneously) #ithin a
given time1band and eect o changes in interest rates on the economic or
market value o assets5 liabilities and o1balance sheet position6 It also does
not take into account any dierences in the timing o payments that might occur
as a result o changes in interest rate environment6 "urther5 the assumption o
parallel shit in yield curves seldom happen in the inancial market6 7he 'ap
report also ails to capture variability in non1interest revenue and e+penses5 a
potentially important source o risk to current income6
In case banks could realistically estimate the magnitude o changes in market
interest rates o various assets and liabilities (basis risk) and their past
behavioural pattern (embedded option risk)5 they could standardise the gap by
multiplying the individual assets and liabilities by ho# much they #ill change or
a given change in interest rate6 7hus5 one or several assumptions o
standardised gap seem more consistent #ith real #orld than the simple gap
method6 :ith the $djusted 'ap5 banks could realistically estimate the 2aR6
Durati'( Gap A(a)y*i*
%atching the duration o assets and liabilities5 instead o matching the maturity
or repricing dates is the most eective #ay to protect the economic values o
banks rom e+posure to IRR than the simple gap model6 Furation gap model
ocuses on managing economic value o banks by recognising the change in
the market value o assets5 liabilities and o1balance sheet (O0S) items6 :hen
#eighted assets and liabilities and O0S duration are matched5 market interest
rate movements #ould have almost same impact on assets5 liabilities and O0S5
thereby protecting the bank9s total e8uity or net #orth6 Furation is a measure
o the percentage change in the economic value o a position that #ill occur
given a small change in the level o interest rates6
%easuring the duration gap is more comple+ than the simple gap model6 "or
appro+imation o duration o assets and liabilities5 the simple gap schedule can
be used by applying #eights to each time1band6 7he #eights are based on
estimates o the duration o assets and liabilities and O0S that all into each
time band6 7he #eighted duration o assets and liabilities and O0S provide a
rough estimation o the changes in banks9 economic value to a given change in
market interest rates6 It is also possible to give dierent #eights and interest
rates to assets5 liabilities and O0S in dierent time buckets to capture
dierences in coupons and maturities and volatilities in interest rates along the
yield curve6
In a more scientiic #ay5 banks can precisely estimate the economic value
changes to market interest rates by calculating the duration o each asset5
liability and O0S position and #eigh each o them to arrive at the #eighted
duration o assets5 liabilities and O0S6 Once the #eighted duration o assets
and liabilities are estimated5 the duration gap can be #orked out #ith the help
o standard mathematical ormulae6 7he Furation 'ap measure can be used to
estimate the e+pected change in %arket Malue o 28uity (%M2) or a given
change in market interest rate6
7he dierence bet#een duration o assets (F$) and liabilities (FL) is bank9s net
duration6 I the net duration is positive (F$NFL)5 a decrease in market interest
rates #ill increase the market value o e8uity o the bank6 :hen the duration
gap is negative (FLN F$)5 the %M2 increases #hen the interest rate increases
but decreases #hen the rate declines6 7hus5 the Furation 'ap sho#s the
impact o the movements in market interest rates on the %M2 through
inluencing the market value o assets5 liabilities and O0S6
7he attraction o duration analysis is that it provides a comprehensive measure
o IRR or the total portolio6 7he duration analysis also recognises the time
value o money6 Furation measure is additive so that banks can match total
assets and liabilities rather than matching individual accounts6 .o#ever5
Furation 'ap analysis assumes parallel shits in yield curve6 "or this reason5 it
ails to recognise basis risk6
%any o the international banks are no# using balance sheet simulation models
to gauge the eect o market interest rate variations on reported
earnings@economic values over dierent time ;ones6 Simulation techni8ue
attempts to overcome the limitations o 'ap and Furation approaches by
computer modelling the bank9s interest rate sensitivity6 Such modelling
involves making assumptions about uture path o interest rates5 shape o
yield curve5 changes in business activity5 pricing and hedging strategies5
etc6 7he simulation involves detailed assessment o the potential eects
o changes in interest rate on earnings and economic value6 7he
simulation techni8ues involve detailed analysis o various components o
on1and o1balance sheet positions6 Simulations can also incorporate
more varied and reined changes in the interest rate environment5 ranging
rom changes in the slope and shape o the yield curve and interest rate
scenario derived rom %onte !arlo simulations6
7he output o simulation can take a variety o orms5 depending on users9 need6
Simulation can provide current and e+pected periodic gaps5 duration gaps5
balance sheet and income statements5 perormance measures5 budget and
inancial reports6 7he simulation model provides an eective tool or
understanding the risk e+posure under variety o interest rate@balance sheet
scenarios6 7his techni8ue also plays an integral1planning role in evaluating the
eect o alternative business strategies on risk e+posures6
7he simulation can be carried out under static and dynamic environment6
:hile the current on and o1balance sheet positions are evaluated under static
environment5 the dynamic simulation builds in more detailed assumptions about
the uture course o interest rates and the une+pected changes in bank9s
business activity6
7he useulness o the simulation techni8ue depends on the structure o the
model5 validity o assumption5 technology support and technical e+pertise o
7he application o various techni8ues depends to a large e+tent on the 8uality
o data and the degree o automated system o operations6 7hus5 banks may
start #ith the gap or duration gap or simulation techni8ues on the basis o
availability o data5 inormation technology and technical e+pertise6 In any
case5 as suggested by R0I in the guidelines on $L% System5 banks should
start estimating the interest rate risk e+posure #ith the help o %aturity 'ap
approach6 Once banks are comortable #ith the 'ap model5 they can
progressively graduate into the sophisticated approaches6
7u(-* Tra(*:er 4rici(0
7he 7ranser Pricing mechanism being ollo#ed by many banks does not
support good $L% Systems6 %any international banks #hich have dierent
products and operate in various geographic markets have been using internal
"unds 7ranser Pricing ("7P)6 "7P is an internal measurement designed to
assess the inancial impact o uses and sources o unds and can be used to
evaluate the proitability6 It can also be used to isolate returns or various risks
assumed in the intermediation process6 "7P also helps correctly identiy the
cost o opportunity value o unds6 $lthough banks have adopted various "7P
rame#orks and techni8ues5 %atched "unds Pricing (%"P) is the most eicient
techni8ue6 %ost o the international banks use %"P6 7he "7P envisages
assignment o speciic assets and liabilities to various unctional units (proit
centres) J lending5 investment5 deposit taking and unds management6 2ach
unit attracts sources and uses o unds6 7he lending5 investment and deposit
taking proit centres sell their liabilities to and buys unds or inancing their
assets rom the unds management proit centre at appropriate transer prices6
7he transer prices are i+ed on the basis o a single curve (%I0OR or derived
cash curve5 etc) so that asset1liability transactions o identical attributes are
assigned identical transer prices6 7ranser prices could5 ho#ever5 vary
according to maturity5 purpose5 terms and other attributes6
7he "7P provides or allocation o margin (ranchise and credit spreads) to
proit centres on original transer rates and any residual spread (mismatch
spread) is credited to the unds management proit centre6 7his spread is the
result o accumulated mismatches6 7he margins o various proit centres areB
Dep'*it pr':it ce(tre<
7ranser Price (7P) on deposits 1 cost o deposits J deposit insurance1
Le(-i(0 pr':it ce(tre<
Loan yields S 7P on deposits J 7P on loan inancing J cost o deposits J
deposit insurance 1 overheads J loan loss provisions6
I(ve*tme(t pr':it ce(tre<
Security yields S 7P on deposits J 7P on security inancing J cost o
deposits J deposit insurance 1 overheads J provisions or depreciation in
investments and loan loss6
7u(-* Ma(a0eme(t pr':it ce(tre<
7P on unds lent J 7P on unds borro#ed J Statutory Reserves cost J
"or illustration5 let us assume that a bank9s Feposit proit centre has raised
a 3 month deposit U 365P p6a6 and that the alternative unding cost i6e6
%I0OR or 3 months and one year U -P and */65P p6a65 respectively6 Let
us also assume that the bank9s Loan proit centre created a one year
loan U *365P p6a6 7he ranchise (liability)5 credit and mismatch spreads o
bank is as underB
Proit !entres T'ta)
Feposit "unds Loan
Interest Income -6/ */65 *365 *365
Interest 2+penditure 365 -6/ */65 365
%argin *65 ,65 36/ &6/
Loan Loss Provision (e+pected) 1 1 *6/ *6/
Feposit Insurance /6* 1 1 /6*
Reserve !ost (!RR@ SLR) 1 *6/ 1 *6/
Overheads /63 /65 /63 *6&
/6- *6/ *64 36,
<nder the "7P mechanism5 the proit centres (other than unds management)
are precluded rom assuming any unding mismatches and thereby e+posing
them to market risk6 7he credit or counterparty and price risks are5 ho#ever5
managed by these proit centres6 7he entire market risks5 i6e interest rate5
li8uidity and ore+ are assumed by the unds management proit centre6
7he "7P allo#s lending and deposit raising proit centres determine their
e+penses and price their products competitively6 Lending proit centre #hich
kno#s the carrying cost o the loans needs to ocus on to price only the spread
necessary to compensate the perceived credit risk and operating e+penses6
7hus5 "7P system could eectively be used as a #ay to centralise the bank9s
overall market risk at one place and #ould support an eective $L% modelling
system6 "7P also could be used to enhance corporate communication? greater
line management control and solid base or re#arding line management6
7he risk inherent in running open oreign e+change positions have been
heightened in recent years by the pronounced volatility in ore+ rates5 thereby
adding a ne# dimension to the risk proile o banks9 balance sheets6
"ore+ risk is the risk that a bank may suer losses as a result o adverse
e+change rate movements during a period in #hich it has an open position5
either spot or or#ard5 or a combination o the t#o5 in an individual oreign
currency6 7he banks are also e+posed to interest rate risk5 #hich arises rom
the maturity mismatching o oreign currency positions6 2ven in cases #here
spot and or#ard positions in individual currencies are balanced5 the maturity
pattern o or#ard transactions may produce mismatches6 $s a result5 banks
may suer losses as a result o changes in premia@discounts o the currencies
In the ore+ business5 banks also ace the risk o deault o the counter parties
or settlement risk6 :hile such type o risk crystallisation does not cause
principal loss5 banks may have to undertake resh transactions in the cash@spot
market or replacing the ailed transactions6 7hus5 banks may incur
replacement cost5 #hich depends upon the currency rate movements6 0anks
also ace another risk called time1;one risk or .erstatt risk #hich arises out o
time1lags in settlement o one currency in one centre and the settlement o
another currency in another time1;one6 7he ore+ transactions #ith counter
parties rom another country also trigger sovereign or country risk6
7'rex ,i*9 Ma(a0eme(t Mea*ure*
*6 Set appropriate limits J open positions and gaps6
,6 !lear1cut and #ell1deined division o responsibility bet#een ront5 middle
and back oices6
7he top management should also adopt the MaR approach to measure the risk
associated #ith e+posures6 Reserve 0ank o India has recently introduced t#o
statements vi;6 %aturity and Position (%$P) and Interest Rate Sensitivity (SIR)
or measurement o ore+ risk e+posures6 0anks should use these statements
or periodical monitoring o ore+ risk e+posures6
Capita) :'r Mar9et ,i*9
7he 0asle !ommittee on 0anking Supervision (0!0S) had issued
comprehensive guidelines to provide an e+plicit capital cushion or the price
risks to #hich banks are e+posed5 particularly those arising rom their trading
activities6 7he banks have been given le+ibility to use in1house models based
on MaR or measuring market risk as an alternative to a standardised
measurement rame#ork suggested by 0asle !ommittee6 7he internal models
should5 ho#ever5 comply #ith 8uantitative and 8ualitative criteria prescribed by
0asle !ommittee6
Reserve 0ank o India has accepted the general rame#ork suggested by the
0asle !ommittee6 R0I has also initiated various steps in moving to#ards
prescribing capital or market risk6 $s an initial step5 a risk #eight o ,65P has
been prescribed or investments in 'overnment and other approved securities5
besides a risk #eight each o *//P on the open position limits in ore+ and
gold6 R0I has also prescribed detailed operating guidelines or $sset1Liability
%anagement System in banks6 $s the ability o banks to identiy and measure
market risk improves5 it #ould be necessary to assign e+plicit capital charge or
market risk6 In the mean#hile5 banks are advised to study the 0asle
!ommittee9s paper on LOvervie# o the $mendment to the !apital $ccord to
Incorporate %arket Risks9 J Canuary *==3 (copy enclosed)6 :hile the small
banks operating predominantly in India could adopt the standardised
methodology5 large banks and those banks operating in international markets
should develop e+pertise in evolving internal models or measurement o
market risk6
7he 0asle !ommittee on 0anking Supervision proposes to develop capital
charge or interest rate risk in the banking book as #ell or banks #here the
interest rate risks are signiicantly above average (Loutliers9)6 7he !ommittee is
no# e+ploring various methodologies or identiying Loutliers9 and ho# best to
apply and calibrate a capital charge or interest rate risk or banks6 Once the
!ommittee inalises the modalities5 it may be necessary5 at least or banks
operating in the international markets to comply #ith the e+plicit capital charge
re8uirements or interest rate risk in the banking book6
Operati'(a) ,i*9
%anaging operational risk is becoming an important eature o sound risk
management practices in modern inancial markets in the #ake o phenomenal
increase in the volume o transactions5 high degree o structural changes and
comple+ support systems6 7he most important type o operational risk involves
breakdo#ns in internal controls and corporate governance6 Such breakdo#ns
can lead to inancial loss through error5 raud5 or ailure to perorm in a timely
manner or cause the interest o the bank to be compromised6
'enerally5 operational risk is deined as any risk5 #hich is not categoried as
market or credit risk5 or the risk o loss arising rom various types o human or
technical error6 It is also synonymous #ith settlement or payments risk and
business interruption5 administrative and legal risks6 Operational risk has some
orm o link bet#een credit and market risks6 $n operational problem #ith a
business transaction could trigger a credit or market risk6
7here is no uniormity o approach in measurement o operational risk in the
banking system6 0esides5 the e+isting methods are relatively simple and
e+perimental5 although some o the international banks have made
considerable progress in developing more advanced techni8ues or allocating
capital #ith regard to operational risk6
%easuring operational risk re8uires both estimating the probability o an
operational loss event and the potential si;e o the loss6 It relies on risk actor
that provides some indication o the likelihood o an operational loss event
occurring6 7he process o operational risk assessment needs to address the
likelihood (or re8uency) o a particular operational risk occurring5 the
magnitude (or severity) o the eect o the operational risk on business
objectives and the options available to manage and initiate actions to reduce@
mitigate operational risk6 7he set o risk actors that measure risk in each
business unit such as audit ratings5 operational data such as volume5 turnover
and comple+ity and data on 8uality o operations such as error rate or measure
o business risks such as revenue volatility5 could be related to historical loss
e+perience6 0anks can also use dierent analytical or judgmental techni8ues to
arrive at an overall operational risk level6 Some o the international banks have
already developed operational risk rating matri+5 similar to bond credit rating6
7he operational risk assessment should be bank1#ide basis and it should be
revie#ed at regular intervals6 0anks5 over a period5 should develop internal
systems to evaluate the risk proile and assign economic capital #ithin the
R$RO! rame#ork6
Indian banks have so ar not evolved any scientiic methods or 8uantiying
operational risk6 In the absence any sophisticated models5 banks could evolve
simple benchmark based on an aggregate measure o business activity such
as gross revenue5 ee income5 operating costs5 managed assets or total assets
adjusted or o1balance sheet e+posures or a combination o these variables6
,i*9 M'(it'ri(0
7he operational risk monitoring system ocuses5 inter alia5 on operational
perormance measures such as volume5 turnover5 settlement acts5 delays and
errors6 It could also be incumbent to monitor operational loss directly #ith an
analysis o each occurrence and description o the nature and causes o the
C'(tr') ': Operati'(a) ,i*9
Internal controls and the internal audit are used as the primary means to
mitigate operational risk6 0anks could also e+plore setting up operational risk
limits5 based on the measures o operational risk6 7he contingent processing
capabilities could also be used as a means to limit the adverse impacts o
operational risk6 Insurance is also an important mitigator o some orms o
operational risk6 Risk education or amiliarising the comple+ operations at all
levels o sta can also reduce operational risk6
4')icie* a(- 4r'ce-ure*
0anks should have #ell deined policies on operational risk management6 7he
policies and procedures should be based on common elements across
business lines or risks6 7he policy should address product revie# process5
involving business5 risk management and internal control unctions6
I(ter(a) C'(tr')
One o the major tools or managing operational risk is the #ell1established
internal control system5 #hich includes segregation o duties5 clear
management reporting lines and ade8uate operating procedures6 %ost o the
operational risk events are associated #ith #eak links in internal control
systems or la+ity in complying #ith the e+isting internal control procedures6
7he ideal method o identiying problem spots is the techni8ue o sel1
assessment o internal control environment6 7he sel1assessment could be
used to evaluate operational risk along#ith internal@e+ternal audit
reports@ratings or R0I inspection indings6 0anks should endeavour or
detection o operational problem spots rather than their being pointed out by
supervisors@internal or e+ternal auditors6
$long#ith activating internal audit systems5 the $udit !ommittees should play
greater role to ensure independent inancial and internal control unctions6
7he 0asle !ommittee on 0anking Supervision proposes to develop an e+plicit
capital charge or operational risk6
,i*9 A00re0ati'( a(- Capita) A))'cati'(
%ost o internally active banks have developed internal processes and
techni8ues to assess and evaluate their o#n capital needs in the light o their
risk proiles and business plans6 Such banks take into account both 8ualitative
and 8uantitative actors to assess economic capital6 7he 0asle !ommittee no#
recognises that capital ade8uacy in relation to economic risk is a necessary
condition or the long1term soundness o banks6 7hus5 in addition to complying
#ith the established minimum regulatory capital re8uirements5 banks should
critically assess their internal capital ade8uacy and uture capital needs on the
basis o risks assumed by individual lines o business5 product5 etc6 $s a part o
the process or evaluating internal capital ade8uacy5 a bank should be able to
identiy and evaluate its risks across all its activities to determine #hether its
capital levels are appropriate6
7hus5 at the bank9s .ead Oice level5 aggregate risk e+posure should receive
increased scrutiny6 7o do so5 ho#ever5 it re8uires the summation o the
dierent types o risks6 0anks5 across the #orld5 use dierent #ays to estimate
the aggregate risk e+posures6 7he most commonly used approach is the Risk
$djusted Return on !apital (R$RO!)6 7he R$RO! is designed to allo# all the
business streams o a inancial institution to be evaluated on an e8ual ooting6
2ach type o risks is measured to determine both the e+pected and une+pected
losses using MaR or #orst1case type analytical model6 Rey to R$RO! is the
matching o revenues5 costs and risks on transaction or portolio basis over a
deined time period6 7his begins #ith a clear dierentiation bet#een e+pected
and une+pected losses6 2+pected losses are covered by reserves and
provisions and une+pected losses re8uire capital allocation #hich is determined
on the principles o conidence levels5 time hori;on5 diversiication and
correlation6 In this approach5 risk is measured in terms o variability o income6
<nder this rame#ork5 the re8uency distribution o return5 #herever possible is
estimated and the Standard Feviation (SF) o this distribution is also estimated6
!apital is thereater allocated to activities as a unction o this risk or volatility
measure6 7hen5 the risky position is re8uired to carry an e+pected rate o
return on allocated capital5 #hich compensates the bank or the associated
incremental risk6 0y dimensioning all risks in terms o loss distribution and
allocating capital by the volatility o the ne# activity5 risk is aggregated and
7he second approach is similar to the R$RO!5 but depends less on capital
allocation and more on cash lo#s or variability in earnings6 7his is reerred to
as 2aR5 #hen employed to analyse interest rate risk6 <nder this analytical
rame#ork also re8uency distribution o returns or any one type o risk can be
estimated rom historical data6 2+treme outcome can be estimated rom the tail
o the distribution6 2ither a #orst case scenario could be used or Standard
Feviation *@,@,63= could also be considered6 $ccordingly5 each bank can
restrict the ma+imum potential loss to certain percentage o past@current
income or market value6 7hereater5 rather than moving rom volatility o value
through capital5 this approach goes directly to current earnings implications
rom a risky position6 7his approach5 ho#ever5 is based on cash lo#s and
ignores the value changes in assets and liabilities due to changes in market
interest rates6 It also depends upon a subjectively speciied range o the risky
environments to drive the #orst case scenario6
'iven the level o e+tant risk management practices5 most o Indian banks may
not be in a position to adopt R$RO! rame#ork and allocate capital to various
businesses units on the basis o risk6
So on the basis o the data provided to us #e can say that the banks are not
strictly ollo#ing the $L% 'uidelines6
$L!O should keep a vigil on the #orking o the banks and ensure
that all the guidelines are met6
R0I should sho# the banks as to ho# the banks can beneit by
ollo#ing their guidelines6
$ll the banks should provide complete inormation so that there is
more transparency6
Re&ort9 A Roa! +a& *or I+&le+enting an Integrate! Ri5 Manage+ent
$%te+ '% In!ian =an5 '% Mar 1227 >CRI$IL? in I=A =ulletin >Dan
Reerve =an5 o* In!ia, Re&ort on Tren! an! &rogre o* =an5ing in
In!ia >variou %ear?,
Annual Re&ort o* all 'an5 >1224C27?,
I=A =ulletin >Mar 1220, Mar 1224?,
Ee'ite o* all 'an5 tu!ie!,