Risk Management in Banks

By:RINI SINHA 12BSPHH010826

Risk in banking business

Banking business lines are many and varied

Corporate finance - mergers and acquisition underwriting and securitization Trading and sales Retail banking - private banking and card services Commercial banking

Payment and settlement Agency services Asset management Retail brokerage

The key driver in managing all the business lines are

enhancing risk adjusted expected returns

 From the risk management point of view banking

business lines may be grouped broadly under the following major heads

The banking book The trading book Off balance sheet exposure

 Banking book

Banking book includes all advances deposits which usually arise from commercial and retail banking operations All assets and liabilities in the banking book are normally held until maturity and accrual system of accounting is applied on them

The banking book is mainly exposed to liquidity risk , interest rate risk, default or credit risk and operational risk

Trading book
The trading book includes all the assets that are

marketed i.e. they can be traded in the market

They are normally not held until maturity and

positions are liquidated in the market after holding it for a period.

 Mark to market system is followed and the

difference between market price and book value taken to profit and loss account.
Trading book mostly comprises of fixed income

securities, equities, foreign exchange holdings, commodities, derivatives etc. held by the bank on its own account.

Off Balance Sheet Exposures

Off Balance Sheet Exposures are contingent in

nature, where banks issue guarantees, committed or back up credit lines or letters of credit etc.
Off Balance Sheet Exposures may become fund

based exposure based on certain contingencies.

Off Balance Sheet Exposures may have liquidity risk,

interest rate risk, market risk, default or credit risk and operational risk.

Liquidity risk
Liquidity risk in banks arises from funding of long

term assets by short term liabilities thereby making the liabilities subject to rollover or refinancing risk.
Funding liquidity risk is the inability to obtain funds to

meet cash flow obligation.

For banks funding liquidity risk is crucial.

The liquidity risk in banks visible in following

dimensions.

Funding risk - arises from the need to replace the net outflows due to unanticipated withdrawals / non renewal of deposits. Time risk - arises from the need to compensate for non receipt of expected inflow of funds i.e. performing assets turning into non performing assets. Call risk - arises due to crystallization of contingent liabilities.

Interest rate risks

Interest rate risk is the banks financial

exposure to adverse movement in interest rates.

IIR (interest rate risk) refers to volatility in NII

or variations NIM (net interest margin), i.e. NII divided earning assets due to changes in interest rates.

 In other words interest rate risk arises from holding

assets and liabilities with a different principal amounts, maturity dates or repricing dates that is rollover rates.
Interest rate risk is broadly classified into mismatch or

gap risk, basis risk, net interest position risk embedded option risk, yield curve risk, price risk and reinvestment risk

 Basis risk

The risk that the interest rate of different assets, liabilities and off balance sheet items may change in different magnitude is termed as basis risk. An example of basis risk would be say in rising interest rate scenario asset interest rate may rise in different magnitude than the interest rate on corresponding liability, creating variation in net interest income

 Reinvestment risk

Uncertainty with the regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.

 Market risk

Market risk is the risk of adverse deviation of a mark to market value of the trading portfolio due to market movements during the period required to liquidate the transaction. Market risk is the risk of adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities and currencies.

Market risk is also referred to as price risk. Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related.

The price risk is closely associated with trading book, which is created for making profits out of short term movements in interest rates.

 Default or credit risk

Credit risk is defined as the potential of a bank borrower or counter party to fail to meet its obligation in accordance with the agreed term. For most banks, loans are the largest and most obvious source of credit risk.

Counter party risk

This is a variant of credit risk and is related to non performance of the trading partners due to counter parties refusal and or inability to perform.

Country risk

This is also a type of credit risk where non performance by a borrower or a counter party arises due to constraints or restriction imposed by a country.

Here reason for non performance is an external factors on which the borrower or the counter party has no control.

 Operational risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. Operational risk includes transaction risk/fraud risk, communication risk, documentation risk, competence risk, model risk, cultural risk, external events risk, legal risks, regulatory risks, compliance risk, system risk etc.

Management of risk
Management of risks begins with identification. It is only after risks are identified and measured banks decide to

accept the risk or to accept the risk at reduced level by undertaking steps to mitigate the risk.
In addition pricing of the transaction should be in accordance

with the risk content of the transaction.

 Hence management of risk may be sub

divided into following 5 processes.

Risk identification Risk measurement Risk pricing Risk monitoring and control Risk mitigation

Risk Identification
Nearly all transactions undertaken would have one or

more of the major risk i.e. liquidity risk, interest rate risk, market risk, default or credit risk, and operational risk with their visibility in different dimensions.
Although all these risks are seen at the transaction

level, certain risks such as liquidity risk and interest rate risk are managed at the aggregate or portfolio level.

 Risks such as credit risk, operational risk and market

risk arising from individual transaction are taken note at transactional level as well as portfolio level.
Guidance for risk taking, therefore, at the transaction

level has to emanate from the corporate level.

In fact, the guidelines help in standardizing risk

content in the business undertaken at the transaction level.

 Risk identification consists of identifying various risk

associated with the risk taking at the transaction level and examining its impact on the portfolio and the capital requirement.
Risk content of a transaction is also instrumental in

pricing the exposure as risk adjusted return is the key driving force in management of banks.

Risk measurement
Risk management relies on quantitative

measures of risk.
The risk measures seek to capture variations

in earnings, market value, losses due to default etc (referred to as target variables), arising out of uncertainties associated with various risk elements.

Quantitative measures of risk can be classified into 3 categories

1. 2. 3.

Based on sensitivity Based on volatility Based on downside potential

Sensitivity captures deviation of a target variable due to unit movement of a single market parameter. E.g. change in market value due to 1% change in interest rate would be a sensitivity based measure.

Risk mitigation

Risk arise from uncertainties associated with the risk elements, risk reduction is achieved by adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is called risk mitigation. In banking a variety of financial instruments and number of techniques are used to mitigate risk. The techniques to mitigate different types of risk are different

Solutions
The banks senior management or board of

directors should, on a regular basis receive reports on banks risk profile and capital needs.
The banks conduct periodic reviews of its risk

management process to ensure its integrity, accuracy and reasonableness.

Identification of large exposures and risk

concentrations, accuracy and completeness of data input into the banks assessment process and stress testing and analysis of assumption and inputs are all part of control and monitoring process.