Risks in the Banking

Sector
Deepak Bhandari
 What is Risk?

Threats

Risk
Vulnerabilities Assets

Risk= Threat X Vulnerability X Cost of

the Asset
 Three major components of
Risk
Vulnerability Threat Assets

►Opportunity for ►Source and the means ►Tangible or intangible

a threat to be realized by which a particular item of significant
attack business
►Gateways through which can be carried out value
threats can be manifested
►Expose the ►Amount of damage that
vulnerabilities the item will cause if
►Can be exploited by an
of the organization destroyed/affected is to
event, a person or a
be
business process
►Broadly classified as desirably kept low
►Man-made
(intentional) ►Damage to these assets
►Natural may cause major business
disaster disruption
►Accidental
(unintentional )

►
 Defining Risk

Uncertai
nty of
►Factor
loss
►Can be
financial or
reputational or
both

Risk Types
►Financial
►Strategic
Threat
Realized ►Operational Relative
►Compliance Impact
ntial that a threat will be realized for a vulnerability ►Relative
impact
level of
exploited
vulnerability
on businesses
Dealing with Risk Exposure:
The 4Ts
Terminate

Transfer
Text Ris
k
Tolerate

Treat
 Types of Risks
Key considerations for management

►Planning and resource What are our key risks?

allocation
►Major initiatives Are we focused on the risks that matter?

Strategic ►Mergers , acquisition and

divestures
►Market dynamics
►Communication and investor
relations
Who is accountable for the key risks?


►Sales and marketing Are resources aligned to our risk profile?



►Supply chain
Operation ►People
al ►Information Technology
►Hazards
►Physical assets
►
►
Are we accepting an appropriate level of risk?


►Market
Are we receiving a fair return on that risk?


►Liquidity and credit

►Accounting and reporting
Financial ►Tax
►Capital structure

Who is monitoring the significant risks?



How are we improving key controls?


►Governance
Complianc ►Code of conduct
►Legal
e ►Regulatory
Top Risks: 2010

Source : Ernst & Young Global Research , 2010

 Changing Risk Scenario post
Economic Downturn
• Dramatic loss of liquidity experienced
during the financial crisis.
• Forward looking approach to risk critical
• Developing a blended set of both risk-
based and financial performance
indicators
– Taking into account both historical and
forward-looking factors
• Improved risk management for
providing a holistic approach to risk
across the enterprise
– Risk forecasting and stress testing
Section 1

Market Risks
 Market Risk
• Defined as the possibility of loss to bank caused
by the changes in the market variables.
• Risk that the value of on-/off-balance sheet
positions will be adversely affected by
movements in equity and interest rate markets,
currency exchange rates and commodity
prices.
• Risk to the bank’s earnings and capital due to
changes in the market level of interest rates or
prices of securities, foreign exchange and
equities, as well as the volatilities, of those
prices.
• Types Of Market Risk
– Liquidity Risk
– Interest Rate Risk
– Forex Risk
 Liquidity Risk (1/2)
• Liquidity is the ability to efficiently accommodate
deposit as also reduction in liabilities and to
fund the loan growth and possible funding of
the off-balance sheet claims.
• Liquidity risk consists of Funding Risk, Time Risk
& Call Risk.
• Funding Risk
– It is the need to replace net out flows due to
unanticipated withdrawal/nonrenewal of
deposit.
• Time risk
– It is the need to compensate for non receipt
of expected inflows of funds, i.e.
performing assets turning into
nonperforming assets.
• Call risk
 Liquidity Risk (2/2)
• The Asset Liability Management (ALM)
– It implies examination of all the assets and
liabilities simultaneously on a continuous
basis with a view to ensuring a proper
balance between funds mobilization and
their deployment with respect to their a)
maturity profiles, b) cost, c) yield, d) risk
exposure, etc


–
 Interest Rate Risk
• Changes in interest rate affect earnings, value of
assets, liability off-balance sheet items and
cash flow.
• The types of Interest Rate Risk are :
– Gap/Mismatch risk:
– Basis Risk
– Embedded option Risk
– Yield curve risk
– Reprice risk
– Reinvestment risk
– Net interest position risk
• Different techniques such as a) the traditional
Maturity Gap Analysis to measure the interest
rate sensitivity, b) Duration Gap Analysis to
measure interest rate sensitivity of capital, c)
simulation and d) Value at Risk for
 Forex Risk
• Foreign exchange risk is the risk that a bank may
suffer loss as a result of adverse exchange rate
movement during a period in which it has an
open position, either spot or forward or both in
same foreign currency.
• Currency Risk is the possibility that exchange rate
changes will alter the expected amount of
principal and return of the lending or
investment.
• By setting appropriates limits-open position and
gaps, stop-loss limits, Day Light as well as
overnight limits for each currency, Individual
Gap Limits and Aggregate Gap Limits ,the risk
element in foreign exchange risk can be
managed/monitored.
 Country Risk
• This is the risk that arises due to cross border
transactions that are growing dramatically in
the recent years owing to economic
liberalization and globalization. It is the
possibility that a country will be unable to
service or repay debts to foreign lenders in
time.


• It comprises of
– Transfer Risk
– Sovereign Risk
– Political Risk
– Cross border risk
–
 Credit Risk (1/2)
• Credit Risk is the potential that a bank
borrower/counter party fails to meet
the obligations on agreed terms
• Credit risk is inherent to the business of
lending funds to the operations linked
closely to market risk variables
• The objective of credit risk
management is to minimize the risk
and maximize bank’s risk adjusted
rate of return by assuming and
maintaining credit exposure within
the acceptable parameters
•
 Credit Risk (2/2)
Credit risk consists of primarily two components:-


– Quantity of risk
– Severity of loss


Credit risk is a combined outcome of :-



– Default Risk
– Exposure Risk


The elements of Credit Risk is :-



– Portfolio risk comprising Concentration Risk as well

as Intrinsic Risk
– Transaction Risk comprising migration/down
gradation risk as well as Default Risk
 Tools of Credit Risk Management


The instruments and tools, through which

credit risk
management is carried out, are detailed

below:-
►Exposure Ceilings
►Review/Renewal
►Risk Rating Model
►Risk based scientific pricing
►Portfolio Management
►Loan Review Mechanism
 Risk Rating Model
Credit Audit is conduced on site, i.e. at the
branch
that has appraised the advance and where

the main
operative limits are made available

The model may consist of minimum of six

grades for
performing and two grades for non-

performing assets
The need for the adoption of the credit risk-
rating model is
on account of the following aspects

► Disciplined way of looking at Credit Risk

► Reasonable estimation of the overall health status of an
account captured under Portfolio approach
► Impact of a new loan asset on the portfolio can be
assessed
► The co-relation or co-variance between different sectors
of portfolio measures the inter relationship between
assets
► Concentration risks are measured in terms of additional
portfolio risk arising on account of increased exposure
to a borrower/group or co-related borrowers.
► Need for Relationship Manager to capture, monitor and
control the over all exposure to high value customers
► Active approach of credit portfolio management
► Pricing of credit risk on a scientific basis linking the loan
price to the risk involved therein
Exposure risk is the loss of amount outstanding at the time of
default as reduced
by the recoverable amount.

 The loss in case of default is D* X * (I-R)

 Where D is Default percentage, X is the Exposure Value
 and R is the recovery rate


 Credit Risk is measured through :-

– Probability of Default (POD) and
– Loss Given Default (LGD)


 Exposure at Default (EaD):-bank’s exposure to the borrower at

the time of default


ELGD:- The extent of provisioning required could be estimated

from the expected
Loss Given Default(ELGD)

 ELGD = POD x LGD x EaD

Section 2

Operational Risks
 Operational Risks
• Operational risk, though defined as any risk that is not categorized
as market or credit risk, is the risk of loss arising from
inadequate or failed internal processes, people and systems or
from external events.
•
• Banks live with the risks arising out of Human errors, Financial
fraud, Natural Disasters.
•
• Exponential growth in the use of technology and increase in global
financial inter linkages are the two primary changes that
contributed to such risks.
•
• Operational risk events are associated with weak links in internal
control procedures.
•
• Operational risk involves breakdown in internal controls and
corporate governance leading to error, fraud, performance
failure, compromise on the interest of the bank resulting in
 Operational Risk
Management
• In order to mitigate this, internal control and internal audit
systems are used as the primary means.

•
• Risk education for familiarizing the complex operations at all
levels of staff can also reduce operational risk.

•
• Putting in place proper corporate governance practices by itself
would serve as an effective risk management tool.

•
• While measurement of operational risk and computing capital
charges as envisaged in the Basel proposals are to be the
ultimate goals, what is to be done at present is start
implementing the Basel proposal in a phased manner and
carefully plan in that direction.

•
• The incentive for banks to move the measurement chain is not just
Section 3

Regulatory Risks
 Regulatory Risks
• Many Banks, having already gone for public issue, have a
greater responsibility and accountability.

•
• As banks deal with public funds and money, they are
subject to various regulations.

•
• The very many regulators include Reserve Bank of India
(RBI), Securities Exchange Board of India (SEBI),
Department of Company Affairs (DCA), etc.

•
• More over, banks should ensure compliance of the
applicable provisions of The Banking Regulation Act, The
Companies Act, etc.

•
• Thus all the banks run the risk of multiple regulatory-risk
 Regulatory Risk
Management



Banks should learn the art of
playing their business activities
within the regulatory controls.
Section 4

Environmental Risks
 Environmental Risk
• With the economic liberalization and
globalization, more national and
international players are operating
the financial markets, particularly
in the banking field.


• This provides the platform for

environmental change and exposes
the bank to the environmental risk.
•
 Environmental Risk
Management


 Unless the banks improve their

delivery channels, reach customers,
innovate their products that are
service oriented, they are exposed to
the environmental risk resulting in
loss in business share with
consequential profit.

Section 5

Case Study : ICICI Bank

 ICICI Bank Risk
Management
• Primarily exposed to credit risk, market
risk, liquidity risk, operational risk and
legal risk.
• Central Risk, Compliance and Audit
Group is responsible for risk
management
• Risk, Compliance and Audit Group is
organized into six subgroups:
– Credit Risk Management, Market Risk
Management, Analytics, Internal Audit,
Retail Risk Management and Credit
Policies and Reserve Bank of India
Inspection
Reporting Hierarchy
Credit Risk Market Risk Analytics Internal Retail Credit
Mgmt Mgmt Audit Risk Mgmt Policies

Borrower Developing & Development Comprehensive Approval of Formulation of

credit implementing of coverage of retail credit
ratings market risk proprietary operational policies policies
measurement models risk inherent and and ensuring
Methodologies for risk in all areas procedures compliance
measurement of business

Sectoral Approval of all Initiation of Impact of Coordinating

analysis and new products systems macro Reserve Bank
review audit in economic of
information changes on India
technology- the inspections
intensive retail
areas portfolio

Credit Monitoring Portfolio

portfolio market review
analysis risk exposures and
monitoring
 Credit Risk
• Structured and standardized credit approval
process involves:


– Credit Risk Assessment Procedure for

Corporate Loans
– Project Finance Procedures
– Corporate Finance Procedures
– Working Capital Finance Procedures
– Credit Monitoring Procedures for Corporate
Loans
– Retail Loan Procedures
– Small Enterprises Loan Procedures
– Investment Banking Procedures
 Market Risk
• Exposure to loss arising from
changes in the value of a financial
instrument as a result of changes in
market variables such as interest
rates, exchange rates and other
asset prices
 Interest Rate Risk
• Asset-liability gap position:
•
 Interest Rate Risk
• Impact of adverse changes in interest rate
•
•
•
•
•
• Based on the asset and liability position at
year-end fiscal 2003, the sensitivity model
shows that net interest income from the
banking book for fiscal 2004 would fall by
Rs. 174 million (US$ 4 million) if interest
rates increased by 100 basis points during
 Price Risk
• Rupee Fixed Income Trading Portfolio
•
•
•
•
•
• The sensitivity model shows that if
interest rates increase by 100 basis
points during fiscal 2004, the value of
the trading portfolio, would fall by Rs.
1.6 billion (US$ 34 million).
 Exchange Rate Risk
• Use cross currency swaps, forwards,
and options to hedge against
exchange risks arising out of foreign
currency hedging transactions
• Trading activities in the foreign currency
markets expose the bank to exchange
rate risks. This risk is mitigated by
setting counterparty limits, stipulating
daily and cumulative stop-loss limits,
and engaging in exception reporting.
• In addition, foreign currency loans are
made on terms that are similar to
foreign currency borrowings
 Liquidity Risk
• The goal of liquidity management is to
be able, even under adverse
conditions, to meet all liability
repayments on time, to meet
contingent liabilities, and fund all
investment opportunities.
• The bank funds operations principally
by accepting deposits from retail and
corporate depositors and through
public issuance of bonds.
• They also borrow in the short-term
 Operational Risk (1/2)
• ICICI Bank is exposed to many types
of operational risk.
• They can result from a variety of
factors, including failure to obtain
proper internal authorizations,
improperly documented
transactions, failure of operational
and information security
procedures, computer systems,
software or equipment, fraud,
inadequate training and employee
errors.
 Operational Risk (2/2)
• ICICI Bank attempts to mitigate
operational risk by maintaining a
comprehensive system of internal
controls, establishing systems and
procedures to monitor transactions,
maintaining key back–up procedures
and undertaking regular contingency
planning. Eg:
– Operational Controls and Procedures for
Internet Banking
– Operational Controls and Procedures in
Regional Processing Centers & Central
Processing Centers
– Operational Controls and Procedures in
 Legal Risk
• The uncertainty of the enforceability of
the obligations of ICICI Bank’s
customers and counterparties,
including the foreclosure on collateral,
creates legal risk.
• ICICI Bank seeks to minimize legal risk
by using stringent legal
documentation, employing
procedures designed to ensure that
transactions are properly authorized
and consulting internal and external
Thank You!