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Risk Management in Banking Sector.

INTRODUCTION

The significant transformation of the banking industry in India is clearly evident

from the changes that have occurred in the financial markets, institutions and products.

While deregulation has opened up new vistas for banks to argument revenues, it has

entailed greater competition and consequently greater risks. Cross- border flows and entry

of new products, particularly derivative instruments, have impacted significantly on the

domestic banking sector forcing banks to adjust the product mix, as also to effect rapid

changes in their processes and operations in order to remain competitive to the globalized

environment. These developments have facilitated greater choice for consumers, who

have become more discerning and demanding compelling banks to offer a broader range

of products through diverse distribution channels. The traditional face of banks as mere

financial intermediaries has since altered and risk management has emerged as their

defining attribute.

Currently, the most important factor shaping the world is globalization. The

benefits of globalization have been well documented and are being increasingly

recognized. Integration of domestic markets with international financial markets has been

facilitated by tremendous advancement in information and communications technology.

But, such an environment has also meant that a problem in one country can sometimesadversely impact one or more countries instantaneously, even if they are fundamentally

strong.

There is a growing realisation that the ability of countries to conduct business

across national borders and the ability to cope with the possible downside risks would

depend, interalia, on the soundness of the financial system. This has consequently meantthe adoption of a strong and transparent, prudential, regulatory, supervisory, technological

and institutional framework in the financial sector on par with international best practices.

All this necessitates a transformation: a transformation in the mindset, a transformation in

the business processes and finally, a transformation in knowledge management. This

process is not a one shot affair; it needs to be appropriately phased in the least disruptive

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manner.

The banking and financial crises in recent years in emerging economies have

demonstrated that, when things go wrong with the financial system, they can result in a

severe economic downturn. Furthermore, banking crises often impose substantial costs on

the exchequer, the incidence of which is ultimately borne by the taxpayer. The World

Bank Annual Report (2002) has observed that the loss of US $1 trillion in banking crisis

in the 1980s and 1990s is equal to the total flow of official development assistance to

developing countries from 1950s to the present date. As a consequence, the focus of

financial market reform in many emerging economies has been towards increasing

efficiency while at the same time ensuring stability in financial markets.

From this perspective, financial sector reforms are essential in order to avoid such

costs. It is, therefore, not surprising that financial market reform is at the forefront of

public policy debate in recent years. The crucial role of sound financial markets in

promoting rapid economic growth and ensuring financial stability. Financial sector

reform, through the development of an efficient financial system, is thus perceived as a

key element in raising countries out of their 'low level equilibrium trap'. As the World

Bank Annual Report (2002) observes, a robust financial system is a precondition for a

sound investment climate, growth and the reduction of poverty .

Financial sector reforms were initiated in India a decade ago with a view to

improving efficiency in the process of financial intermediation, enhancing the

effectiveness in the conduct of monetary policy and creating conditions for integration of

the domestic financial sector with the global system. The first phase of reforms was

guided by the recommendations of Narasimham Committee.

The approach was to ensure that the financial services industry operates on the

basis of operational flexibility and functional autonomy with a view to enhancing

efficiency, productivity and profitability'.

The second phase, guided by Narasimham Committee II, focused on strengthening

the foundations of the banking system and bringing about structural

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improvements. Further intensive discussions are held on important issues related

to corporate governance, reform of the capital structure, (in the context of Basel II

norms), retail banking, risk management technology, and human resources

development, among others.

Since 1992, significant changes have been introduced in the Indian financial system.

These changes have infused an element of competition in the financial system, marking

the gradual end of financial repression characterized by price and non-price controls in the

process of financial intermediation. While financial markets have been fairly developed,

there still remains a large extent of segmentation of markets and non-level playing field

among participants, which contribute to volatility in asset prices. This volatility is

exacerbated by the lack of liquidity in the secondary markets. The purpose of this paper is

to highlight the need for the regulator and market participants to recognize the risks in the

financial system, the products available to hedge risks and the instruments, including

derivatives that are required to be developed/introduced in the Indian system.

The financial sector serves the economic function of intermediation by ensuring

efficient allocation of resources in the economy. Financial intermediation is enabled

through a four-pronged transformation mechanism consisting of liability-asset

transformation, size transformation, maturity transformation and risk transformation.

Risk is inherent in the very act of transformation. However, prior to reform of

1991-92, banks were not exposed to diverse financial risks mainly because interest rates

were regulated, financial asset prices moved within a narrow band and the roles of

different categories of intermediaries were clearly defined. Credit risk was the major risk

for which banks adopted certain appraisal standards.

Several structural changes have taken place in the financial sector since 1992. Theoperating environment has undergone a vast change bringing to fore the critical

importance of managing a whole range of financial risks. The key elements of this

transformation process have been

1. The deregulation of coupon rate on Government securities.

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2. Substantial liberalization of bank deposit and lending rates.

3. A gradual trend towards disintermediation in the financial system in the wake of

increased access of corporates to capital markets.

4. Blurring of distinction between activities of financial institutions.

5. Greater integration among the various segments of financial markets and their

increased order of globalisation, diversification of ownership of public sector

banks.

6. Emergence of new private sector banks and other financial institutions, and,

7. The rapid advancement of technology in the financial system.

CHAPTER -1

INTRODUCTION TO RISK

"What is risk?" And what is a pragmatic definition of risk? Risk means different

things to different people. For some it is "financial (exchange rate, interest-call money

rates), mergers of competitors globally to form more powerful entities and not leveraging

IT optimally" and for someone else "an event or commitment which has the potential to

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generate commercial liability or damage to the brand image". Since risk is accepted in

business as a trade off between reward and threat, it does mean that taking risk bring forth

benefits as well. In other words it is necessary to accept risks, if the desire is to reap the

anticipated benefits.

Risk in its pragmatic definition, therefore, includes both threats that can materialize

and opportunities, which can be exploited. This definition of risk is very pertinent today as

the current business environment offers both challenges and opportunities to organizations,

and it is up to an organization to manage these to their competitive advantage.

What is Risk Management - Does it eliminate risk?

Risk management is a discipline for dealing with the possibility that some future

event will cause harm. It provides strategies, techniques, and an approach to recognizing

and confronting any threat faced by an organization in fulfilling its mission. Risk

management may be as uncomplicated as asking and answering three basic questions:

1. What can go wrong?

2. What will we do (both to prevent the harm from occurring and in the aftermath of

an "incident")?

3. If something happens, how will we pay for it?

Risk management does not aim at risk elimination, but enables the organization to

bring their risks to manageable proportions while not severely affecting their income. This

balancing act between the risk levels and profits needs to be well-planned. Apart from

bringing the risks to manageable proportions, they should also ensure that one risk does not

get transformed into any other undesirable risk. This transformation takes place due to the

inter-linkage present among the various risks. The focal point in managing any risk will be

to understand the nature of the transaction in a way to unbundled the risks it is exposed to.

Risk Management is a more mature subject in the western world. This is largely a

result of lessons from major corporate failures, most telling and visible being the Barings

collapse. In addition, regulatory requirements have been introduced, which expect

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organizations to have effective risk management practices. In India, whilst risk

management is still in its infancy, there has been considerable debate on the need to

introduce comprehensive risk management practices.

Objectives of Risk Management Function

Two distinct viewpoints emerge

One which is about managing risks, maximizing profitability and creating

opportunity out of risks

And the other which is about minimizing risks/loss and protecting corporate assets.

The management of an organization needs to consciously decide on whether they

want their risk management function to 'manage' or 'mitigate' Risks.

Managing risks essentially is about striking the right balance between risks and

controls and taking informed management decisions on opportunities and threats

facing an organization. Both situations, i.e. over or under controlling risks are

highly undesirable as the former means higher costs and the latter means possible

exposure to risk.

Mitigating or minimizing risks, on the other hand, means mitigating all risks even if

the cost of minimizing a risk may be excessive and outweighs the cost-benefit

analysis. Further, it may mean that the opportunities are not adequately exploited.

In the context of the risk management function, identification and management of

Risk is more prominent for the financial services sector and less so for consumer products

industry. What are the primary objectives of your risk management function? When

specifically asked in a survey conducted, 33% of respondents stated that their risk

management function is indeed expressly mandated to optimise risk.

Risks in Banking

Risks manifest themselves in many ways and the risks in banking are a result of

many diverse activities, executed from many locations and by numerous people. As a

financial intermediary, banks borrow funds and lend them as a part of their primary

activity. This intermediation activity, of banks exposes them to a host of risks. The

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volatility in the operating environment of banks will aggravate the effect of the various

risks. The case discusses the various risks that arise due to financial intermediation and by

highlighting the need for asset-liability management; it discusses the Gap Model for risk

management.

Typology of Risk Exposure

Based on the origin and their nature, risks are classified into various categories. The

most prominent financial risks to which the banks are exposed to taking into consideration

practical issues including the limitations of models and theories, human factor, existence of

frictions such as taxes and transaction cost and limitations on quality and quantity of

information, as well as the cost of acquiring this information, and more.

CHAPTER 2

RISK IN BANKING BUSINESS

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FINANCIAL RISKS


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8

MARKET

RISK

LIQUIDITY

RISK

OPERATIONAL

RISK

HUMAN

FACTOR RISK

CREDIT RISK LEGAL &

REGULATORY RISK

FUNDING

LIQUIDITYRISKTRADING

LIQUIDITY RISK

TRANSACTION

RISK

PORTFOLIO

CONCENTRATION

ISSUE RISK ISSUER RISK COUNTERPARTY

RISK

EQUITY RISK INEREST

RATE RISK

CURRENCY

RISK

COMMODITY

RISK

TRADING

RISK

GAP RISK

GENERAL

MARKET RISK

SPECIFIC

RISK


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LIQUIDITY RISK

Liquidity risk comprises both

Funding liquidity risk

Trading-related liquidity risk.

Funding liquidity risk relates to a financial institutions ability to raise the necessary

cash to roll over its debt, to meet the cash, margin, and collateral requirements of

counterparties, and (in the case of funds) to satisfy capital withdrawals. Funding liquidity

risk is affected by various factors such as the maturities of the liabilities, the extent of

reliance of secured sources of funding, the terms of financing, and the breadth of funding

sources, including the ability to access public market such as commercial paper market.

Funding can also be achieved through cash or cash equivalents, buying power, and

available credit lines.

Trading-related liquidity risk, often simply called as liquidity risk, is the risk that an

institution will not be able to execute a transaction at the prevailing market price because

there is, temporarily, no appetite for the deal on the other side of the market. If the

transaction cannot be postponed its execution my lead to substantial losses on position.

This risk is generally very hard to quantify. It may reduce an institutions ability to manage

and hedge market risk as well as its capacity to satisfy any shortfall on the funding side

through asset liquidation.

LEGAL RISK

Legal risk arises for a whole of variety of reasons. For example, counterparty might

lack the legal or regulatory authority to engage in a transaction. Legal risks usually only

become apparent when counterparty, or an investor, lose money on a transaction and

decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk

is the potential impact of a change in tax law on the market value of a position.

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HUMAN FACTOR RISK

Human factor risk is really a special form of operational risk. It relates to the losses

that may result from human errors such as pushing the wrong button on a computer,

inadvertently destroying files, or entering wrong value for the parameter input of a model.

MARKET RISK

Market risk is that risk that changes in financial market prices and rates will reduce

the value of the banks positions. Market risk for a fund is often measured relative to a

benchmark index or portfolio, is referred to as a risk of tracking error market risk also

includes basis risk, a term used in risk management industry to describe the chance of a

breakdown in the relationship between price of a product, on the one hand, and the price of

the instrument used to hedge that price exposure on the other. The market-Vary

methodology attempts to capture multiple component of market such as directional risk,

convexity risk, volatility risk, basis risk, etc

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Market Risk may be defined as the possibility of loss to a bank caused by changes

in the market variables. The Bank for International Settlements (BIS) defines market risk as

the risk that the value of 'on' or 'off' balance sheet positions will be adversely affected by

movements in equity and interest rate markets, currency exchange rates and commodityprices". Thus, Market Risk is the 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 changes. Besides, it is equally concerned about the bank's

ability to meet its obligations as and when they fall due. In other words, it should be

ensured that the bank is not exposed to Liquidity Risk. Thus, focus on the management of

Liquidity Risk and Market Risk, further categorized into interest rate risk, foreign exchange

risk, commodity price risk and equity price risk. An effective market risk management

framework in a bank comprises risk identification, setting up of limits and triggers, risk

monitoring, models of analysis that value positions or measure market risk, risk reporting,

etc.

Types of market risk

Interest rate risk:

Interest rate risk is the risk where changes in market interest rates might adversely

affect a bank's financial condition. The immediate impact of changes in interest rates is on

the Net Interest Income (NII). A long term impact of changing interest rates is on the

bank's net worth since the economic value of a bank's assets, liabilities and off-balance

sheet positions get affected due to variation in market interest rates. The interest rate risk

when viewed from these two perspectives is known as 'earnings perspective' and 'economic

value' perspective, respectively.

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Management of interest rate risk aims at capturing the risks arising from the

maturity and repricing mismatches and is measured both from the earnings and economic

value perspective.

Earnings perspective involves analyzing the impact of changes in interest rates onaccrual or reported earnings in the near term. This is measured by measuring the changes in

the Net Interest Income (NII) or Net Interest Margin (NIM) i.e. the difference between the

total interest income and the total interest expense.

Economic Value perspective involves analyzing the changes of impact on interest

on the expected cash flows on assets minus the expected cash flows on liabilities plus the

net cash flows on off-balance sheet items. It focuses on the risk to net worth arising from

all repricing mismatches and other interest rate sensitive positions. The economic value

perspective identifies risk arising from long-term interest rate gaps.

The management of Interest Rate Risk should be one of the critical components of

market risk management in banks. The regulatory restrictions in the past had greatly

reduced many of the risks in the banking system. Deregulation of interest rates has,

however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income

(NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest

rates. Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates

(floating assets or liabilities), expose bank's NII or NIM to variations. The earning of assets

and the cost of liabilities are now closely related to market interest rate volatility

Generally, the approach towards measurement and hedging of IRR varies with the

segmentation of the balance sheet. In a well functioning risk management system, banks

broadly position their balance sheet into Trading and Banking Books. While the assets in

the trading book are held primarily for generating profit on short-term differences inprices/yields, the banking book comprises assets and liabilities, which are contracted

basically on account of relationship or for steady income and statutory obligations and are

generally held till maturity. Thus, while the price risk is the prime concern of banks in

trading book, the earnings or economic value changes are the main focus of banking book.

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Equity price risk:

The price risk associated with equities also has two components General market

risk refers to the sensitivity of an instrument / portfolio value to the change in the level of

broad stock market indices. Specific / Idiosyncratic risk refers to that portion of thestocks price volatility that is determined by characteristics specific to the firm, such as its

line of business, the quality of its management, or a breakdown in its production process.

The general market risk cannot be eliminated through portfolio diversification while

specific risk can be diversified away.

Foreign exchange risk:

Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a

result of adverse exchange rate movements during a period in which it has an open

position, either spot or forward, or a combination of the two, in an individual foreign

currency. The banks are also exposed to interest rate risk, which arises from the maturity

mismatching of foreign currency positions. Even in cases where spot and forward positions

in individual currencies are balanced, the maturity pattern of forward transactions may

produce mismatches. As a result, banks may suffer losses as a result of changes in

premia/discounts of the currencies concerned.

In the forex business, banks also face the risk of default of the counterparties or

settlement risk. While such type of risk crystallization does not cause principal loss, banks

may have to undertake fresh transactions in the cash/spot market for replacing the failed

transactions. Thus, banks may incur replacement cost, which depends upon the currency

rate movements. Banks also face another risk called time-zone risk or Herstatt risk which

arises out of time-lags in settlement of one currency in one center and the settlement of

another currency in another time-zone. The forex transactions with counterparties from

another country also trigger sovereign or country risk (dealt with in details in the guidance

note on credit risk).

The three important issues that need to be addressed in this regard are:

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Nature and magnitude of exchange risk

Exchange managing or hedging for adopted be to strategy>

The tools of managing exchange risk

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Commodity price risk:

The price of the commodities differs considerably from its interest rate risk and

foreign exchange risk, since most commodities are traded in the market in which the

concentration of supply can magnify price volatility. Moreover, fluctuations in the depth of

trading in the market (i.e., market liquidity) often accompany and exacerbate high levels of

price volatility. Therefore, commodity prices generally have higher volatilities and larger

price discontinuities.

Measuring Market Risk

The measurement of risk has changed over time. It has evolved from the simple

indicators, such as Face value/ Notional amount for an individual security to the latest

methodologies of computing VaR. the quest for better and more accurate measure of

market risk is ongoing; each new market turmoil reveals the limitations of even the most

sophisticated measure of market risk.

The Notional Amount Approach:

Until recently, trading desks in major banks were allocated economic capital by

reference to notional amount. The notional approach measures risk as the notional, or

nominal, amount of a security, or the sum of the notional values of the holdings for a

portfolio.

This method is flawed since it does not:

Differentiate between short and long positions.

Reflect price volatility and correlation between prices.

Moreover, in the case of derivative positions in the over the counter market, there

are often very large discrepancies between true amount of market exposure, which is often

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small, and the notional amount which may be huge. For example, two call options on the

same underlying instrument with the same notional value and same maturity, with one

option being in the money and the other one out-of-the-money, have very different market

values and risk exposures.

Value At Risk (VaR):

Value at risk can be defined as the worst loss that might be expected from holding

a security or portfolio over a given period of time (say a single day, 10 days for the purpose

of regulatory capital reporting), given a specified level of probability (known as the

confidence level)

For example, if we say that a position has a daily VaR of Rs. 10 million at the 99%confidence level, we mean that the realized daily losses from the position will, on average,

be higher than Rs. 10 million on only one day every 100 trading days (i.e., two to three

days each year).VaR offers probability statement about the potential change in the value of

a portfolio resulting from a change in the market factors, over a specified period of time.

VaR is the answer to the following question: What is the maximum loss over a

given period of time period such that there is a low probability, say a 1% probability, that

the actual loss over the given period will be larger?

Treatment of Market Risk in the Proposed Basel Capital Accord

The Basle Committee on Banking Supervision (BCBS) had issued comprehensive

guidelines to provide an explicit capital cushion for the price risks to which banks are

exposed, particularly those arising from their trading activities. The banks have been given

flexibility to use in-house models based on VaR for measuring market risk as an alternative

to a standardized measurement framework suggested by Basle Committee. The internal

models should, however, comply with quantitative and qualitative criteria prescribed by

Basle Committee.

Reserve Bank of India has accepted the general framework suggested by the Basle

Committee. RBI has also initiated various steps in moving towards prescribing capital for

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market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in

Government and other approved securities, besides a risk weight each of 100% on the open

position limits in forex and gold. RBI has also prescribed detailed operating guidelines for

Asset-Liability Management System in banks. As the ability of banks to identify and

measure market risk improves, it would be necessary to assign explicit capital charge for

market risk. While the small banks operating predominantly in India could adopt the

standardized methodology, large banks and those banks operating in international markets

should develop expertise in evolving internal models for measurement of market risk.

The Basle Committee on Banking Supervision proposes to develop capital charge

for interest rate risk in the banking book as well for banks where the interest rate risks are

significantly above average ('outliers'). The Committee is now exploring various

methodologies for identifying 'outliers' and how best to apply and calibrate a capital charge

for interest rate risk for banks. Once the Committee finalizes the modalities, it may be

necessary, at least for banks operating in the international markets to comply with the

explicit capital charge requirements for interest rate risk in the banking book. As the

valuation norms on banks' investment portfolio have already been put in place and aligned

with the international best practices, it is appropriate to adopt the Basel norms on capital

for market risk. In view of this, banks should study the Basel framework on capital for

market risk as envisaged in Amendment to the Capital Accord to incorporate market risks

published in January 1996 by BCBS and prepare themselves to follow the international

practices in this regard at a suitable date to be announced by RBI.

The Proposed New Capital Adequacy Framework

The Basel Committee on Banking Supervision has released a Second Consultative

Document, which contains refined proposals for the three pillars of the New Accord -

Minimum Capital Requirements, Supervisory Review and Market Discipline. It may be

recalled that the Basel Committee had released in June 1999 the first Consultative Paper on

a New Capital Adequacy Framework for comments. However, the proposal to provide

explicit capital charge for market risk in the banking book which was included in the Pillar

I of the June 1999 Document has been shifted to Pillar II in the second Consultative Paper

issued in January 2001. The Committee has also provided a technical paper on evaluation

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of interest rate risk management techniques. The Document has defined the criteria for

identifying outlier banks. According to the proposal, a bank may be defined as an outlier

whose economic value declined by more than 20% of the sum of Tier 1 and Tier 2 capital

as a result of a standardized interest rate shock (200 bps.)

The second Consultative Paper on the New Capital Adequacy framework issued in

January, 2001 has laid down 13 principles intended to be of general application for the

management of interest rate risk, independent of whether the positions are part of the

trading book or reflect banks' non-trading activities. They refer to an interest rate risk

management process, which includes the development of a business strategy, the

assumption of assets and liabilities in banking and trading activities, as well as a system of

internal controls. In particular, they address the need for effective interest rate risk

measurement, monitoring and control functions within the interest rate risk management

process. The principles are intended to be of general application, based as they are on

practices currently used by many international banks, even though their specific application

will depend to some extent on the complexity and range of activities undertaken by

individual banks. Under the New Basel Capital Accord, they form minimum standards

expected of internationally active banks. The principles are given in Annexure II.

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CHAPTER 3

CREDIT RISK

Credit risk is that risk that a change in the credit quality of a

counterparty will affect the value of a banks position. Default, whereby

counterparty is unwilling or unable to fulfill its contractual obligations, is the

extreme case; however banks are also exposed to the risk that the counterparty

might downgraded by a rating agency.

Credit risk is only an issue when the position is an asset, i.e., when it

exhibits a positive replacement value. In that instance if the counterparty

defaults, the bank either loses all of the market value of the position or, more

commonly, the part of the value that it cannot recover following the credit

event. However, the credit exposure induced by the replacement values of

derivative instruments is dynamic: they can be negative at one point of time,

and yet become positive at a later point in time after market conditions have

changed. Therefore the banks must examine not only the current exposure,

measured by the current replacement value, but also the profile of future

exposures up to the termination of the deal.

Credit risk is defined as the possibility of losses associated with

diminution in the credit quality of borrowers or counterparties. In a bank's

portfolio, losses stem from outright default due to inability or unwillingness of

a customer or counterparty to meet commitments in relation to lending,

trading, settlement and other financial transactions. Alternatively, losses result

from reduction in portfolio value arising from actual or perceived

deterioration in credit quality. Credit risk emanates from a bank's dealings

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with an individual, corporate, bank, financial institution or a sovereign. Credit

risk may take the following forms

In the case of direct lending: principal/and or interest amount may not

be repaid;

In the case of guarantees or letters of credit: funds may not be

forthcoming from the constituents upon crystallization of the liability;

In the case of treasury operations: the payment or series of payments

due from the counter parties under the respective contracts may not be

forthcoming or ceases;

In the case of securities trading businesses: funds/ securities settlement

may not be effected;

In the case of cross-border exposure: the availability and free transfer of

foreign currency funds may either cease or the sovereign may impose

restrictions.

Types of Credit Rating

Credit rating can be classified as:1. External credit rating.

2. Internal credit rating

External credit rating:

A credit rating is not, in general, an investment recommendation

concerning a given security. In the words of S&P, A credit rating is S&P's

opinion of the general creditworthiness of an obligor, or the creditworthiness

of an obligor with respect to a particular debt security or other financial

obligation, based on relevant risk factors. In Moody's words, a rating is, an

opinion on the future ability and legal obligation of an issuer to make timely

payments of principal and interest on a specific fixed-income security.

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Since S&P and Moody's are considered to have expertise in credit

rating and are regarded as unbiased evaluators, there ratings are widely

accepted by market participants and regulatory agencies. Financial

institutions, when required to hold investment grade bonds by their regulatorsuse the rating of credit agencies such as S&P and Moody's to determine which

bonds are of investment grade.

The subject of credit rating might be a company issuing debt

obligations. In the case of such issuer credit ratings the rating is an opinion

on the obligors overall capacity to meet its financial obligations. The

opinion is not specific to any particular liability of the company, nor does it

consider merits of having guarantors for some of the obligations. In the issuer

credit rating categories are

a) Counterparty ratings

b) Corporate credit ratings

c) Sovereign credit ratings

The rating process includes quantitative, qualitative, and legal analyses.

The quantitative analyses. The quantitative analysis is mainly financial

analysis and is based on the firms financial reports. The qualitative analysis is

concerned with the quality of management, and includes a through review of

the firms competitiveness within its industry as well as the expected growth

of the industry and its vulnerability to technological changes, regulatory

changes, and labor relations.

Internal credit rating:

A typical risk rating system (RRS) will assign both an obligor rating to

each borrower (or group of borrowers), and a facility rating to each available

facility. A risk rating (RR) is designed to depict the risk of loss in a credit

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facility. A robust RRS should offer a carefully designed, structured, and

documented series of steps for the assessment of each rating.

The following are the steps for assessment of rating:

a) Objectivity and Methodology:The goal is to generate accurate and consistent risk rating, yet also to

allow professional judgment to significantly influence a rating where it is

appropriate. The expected loss is the product of an exposure (say, Rs. 100)

and the probability of default (say, 2%) of an obligor (or borrower) and the

loss rate given default (say, 50%) in any specific credit facility. In this

example,

The expected loss = 100*.02*.50 = Rs. 1

A typical risk rating methodology (RRM)

a. Initial assign an obligor rating that identifies the expected

probability of default by that borrower (or group) in repaying its

obligations in normal course of business.

b. The RRS then identifies the risk loss (principle/interest) by assigning

an RR to each individual credit facility granted to an obligor.

The obligor rating represents the probability of default by a borrower in

repaying its obligation in the normal course of business. The facility rating

represents the expected loss of principal and/ or interest on any business credit

facility. It combines the likelihood of default by a borrower and conditional

severity of loss, should default occur, from the credit facilities available to the

borrower.

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Risk Rating Continuum (Prototype Risk Rating System)

RISK RR Corresponding

Probable S&P or

Moody's Rating

Sovereign 0 Not Applicable

Low 1 AAA2 AA Investment Grade3 A

4 BBB+/BBBAverage 5 BBB-

6 BB+/BB7 BB-

High 8

9

10

B+/B

B-

CCC+/CCC

Below Investment

Grade11 CC-

12 In Default

The steps in the RRS (nine, in our prototype system) typically start with

a financial assessment of the borrower (initial obligor rating), which sets a

floor on the obligor rating (OR). A series of further steps (four) arrive at the

final obligor rating. Each one of steps 2 to 5 may result in the downgrade of

the initial rating attributed at step 1. These steps include analyzing the

managerial capability of the borrower (step 2), examining the borrowers

absolute and relative position within the industry (step 3), reviewing the

quality of the financial information (step 4) and the country risk (step 5). The

process ensures that all credits are objectively rated using a consistent process

to arrive at the accurate rating.

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Additional steps (four, in our example) are associated with arriving at a final

facility rating, which may be above OR below the final obligor rating. These

steps include examining third-party support (step 6), factoring in the maturity

of the transaction (step 7), reviewing how strongly the transaction isstructured. (Step 8), and assessing the amount of collateral (step 9).

Credit Risk Management

In this backdrop, it is imperative that banks have a robust credit risk

management system which is sensitive and responsive to these factors. The

effective management of credit risk is a critical component of comprehensive

risk management and is essential for the long term success of any banking

organization. Credit risk management encompasses identification,

measurement, monitoring and control of the credit risk exposures.

Credit Risk Policy

1. Every bank should have a credit risk policy document approved by the

Board. The document should include risk identification, risk

measurement, risk grading/ aggregation techniques, reporting and risk

control/ mitigation techniques, documentation, legal issues and

management of problem loans.

2. Credit risk policies should also define target markets, risk acceptance

criteria, credit approval authority, credit origination/ maintenance

procedures and guidelines for portfolio management.

3. The credit risk policies approved by the Board should be communicated

to branches/controlling offices. All dealing officials should clearly

understand the bank's approach for credit sanction and should be held

accountable for complying with established policies and procedures.

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4. Senior management of a bank shall be responsible for implementing the

credit risk policy approved by the Board.

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CHAPTER 4

CREDIT RISK STRATEGY

Each bank should develop, with the approval of its Board, its own credit risk

strategy or plan that establishes the objectives guiding the bank's credit-

granting activities and adopt necessary policies/ procedures for conducting

such activities. This strategy should spell out clearly the organizations credit

appetite and the acceptable level of risk-reward trade-off for its activities.

The strategy would, therefore, include a statement of the bank's willingness to

grant loans based on the type of economic activity, geographical location,

currency, market, maturity and anticipated profitability. This would

necessarily translate into the identification of target markets and business

sectors, preferred levels of diversification and concentration, the cost of

capital in granting credit and the cost of bad debts.

The credit risk strategy should provide continuity in approach as also take into

account the cyclical aspects of the economy and the resulting shifts in the

composition/ quality of the overall credit portfolio. This strategy should be

viable in the long run and through various credit cycles.

Senior management of a bank shall be responsible for implementing the credit

risk strategy approved by the Board.

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Organizational Structure

Sound organizational structure is sine qua non for successful implementation

of an effective credit risk management system. The organizational structure

for credit risk management should have the following basic features:

1. The Board of Directors should have the overall responsibility for

management of risks. The Board should decide the risk management

policy of the bank and set limits for liquidity, interest rate, foreign

exchange and equity price risks.

The Risk Management Committee will be a Board level Sub committeeincluding CEO and heads of Credit, Market and Operational Risk

Management Committees. It will devise the policy and strategy for integrated

risk management containing various risk exposures of the bank including the

credit risk. For this purpose, this Committee should effectively coordinate

between the Credit Risk Management Committee (CRMC), the Asset

Liability Management Committee and other risk committees of the bank, if

any. It is imperative that the independence of this Committee is preserved.

The Board should, therefore, ensure that this is not compromised at any cost.

In the event of the Board not accepting any recommendation of this

Committee, systems should be put in place to spell out the rationale for such

an action and should be properly documented. This document should be made

available to the internal and external auditors for their scrutiny and comments.

The credit risk strategy and policies adopted by the committee should be

effectively

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Operations / Systems

Banks should have in place an appropriate credit administration, credit

risk measurement and monitoring processes. The credit administration process

typically involves the following phases:

1. Relationship management phase i.e. business development.

2. Transaction management phase covers risk assessment, loan pricing,

structuring the facilities, internal approvals, documentation, loan

administration, on going monitoring and risk measurement.

3. Portfolio management phase entails monitoring of the portfolio at a

macro level and the management of problem loans

4. On the basis of the broad management framework stated above, the

banks should have the following credit risk measurement and

monitoring procedures:

5. Banks should establish proactive credit risk management practices like

annual / half yearly industry studies and individual obligor reviews,

periodic credit calls that are documented, periodic visits of plant andbusiness site, and at least quarterly management reviews of troubled

exposures/weak credits

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Credit Risk Models

A credit risk model seeks to determine, directly or indirectly, the answer to the

following question: Given our past experience and our assumptions about the

future, what is the present value of a given loan or fixed income security? A

credit risk model would also seek to determine the (quantifiable) risk that the

promised cash flows will not be forthcoming. The techniques for measuring

credit risk that have evolved over the last twenty years are prompted by these

questions and dynamic changes in the loan market.

The increasing importance of credit risk modeling should be seen as the

consequence of the following three factors:

1. Banks are becoming increasingly quantitative in their treatment of

credit risk.

2. New markets are emerging in credit derivatives and the marketability of

existing loans is increasing through securitization/ loan sales market."

3. Regulators are concerned to improve the current system of bank capitalrequirements especially as it relates to credit risk.

CHAPTER - 5

IMPORTANCE OF CREDIT RISK MODELS

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Credit Risk Models have assumed importance because they provide the

decision maker with insight or knowledge that would not otherwise be readily

available or that could be marshalled at prohibitive cost. In a marketplace

where margins are fast disappearing and the pressure to lower pricing isunrelenting, models give their users a competitive edge. The credit risk

models are intended to aid banks in quantifying, aggregating and managing

risk across geographical and product lines. The outputs of these models also

play increasingly important roles in banks' risk management and performance

measurement processes, customer profitability analysis, risk-based pricing,

active portfolio management and capital structure decisions. Credit risk

modeling may result in better internal risk management and may have the

potential to be used in the supervisory oversight of banking organizations.

Techniques for Measuring Credit Risk

In the measurement of credit risk, models may be classified along three

different dimensions:

1. the techniques employed,

2. the domain of applications in the credit process and

3. The products to which they are applied.

CHAPTER - 6

RBI GUIDELINES ON CREDIT RISK

New Capital Accord: Implications for Credit Risk Management

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The Basel Committee on Banking Supervision had released in June

1999 the first Consultative Paper on a New Capital Adequacy Framework

with the intention of replacing the current broad-brush 1988 Accord. The

Basel Committee has released a Second Consultative Document in January2001, which contains refined proposals for the three pillars of the New Accord

- Minimum Capital Requirements, Supervisory Review and Market

Discipline.

The Committee proposes two approaches, for estimating regulatory

capital. Viz.,

1. Standardized and

2. Internal Rating Based (IRB)

Under the standardized approach, the Committee desires neither to

produce a net increase nor a net decrease, on an average, in minimum

regulatory capital, even after accounting for operational risk. Under the

Internal Rating Based (IRB) approach, the Committee's ultimate goals are to

ensure that the overall level of regulatory capital is sufficient to address the

underlying credit risks and also provides capital incentives relative to the

standardized approach, i.e., a reduction in the risk weighted assets of 2% to

3% (foundation IRB approach) and 90% of the capital requirement under

foundation approach for advanced IRB approach to encourage banks to adopt

IRB approach for providing capital.

The minimum capital adequacy ratio would continue to be 8% of the

risk-weighted assets, which cover capital requirements for market (trading

book), credit and operational risks. For credit risk, the range of options to

estimate capital extends to include a standardized, a foundation IRB and an

advanced IRB approaches.

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CHAPTER - 7

RBI GUIDELINES FOR CREDIT RISK MANAGEMENT

Credit Rating FrameworkA Credit-risk Rating Framework (CRF) is necessary to avoid the limitations

associated with a simplistic and broad classification of loans/exposures into a

"good" or a "bad" category. The CRF deploys a number/ alphabet/ symbol as

a primary summary indicator of risks associated with a credit exposure. Such

a rating framework is the basic module for developing a credit risk

management system and all advanced models/approaches are based on this

structure. In spite of the advancement in risk management techniques, CRF is

continued to be used to a great extent. These frameworks have been primarily

driven by a need to standardize and uniformly communicate the "judgment" in

credit selection procedures and are not a substitute to the vast lending

experience accumulated by the banks' professional staff.

Broadly, CRF can be used for the following purposes:

1. Individual credit selection, wherein either a borrower or a particular

exposure/ facility is rated on the CRF

2. Pricing (credit spread) and specific features of the loan facility. This

would largely constitute transaction-level analysis.

3. Portfolio-level analysis.

4. Surveillance, monitoring and internal MIS

Assessing the aggregate risk profile of bank/ lender. These would be relevant

for portfolio-level analysis. For instance, the spread of credit exposures across

various CRF categories, the mean and the standard deviation of losses

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occurring in each CRF category and the overall migration of exposures would

highlight the aggregated credit-risk for the entire portfolio of the bank.

CHAPTER - 8

OPERATIONAL RISK

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It refers to potential losses resulting from inadequate systems, management

failure, faulty control, fraud and human error. Many of the recent large losses

related to derivatives are the direct consequences of operational failure.

Derivative trading is more prone to operational risk than cash transactionsbecause derivatives are, by heir nature, leveraged transactions. This means

that a trader can make very large commitment on behalf of the bank, and

generate huge exposure in to the future, using only small amount of cash.

Very tight controls are an absolute necessary if the bank is to avoid huge

losses.

Operational risk includes fraud, for example when a trader or other

employee intentionally falsifies and misrepresents the risk incurred in a

transaction. Technology risk and principally computer system risk also fall

into the operational risk category.

Operational risk is the risk associated with operating a business. Operational

risk covers such a wide area that it is useful to subdivide operational risk into

two components:

Operational failure risk.

Operational strategic risk.

Operational failure riskarises from the potential for failure in

the course of operating the business. A firm uses people,

processes and technology to achieve the business plans, and anyone of these factors may experience a failure of some kind.

Accordingly, operational failure risk can be defined as the risk

that there will be a failure of people, processes or technology

within the business unit. A portion of failure may be anticipated,

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and these risks should be built into the business plan. But it is

unanticipated, and therefore uncertain, failures that give rise to

key operational risks. These failures can be expected to occur

periodically, although both their impact and their frequency maybe uncertain.

The impact or severity of a financial loss can be divided into two

categories:

An expected amount

An unexpected amount.

The latter is itself subdivided into two classes: an amount classed as severe,

and a catastrophic amount. The firm should provide for the losses that arise

from the expected component of these failures by charging expected revenues

with a sufficient amount of reserves. In addition, the firm should set aside

sufficient economic capital to cover the unexpected component, or resort to

insurance.

Operational strategic riskarises from environmental factors, such as

a new competitor that changes the business paradigram, a major

political and regulatory regime change, and earthquakes and other such

factors that are outside the control of the firm. It also arises from major

new strategic initiatives, such as developing a new line of business or

re-engineering an existing business line. All business relies on people,

processes and technology outside their business unit and the potentialfor failure exists there too, this type of risk is referred to as external

dependency risk.

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The figure above summarizes the relationship between operational failure risk

and operational strategic risk. These two principal categories of risk are also

sometimes defined as internal and external operational risk.

Operational risk is often thought to be limited to losses that can occur in

operating or processing centers. This type of operational risk, sometimes

referred as operations risk, is an important component, but it by no means

covers all of the operational risks facing the firm. Our definition ofoperational risk as the risk associated with operating the business means

significant amounts of operational risk are also generated outside the

processing centers.

36

Figure: Two Broad Categories of Operational Risk

Operational Risk

Operational failure risk(Internal operational risk)

The risk encountered in pursuitof a particular strategy due to:

People Process Technology

Operational strategic risk(External operational risk)

The risk of choosing aninappropriate strategy inresponse to environmentalfactor, such as

Political Taxation Regulation Government Societal Competition, etc.


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Risk begins to accumulate even before the design of the potential

transaction gets underway. It is present during negotiations with the client

(regardless of whether the negotiation is a lengthy structuring exercise or a

routine electronic negotiation.) and continues after the negotiation as thetransaction is serviced.

A complete picture of operational risk can only be obtained if the

banks activity is analyzed from beginning to end. Several things have to be in

place before a transaction is negotiated, and each exposes the firm to

operational risk. The activity carried on behalf of the client by the staff can

expose the institution to people risk. People risk is not only in the form of

risk found early in a transaction. But they further rely on using sophisticated

financial models to price the transaction. This creates what is called as Model

risk which can arise because of wrong parameters like input to the model, or

because the model is used inappropriately and so on.

Once the transaction is negotiated and a ticket is written, errors can

occur as the transaction is recorded in various systems or reports. An error

here may result in the delayed settlement of the transaction, which in turn can

give rise to fines and other penalties. Further an error in market risk and credit

risk report might lead to the exposures generated by the deal being

understated. In turn this can lead to the execution of additional transactions

that would otherwise not have been executed. These are examples of what is

often called as process risk

The system that records the transaction may not be capable of handlingthe transaction or it may not have the capacity to handle such transactions. If

any one of the step is out-sourced, then external dependency risk also arises.

However, each type of risk can be captured either as people, processes,

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technology, or an external dependency risk, and each can be analyzed in terms

of capacity, capability or availability

Who Should Manage Operational Risk?

The responsibility for setting policies concerning operational risk

remains with the senior management, even though the development of those

policies may be delegated, and submitted to the board of directors for

approval. Appropriate policies must be put in place to limit the amount of

operational risk that is assumed by an institution. Senior management needs

to give authority to change the operational risk profile to those who are the

best able to take action. They must also ensure that a methodology for the

timely and effective monitoring of the risks that are incurred is in place. To

avoid any conflict of interest, no single group within the bank should be

responsible for simultaneously setting policies, taking action and monitoring

risk.

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Internal Audit


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Policy Setting

The authority to take action generally rests with business management,

which is responsible for controlling the amount of operational risk taken

within each business line. The infrastructure and the governance groups share

with business management the responsibility for managing operational risk.

The responsibility for the development of a methodology for measuring

and monitoring operational risks resides most naturally with group risk

management functions. The risk management function also needs to ensure

the proper operational risk/ reward analysis is performed in the review of

existing businesses and before the introduction of new initiatives andproducts. In this regard, the risk management function works very closely

with, but independent from, business management, infrastructure, and other

governance group

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Senior Management

Business Management Risk Management

Legal

Operations

InformationTechnology

Finance

Insurance


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Senior management needs to know whether the responsibilities it has

delegated are actually being tended to, and whether the resulting processes are

effective. The internal audit function within the bank is charged with this

responsibility.

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CHAPTER 9

KEY TO IMPLEMENTING BANK-WIDE OPERATIONAL RISK

MANAGEMENT

The eight key elements are necessary to successfully implement a bank-wide operational risk management framework. They involve setting policy

and identifying risk as an outgrowth of having designed a common language,

constructing business process maps, building a best measurement

methodology, providing exposure management, installing a timely reporting

capability, performing risk analysis inclusive of stress testing, and allocating

economic capital as a function of operational risk.

EIGHT KEY ELEMENTS TO ACHIEVE BEST OPERATIONAL

RISK MANAGEMENT.

1. Develop well-defined operational risk policies. This includes explicitly

articulating the desired standards for the risk measurement. One also

41

1. Policy

Best Practice

2. Risk Identification

3. Business Process

4. Measuring Methodology

8. Economic Capital

7. Risk Analysis

6. Reporting

5. Exposure Management


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needs to establish clear guidelines for practices that may contribute to a

reduction of operational risk.

2. Establish a common language of risk identification. For e.g., the term

people risk includes a failure to deploy skilled staff. Technologyrisk would include system failure, and so on.

3. Develop business process maps of each business. For e.g., one should

create an operational risk catalogue which categories and defines the

various operational risks arising from each organizational unit in terms

of people, process, and technology risk. This catalogue should be tool

to help with operational risk identification and assessment.

4. Develop a comprehensible set of operational risk metrics. Operational

risk assessment is a complex process. It needs to be performed on a

firm-wide basis at regular intervals using standard metrics. In early

days, business and infrastructure groups performed their own

assessment of operational risk. Today, self-assessment has been

discredited. Sophisticated financial institutions are trying to develop

objective measures of operational risk that build significantly more

reliability into the quantification of operational risk.

5. Decide how to manage operational risk exposure and take appriate

action to hedge the risks. The bank should address the economic

question of the cost-benefit of insuring a given risk for those

operational risks that can be insured.

6. Decide how to report exposure.

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Types of Operational Failure Risk

1. People Risk 1. Incompetancy.

2. Fraud.

2. Process Risk

Model Risk

TR

OCR

1. Model/ methodology error

2. Mark-to-model error.

1. Execution error.

2. Product complexity.

3. Booking error.

4. Settlement error.1. Exceeding limits.

2. Security risk.

3. Volume risk.

3. Technology Risk 1. System failure.

2. Programming error.

3. Information risk.

4. Telecommunications failure.

7. Develop tools for risk analysis, and procedures for when these tools

should deploy. For e.g., risk analysis is typically performed as part of a

new product process, periodic business reviews, and so on. Stress

testing should be a standard part of risk analysis process. The frequency

of risk assessment should be a function of the degree to which

operational risks are expected to change over time as businesses

undertake new initiatives, or as business circumstances evolve. This

frequency might be reviewed as operational risk measurement is rolled

out across the bank a bank should update its risk assessment more

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frequently. Further one should reassess whenever the operational risk

profile changes significantly.

8. Develop techniques to translate the calculation of operational risk into a

required amount of economic capital. Tools and procedures should bedeveloped to enable businesses to make decisions about operational risk

based on risk/reward analysis.

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CHAPTER 10

FOUR-STEP MEASUREMENT PROCESS FOR OPERATIONAL

RISK

Clear guiding principle for the operational risk measurement processshould be set to ensure that it provides an appropriate measure of operational

risk across all business units throughout the bank. This problem of measuring

operational risk can be best achieved by means of a four-step operational risk

process. The following are the four steps involved in the process:

1. Input.

2. Risk assessment framework.

3. Review and validation.

4. Output.

1. Input:

The first step in the operational risk measurement process is to gather

the information needed to perform a complete assessment of all significant

operational risks. A key source of this information is often the finished

product of other groups. For example, a unit that supports the business group

often publishes report or documents that may provide an excellent starting

point for the operational risk assessment.

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Sources of Information in the Measurement Process of Operational Risk:

The Inputs (for Assessment)

Likelihood of Occurrence Severity Audit report Management interviews

Regulatory report Loss history

Management report

Expert opinion

Business Recovery Plan

Business plans

Budget plans

Operations plans

For example, if one is relying on audit documents as an indication of

the degree of control, then one needs to ask if the audit assessment is current

and sufficient. Have there been any significant changes made since the last

audit assessment? Did the audit scope include the area of operational risk that

is of concern to the present risk assessment? As one diligently works through

available information, gaps often become apparent. These gaps in the

information often need to be filled through discussion with the relevant

managers.

Typically, there are not sufficient reliable historical data available to

confidently project the likelihood or severity of operational losses. One often

needs to rely on the expertise of business management, until reliable data are

compiled to offer an assessment of the severity of the operational failure for

each of the risks. The time frame employed for all aspects of the assessment

process is typically one year. The one-year time horizon is usually selected to

align with the business planning cycle of the bank.

2. Risk Assessment Framework

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The input information gathered in the above step needs to be analyzed

and processed through the risk assessment framework. Risk assessment

framework includes:

1. Risk categories:The operational risk can be broken down into four headline risk categories

like the risk of unexpected loss due to operational failure in people, process

and technology deployed within the business

Internal dependencies should each be reviewed according to a set of

factors. We examine these 9nternal dependencies according to three key

components of capability, capacity and availability.

External dependencies can also be analyzed in terms of the specific type of

external interaction.

2. Connectivity and interdependencies

The headline risk categories cannot be viewed in isolation from one

another. One needs to examine the degree of interconnected risk exposures

that cut across the headline operational risk categories, in order to

understand the full impact of risk.

3. Change, complexity, compliancy:

One may view the sources that drive the headline risk categories as falling

under the broad categories of Change refers to such items as introducing

new technology or new products, a merger or acquisition, or moving from

internal supply to outsourcing, etc. Complexity refers to such items as

complexity of products, process or technology. Complacency refers toineffective management of the business.

4. Net likelihood assessment

The likelihood that an operational failure might occur within the next year

should be assessed, net of risk mitigants such as insurance, for each

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identified risk exposure and for each of the four headline risk categories.

Since it is often unclear how to quantify risk, this assessment can be rated

along five point likelihood continuum from very low, low, medium, high

and very high.5. Severity assessment

Severity describes the potential loss to the bank given that an operational

risk failure has occurred. It should be assessed for each identified risk

exposure.

6. Combined likelihood and severity into the overall Operational Risk

Assessment

Operational risk measures are constrained in that there is not usually a

defensible way to combine the individual likelihood of loss and severity

assessments into overall measure of operational risk within a business unit.

To do so, the likelihood of loss would need to be expressed in numerical

terms. This cannot be accomplished without statistically significant

historical data on operational losses.

7. Defining Cause and Effect:

Loss data are easier to collect than data associated with the cause of loss.

This complicates the measurement of operational risk because each loss is

likely to have several causes. This relationship between these causes, and

the relative importance of each, can be difficult to assess in an objective

fashion.

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8. Sample of a risk assessment report.

Risk Assessment Report

RiskCa

teg

or

y

Cause Effect Source ofProbability &

Magnitude of Loss

Data

People Loss of key staff,due to defection toa competitor.

Variance in revenue/ profit

Delphictechnique

based onbusiness

assessment.Process Declining

productivity asvolume grows

Variance in processcosts from predictedlevels, excluding

processmalfunctions

Historicalvariance.

Suppliersestimates

Industrybenchmarking

Technology Year 2000upgrade

expenditure

Variance intechnology running

costs from predictedlevels

Historicalvariance.

Suppliersestimates

Industrybenchmarking

Review and validation:

Once the report is generated. First the centralized operational risk

management group (ORMG) reviews the assessment results with senior

business unit management and key officers, in order to finalize the proposed

operational risk rating. Second, one may want an operational risk rating

committee to review the assessment a validation process similar to that

followed by credit rating agencies. This takes the form of review of the

individual risk assessments by knowledgeable senior committee personnel to

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ensure that the framework has been consistently applied across businesses,

that there has been sufficient scrutiny to remove any imperfections, and so on.

The committee should have representation from business management, audit,

and functional areas, and be chaired by risk management unit.3. Output

The final assessment of operational risk will be formally reported to

business management, the centralized risk-adjusted return on capital

(RAROC) group, and the partners in corporate governance such as internal

audit and compliance. The output of the assessment process has two main

uses:

1. The assessment provides better operational risk information to

management for use in improving risk management decisions.

2. The assessment improves the allocation of economic capital to better

reflect the extent of the operational riskier, being taken by a business

unit.

3. The over all assessment of the likelihood of operational risk & severity

of loss for a business unit can be shown as:

Mgmt. Attention

Severity of Loss ($)

Likelihood of Loss ($)

A business unit may address its operational risks in several ways. First,

one can invest in business unit. Second, one can avoid the risk by withdrawing

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MediumRisk

HighRisk

MediumRisk

LowRisk


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from business activity. Third, one can accept and manage risk through

effective monitoring and control. Fourth, one can transfer risk to another

party. Of course, not all-operational risks are insurable, and in that case of

those that are insurable the required premium may be prohibitive. The strategyand eventually the decision should be based on cost benefit analysis.

Risk Management in Future

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The bank of the future will be recognized around a new vision. To

succeed, it will have to be able to respond to opportunities as they present

themselves. And it will have to strive to improve the portfolio management of

its balance sheet and capital.To manage conflicting objectives, it will need to determine a number of

policy variables such as a target risk-adjusted rate of returns (RAROC), target

regulatory return, target tier 1 ratio, target liquidity, and so on. (Figure 17.1)

In turn, this will mean transforming the risk management function. Risk

management will need to encompass limit management, risk analysis,

RAROC, and active portfolio management of risk (APMR). These changes in

the risk management will be induced by:

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Target RAROC by:TransactionCustomer

ProductLine of Business

Target RegulatoryReturn by:1. Transaction

2. Customer3. Product4. Line of Business

Target Return onEquity Target LiquidityTarget Tier 1

Ratio

Target Risk WeightedAssets (RWA)

Target Leverage Ratio

Target Senior DebtRating


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1. Advances in technology

2. Introduction of more sophisticated regulatory measures

3. Rapidly accelerating market forces

4. Complex legal environment1. Advances in technology:

Banking is moving into an era in which complex mathematical model

programmed into risk engines will provide the foundation of portfolio

management. Banks with sophisticated risk engine will be able to measure the

risk of sophisticated products, compute and implement hedging strategies, and

understand the relative risk-adjusted return almost instantaneously.

Given the current trend toward consolidation, vast and complex

organizations will demand the ability to quickly and consistently provide

key decision-support tools for comparing profitability measures and risk

tolerance for diverse businesses.

Technology will allow risk management information to be integrated

into overall management reporting- including intraday risk reporting. The

Internet and intranet will become the delivery vehicles of choice for the results

of risk analyses.

Infrastructure investment will be required within many banks to

improve performance in a variety of tasks. The task includes information

collection and normalization, storage and dimensioning, and analytics

processing as well as information sharing and distribution.

One method of deployment for information, as shown in figure 17.3,will be via either the intranet or the Internet. There should only be official risk

measure from a fully integrated risk infrastructure. Real-time access will be

provided to the risk system via web-based technologies. Independent risk

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calculators may exist for offline use, but these will be able to use the same

analytics as the official reporting process.

The benefits of this type of infrastructure are consistency-one source for

one answer; efficiency work is executed once to serve multiple purposes;and ease of use- one place, one view. The risk database will include

transaction details (e.g., cash flows, principle amount, currencies); cross-

references to other internal systems, which house critical data (e.g., credit

rating, counterparty, instrument); external data (e.g., yield curve, prices,

industry classifications); and a variety of dimension indicators (e.g., product

identification codes, asset class, currency).

The infrastructure will include appropriate linkages within a robust

environment for data collection and scrubbing, data warehousing, and risk

analytics as well as the appropriate data and systems maintenance

components. Above all, the risk management information system (risk MIS)

should be designed to provide full risk transparency from the bottom to the

top of the house.

2. Regulatory Measures and Market Forces:

In the future, the regulatory review process (e.g., review of bank

internal models) will become more sophisticated. Regulators will hire staff

with a greater risk management expertise. Regulators will increasingly sever

as a catalyst for quantifying risk ( market, credit, operational, liquidity,etc.)

through their imposition of new capital regimes as discussed in the Basle

Accord Consultative Paper (Basle 1999).Market forces will also bring change. External users of financial

information will demand better information on which to make investment

decisions. In the future there will be more detailed and more frequent

reporting of risk positions to company shareholders, creditors, etc. this will

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lead to generally accepted reporting principles (GARP) for risk along the lines

of the existing generally accepted accounting principles (GAAP) for financial

statements.

There will be increasing growth in consulting services such as dataproviders, risk advisory service bureaus, treasury transaction services, etc.

independent external reviewers may even be hooked up to a banks systems to

allow them to offer regular automated independent risk reviews. The reviews

will be intended to provide comfort to senior managers and regulators, and to

show that internal systems provide sound risk measures.

The risk management function will be fully independent from the

business and centralized. Risk management processes will be fully and

seamlessly integrated into the business process. Risk/ return will be assessed

for new business opportunities and incorporated into the design of new

products. All risks-credit, market, operational, liquidity, and so on will be

combined, reported, and managed on an ever more integrated basis. The total

figures for credit risk by counterparty will use credit value-at-risk

methodologies to combine the risk arising from more traditional lending. The

problem of liquidating portfolios during turbulent markets will also become an

important factor in the total risk numbers.

The banks of the future will have a sophisticated central risk engine

capable of measuring the risk and the price of anything that the bank trades

and originates. Risk management will be a value added never center for

trading, ideas and deal structuring as well as provide the impetus for newmarketing initiatives, while pricing will become more complex and

competitive.

The risk management function will become much more tightly

integrated with profit & loss reporting. Risk capital will be charged to a

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business unit according to its contribution to the total risk of the firm, not

according to its contribution to the total risk of the firm, not according to the

volatility of the business lines revenues. And the balance sheet will be

supplemented by business unit value-at-risk (VaR) report. Information willpass back and forth between the risk management function and the business

units, and they will work in parternership to balance risk and return.

3. Legal Environment:

Legal risk is the risk that contracts are not legally enforceable or

documented correctly. Legal risks should be limited and managed through

policies developed by the institution's legal counsel (typically in consultation

with officers in the risk management process) that have been approved by the

institution's senior management and board of directors. At a minimum, there

should be guidelines and processes in place to ensure the enforceability of

counterparty agreements. Prior to engaging in derivatives transactions, an

institution should reasonably satisfy itself that its counterparties have the legal

and necessary regulatory authority to engage in those transactions. In addition

to determining the authority of a counterparty to enter into a derivatives

transaction, an institution should also reasonably satisfy itself that the terms of

any contract governing its derivatives activities with counterparty are legally

sound.

An institution should adequately evaluate the enforceability of its

agreements before individual transactions are consummated. Participants in

the derivatives markets have experienced significant losses because they wereunable to recover losses from a defaulting counterparty when a court held the

counterparty had acted outside of its authority in entering into such

transactions. An institution should ensure that its counterparties have the

power and authority to enter into derivatives transactions and that the

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counterparties' obligations arising from them are enforceable. Similarly, an

institution should also ensure that its rights with respect to any margin or

collateral received from counterparty are enforceable and exercisable.

The advantages of netting arrangements can include a reduction incredit and liquidity risks, the potential to do more business with existing

counterparties within existing credit lines and a reduced need for collateral to

support counterparty obligations. The institution should ascertain that its

netting agreements are adequately documented and that they have been

executed properly. Only when a netting arrangement is legally enforceable in

all relevant jurisdictions should an institution monitor its credit and liquidity

risks on a net basis. The institution should have knowledge of relevant tax

laws and interpretations governing the use of derivatives instruments.

Knowledge of these laws is necessary not only for the institution's marketing

activities but also for its own use of these products.

4. Building Block to Create Shareholders Value:

To use a sporting analogy, first-class risk management is not only about

outstanding goal keeping, but also about the ability to move up field and help

the team score. Advances in leading edge risk and capital management tools

suggest that banks are ready to move to this next stage of implementation.

RAROC will be used to drive pricing, performance measurement, portfolio

management, and capital management. The new paradigm of a total risk

enabled enterprise (TREE) will increase shareholders value at tactical and

strategic level, as well as attracting

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