UNIT –II

Part- 1

Financial Risks and their management

• Risk maybe defined as the “exposure to uncertainty” which leads to favourable or
unfavourable outcomes.
• Risks faced by bankers are of three generic categories viz.
- Credit risk
- Market risk
- Operational risk

Credit risk
• It is the most fundamental of risks.
• It maybe defined as, ‘ failure on the part of a borrower to either repay the loan principal
or to service the loan as per the terms of the loan agreement.’
• An effective system to manage the credit risk is essential to the long-term success of any
banking organisation.
• The guidelines issued by RBI recommend an organisational structure for credit risk
management with a high level Credit Policy Committee at the top.
• This committee should formulate clear policies on various aspects relating to credit
management.

Market Risk
• It is defined as the losses in on and off balance sheet items arising from movements in
market prices.
• There are basically four types of market risks that banks are exposed to viz.,
- Interest rate risk
- Exchange rate risk
- Commodity price risk
- Equity price risk.
• Liquidity risk is also a type of market risk.
 Categories of Interest Rate Risk
Interest rate risk faced by a financial institution can be categorized as follows:
• Mis-match risk
- It is the risk arising from the mismatch in the ‘ repricing maturities’ of interest rate sensitive
assets and liabilities.
- ‘Repricing maturities need not be same as the contractual maturities.
- For eg., a deposit contracted for a five year term repriceable every six months has a
repricing maturity of six months.
- Gap between the interest sensitive liabilities(RSL) and assets (RSA) on any day or during a
specified time bucket is a measure of the Mis-match risk on dat day or time bucket, as the case
maybe

• If RSA > RSL the gap is positive and if RSL > RSA the gap is negative.
• The relationships between interest rate changes and their impact on net interest income
are shown in the table below :

GAP INTEREST RATE IMPACT ON NII

CHANGE

Positive Increases Positive

Positive Decreases Negative

Negative Increases Negative

Negative Decreases Positive

• Basis Risk
- It is the risk arising from the differing impact of a given change in any of the benchmark
interest rates on the interest rates in different segments such as treasury bills, call money, repo,
CDs etc.
 - The interest rate gaps (positive or negative) worked out on the basis of the repricing period of
RSL/RSA need to be adjusted for the basis risk to obtain a more refined gap structure.

• Embedded Option Risk

- This risk occurs on account of pre-mature withdrawal of funds by the lenders, pre-payment
option in a loan contract, cash credit system etc.
- That is, it is the risk that the depositors may prematurely close the deposits if interest rates
rises and borrowers
may repay loans if interest rate declines.
- In the former case, the bank is forced to replace deposits at a higher rate to fund the assets,
returns from which are now lower compared to market interest rates
- In case of prepayment of loans, the bank is forced to replace assets with new assets which
now fetch lower returns, while continuing to pay interest on deposits at the earlier contracted
rates which are comparatively high.

• Yield Curve Risk

- This risk emanates from the variation in spread between two instruments (based on the yields
of which a pair of asset and a liability is priced) in a composite yield curve.

• Reinvestment Risk
- It is the risk that the periodic coupons may have to be reinvested at a lower rate if interest
rate declines.

• Price Risk
- It is the interest rate risk resulting in the change in the market value of assets and liabilities
and in turn the value of net worth of a bank. (Market value of equity)

Operational Risk
• Basel Committee defines it as “ the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and systems or from external events”.
• The use of more highly automated technology, the growth of e-commerce, large-scale
mergers and acquisitions that test the viability of newly integrated systems, the increased
prevalence of outsourcing, etc. all suggest that operational risk exposures maybe
substantial and growing.
• Experimental measures adopted by a few banks identified factors like internal audit
ratings, volume, turnover, error rates and income volatility as indicators of the levels of
OR.
• Management of this risk is complicated and requires integration with other risk
management strategies.
 PART – 2
Organisational Structure for Risk Management in Banks
• Risk management covers all risks encountered by the bank and they are grouped into a
number of clearly identifiable categories as follows
a.) Credit risk
b.) Market risk (interest rate and other price risks)
c.) Liquidity risk (Funding and market liquidity)
d.) Operational risk
• Risk management in a bank involves identification, measurement and control/mitigation
of all the above risks across the entire bank.
• Due to the differing sizes and the varying business activities of banks, there is no single
optimal organisational structure which must be adopted.
• Historically banks did not have separation of risk taking functions from risk control
functions.
• The audit functions usually addressed the risk aspects, but they were more from
compliance angle and less from proactive risk management angle.
• Later, the RBI guidelines insisted that the risk taking and risk control functions nee to be
separated.
• In today’s Indian Banking, due to the increased exposure to all types of risk, there is a
need to ensure that the organisational structure provides prudent control.
• The global trend is towards centralising risk management with integrated treasury
management.
• Irrespective of the bank’s profile, it is the responsibility of the Board of Directors to
ensure that adequate structure, policies and procedures are in place and are properly
implemented.
• The board should also set risk limits.
• At the organisational level, these responsibilities are delegated to the executive
management or a “Risk Management Committee” consisting of the Managing Director,
heads of business units of the banks and the head of Risk Management.
• It would be responsible for supervising the activities and operations of other committees
entrusted with risk management functions of the bank
• These committees/ functions include the Credit Committee, the Asset and Liability
Management Committee(ALCO), Operational Risk Control function and the capital
planning function.
• The Risk Management Department supports the activities of the Risk Management
Committee through research on and analysis of risks, reporting risk positions and making
recommendations as to the level and degree of risk to be assumed.
• In smaller banks, the Risk Management Committee may be incorporated within the
activities of the Board of Directors.

Risk Management Process

The Primary components of a sound risk management process are the following :
• A comprehensive risk management approach
• Guidelines and other parameters used to govern risk taking
• A strong management information system for controlling, monitoring and reporting risk.
Appropriate limit systems should permit management to control exposure, to initiate
discussion and pre-determine tolerances as determined by the Board of Directors and the
Risk Management Committee

Asset and Liability Management Committee (ALCO)

The ALCO is delegated the responsibility from the Risk Management Committee (or the
Board of Directors) to manage :
a. the market risks in the balance sheet of the bank
b. the capital adequacy
c. the liquidity
d. the profit performance
e. the mis-match positions
f. the treasury risk positions

• The ALCO establishes policies and procedures to cover the activities of the Treasury and
to ensure that regular reporting of exposures takes place without any delay.
• There maybe three alternative structures as follows :
1) Middle office monitoring risk exposures and providing
information and analysis to ALCO. The Back office will
handle confirmation, settlements, payments, reconciling
 accounts used for Treasury activities and report
exceptions.
2) An ALCO Secretariat providing support and information
to the ALCO, but not capable of monitoring risk exposure
or complex analysis. The Back office functions as above,
but in addition, monitors risk exposures on a basic level.
3) If Neither Middle office nor ALCO Secretariat exists,
the back office would provide some basic information
to ALCO and monitor risk exposure to the best of its capabilities.

Functions of Treasury Department

• The Treasury is normally responsible for foreign exchange trading, money market
trading, liquidity management, interest rate management and maintenance of reserve
requirements.
• It is also responsible for investments in Government securities, debt instruments, bonds,
commodity and equity underwriting and trading.
• It operates under authorities and limits delegated to it by the ALCO, which in turn
operates under authorities and limits delegated from the Risk Management Committee.
• The main component of the Treasury division is the Dealing room, back office and the
middle office. The important functions of them are as mentioned below :

- The Dealing Room

• The Dealing room acts as the bank’s interface to international and domestic financial
markets.
• Through this dealing room, the Treasury manages the market risks in accordance with
instructions received from the bank’s ALCO.
• It is the centre for market risk management activities of the bank.
• It is the clearing house for such risk and has the responsibility to manage the treasury
risks taken in all areas of the ban, on behalf of customers, and on behalf of the bank,
within the policies and limits prescribed by the Board and Risk Management Committee.
• All activities in the dealing area must be under the most stringent control, with risk
commitments reported accurately and promptly to risk management.
- The Middle Office
• It is a new concept in the risk management structure and not all banks have a formal
structure for it.
• It is seen only in large banks whose business and activities are heavily geared towards the
trading of market risks.
• Middle offices are in place primarily to provide market risk monitoring, evaluation and
reporting for ALCO and Treasury.
• It is the first line of review of the dealing activities and the function provides timely
assessment of dealing activities and consolidated market risk exposures of the bank.
• Middle office must report independently of the Treasury.
• The main functions of the middle office are :
a) monitoring performance of dealing room
b) monitoring individual dealer’s performance
c) analysis of use of approved risk limits
d) analysis of usage of limits and recommendations in
in changes of limits or products
e) analysis of risk of new instruments and products
f) real-time evaluation of risk exposures
g) verification of information used in gap and cash
flow reports
h) analysis of gap and cash flow reports
i) maintenance of ALM model
j) verification of data used in ALM model
k) comment and analysis on output of ALM model
l) maintenance of VaR model
m) verification of data used in VaR model
n) comment and analysis on output of VaR model
• Middle office not only has a control function, but an analytical function of ALM
information which is primarily for the purpose of ALCO but which is also used to
improve Treasury.
 - The Back Office
• The key controls over market risk activities, and particularly over Dealing Room
activities, are exercised by the Back office.
• A clear segregation of duties and reporting lines is maintained between Dealing room
staff and back office staff and also there exists clearly defined physical and systems
access between the two areas.
• It is charged with the responsibility of ensuring the timeliness and completeness of data
in regard to market risk activities.
• Key controls performed in this area are :
i) the control over confirmations, both inward and
outward
ii) the control over dealing accounts
iii) revaluations and marking-to-market of market risk
exposures
iv) monitoring and reporting of risk limits
v) reporting and prompt resolution of exceptions and
excesses
vi) control over payment systems.
Linkages with other Business units
• In order to discharge its responsibilities in the management of market risk, Treasury
department receives information on all the assets and liabilities generated by branches
arising from the commercial or core businesses of the bank.
• Banks which have surplus funds should transfer the same to the Treasury
• Deficit branches can borrow from the Treasury to fund their authorised assets.
• The Treasury manages the bank’s liquidity and its investments in market instruments.
• It is also responsible for providing branches with prices for those products and services,
such as foreign exchange, interest rate and derivative products.
• Its responsibility includes the proper management and control of all day-to-day market
risks generated by all business units in the bank.
• Thus, a bank’s effectiveness at managing its market risks, including the effectiveness of
its mechanisms to monitor, report, and supervise market risks on the balance sheet is
centered on the Treasury function.
 PART – 3
Liquidity and Liquidity risk
Introduction
• Banks are primarily engaged in mobilization of funds from various sources for the
purpose of lending and investment.
• This process of financial intermediation and liberalization expose banks to a variety of
risks.
• They are mainly faced with Credit risk, Market risk , Liquidity risk and Operational risk.

Liquidity
• It is the ease with which one can obtain cash by selling non-cash assets.
• Providing liquidity to customers is one of the intermediation functions of banks
• Bank liquidity may be defined as ability to raise a certain amount of funds at a certain
cost within a certain amount of time.
• If a bank is in a position to raise additional funds at a cheaper rate in a shorter period
compared to another bank, then the liquidity position of that bank is considered better
than the other bank.
• The liquidity of an individual bank is different from the liquidity in the financial system
and also liquidity is different from liquidation.
• Thus, each bank needs to assess its liquidity needs based on the nature and composition
of its Assets and Liabilities.

Liquidity Risk
• It is the possibility that an institution may be unable to meet its maturing commitments
or may do so only by borrowing funds at prohibitive costs or by disposing assets at rock
bottom prices.
• It originates form mismatches in the maturity pattern of assets and liabilities.
• The liquidity risk manifests itself in different dimensions :
- Funding risk : need to replace net outflows due to unanticipated withdrawal/ non-
renewal of deposits
- Time risk : need to compensate for non-receipt of expected inflows of fund
- Call risk : due to crystallisation of contingent liabilities
 Need For Liquidity by Banks
Liquidity has two separate and mutually exclusive purposes.
• Demand from Depositors
– on the liability side of the balance sheet, deposit withdrawals represent an important
factor requiring banks to be liquid
-- banks must therefore build adequate amount of liquidity in their portfolio so that
they may in case of necessity meet any claims upon them in cash on demand.
• Demand from Borrowers
-- on the asset side of the balance sheet, demand for loans from customers have to be
accommodated as they have a substantial impact on bank profits.
-- they have to maintain liquidity to meet with fresh loans and also provision for full
utilization of credit already sanctioned.

Sources of Liquidity
• The primary sources of liquidity can be of two categories – first are the assets in which
funds are temporarily invested and second includes the various methods by which banks
can borrow or otherwise obtain funds.
• The potential sources of bank liquidity are
- money at call and short notice
- short term central government securities
- other marketable short term securities
- Repos
- refinance from RBI
- bills rediscounting

Sources Of Liquidity Risk

• Liquidity risk in banks may be attributed to following factors :
a) Mismatch in Tenor profile of Assets and Liabilities
b) Embedded options
c) Non-Performing Assets
d) Undrawn Credit limits
 LIQUIDITY MANAGEMENT – MEASURING AND MONITORING
• Liquidity measurement is difficult and can be measured through stock or cash flows.
• While the liquidity ratios are the ideal indicator for banks operating in developed
financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian Banks,
which are operating in an illiquid market.
• For measuring and managing net funding requirements, the use of maturity ladder and
calculation of cumulative surplus or deficit is done in the Structural Liquidity Gap reports
prepared at periodic intervals.
• The banks are also required to evaluate liquidity profile under different scenarios both
bank specific and market driven crisis by preparing various simulation models.
• Static Liquidity Gap Analysis
• The statement of Structural Liquidity as per format designed by RBI is to be prepared by
banks by placing all cash inflows and outflows in the maturity ladder according to its
expected timing
• The time buckets given the statutory reserve cycle of 14 days may be distributed in 8
buckets as suggested by RBI as under :
• 1.) 1 to 14 days
• 2.) 15 to 28 days
• 3.) 29days and up to 3 months
• 4.) over 3 months and up to 6 months
• 5.) over 6 months and up to 1 year
• 6.) over 1 year and up to 3 years
• 7.) over 3 years and up to 5 years
• 8.) over 5 years
• A maturing liability will be a cash outflow because funds have to be paid to meet the
liability whereas a maturing asset will be a cash inflow.
• The cash flows should be placed in different time bands based on future behaviour of
assets, liabilities and off-balance sheet items.
• RBI has given certain guidelines for putting cash inflows and outflows in different time
buckets
• The classification of assets and liabilities into particular time buckets will have to be on
the basis of remaining maturity.
• In case of no fixed repayment schedule, classification will have to be based on behavioral
pattern of assets and liabilities.
• After classification in particular time buckets, the mismatches or GAP in cash inflows
and outflows in each bucket can be determined to assess liquidity situation of the bank.
• Its limitation is that it is based on asset and liability positioning on a particular date and
does not consider any likely change in future due to business considerations.

Dynamic Liquidity Gap Analysis

• Dynamic Liquidity analysis is essentially extension of static liquidity model.
• Cash inflows and outflows are projected in the same manner as computed in the static
GAP analysis, however, changes on account of fresh business are interpolated in the
projections.
• RBI has suggested to monitor the short term liquidity on a dynamic basis over a time
horizon spanning from 1-90 days on the basis of business projections and other
commitments for planning purposes.
• Based on the cash inflows and outflows estimates, mismatches will give a clue about the
liquidity position of the bank in a short time horizon.
• If cash outflows are substantially higher than cash inflows, the banks may face liquidity
problems.

Scenario Analysis
• Liquidity management is more crucial in times of crisis.
• During crisis, the demand for deposit withdrawals will be heavy while other sources for
funding these outflows may dry up.
• Banks may also be faced with excessive liquidity without adequate avenues for deploying
the funds.
• Therefore, it is important to visualize various scenarios and assess liquidity requirements
under these situations
• Stress scenarios can be both bank specific and market specific
a) Bank specific
- these are on account of specific problems faced by the
bank creating panic or loss of reputation leading to
liquidity crisis.
 b) Market specific
- cases of extreme tightening of liquidity arising out of monetary policy stance of
RBI, risk perception of the banking system, several market disruptions, failure of one or
more banks and financial crisis can create liquidity crisis.
• Various scenarios can be anticipated based on economic environment and past trends.
• Based on these scenarios, impact on liquidity can be analyzed.

LIQUIDITY ADJUSTMENT FACILITY

• RBI among its many roles acts as a banker of last resort.
• It injects funds into the system to help participants tide over temporary mismatches of
funds.
• RBI has now moved over to auction system of Repos and Reverse Repos to suck out or
inject liquidity into the market.
• Repo transactions are major sources for meeting short term liquidity needs.
• RBI decides on the quantum of adjustments as also rates by responding to the system on a
daily basis.
• The funds under LAF are expected to be used by banks for their day-to-day mismatches
in liquidity.