RISK MANAGEMENT IN BANKS

NOTES SESSION 1-30

Risk Management Systems in Banks

Introduction

Banks in the process of financial intermediation are confronted with various kinds of financial

and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price,

commodity price, legal, regulatory, reputational, operational, etc. These risks are highly

interdependent and events that affect one area of risk can have ramifications for a range of other

risk categories. Thus, top management of banks should attach considerable importance to

improve the ability to identify, measure, monitor and control the overall level of risks

undertaken.

The broad parameters of risk management function should encompass:

i) organisational structure;

ii) comprehensive risk measurement approach;

iii) risk management policies approved by the Board which should be consistent with the

broader business strategies, capital strength, management expertise and overall

willingness to assume risk;

iv) guidelines and other parameters used to govern risk taking including detailed structure of

prudential limits;

v) strong MIS for reporting, monitoring and controlling risks;

vi) well laid out procedures, effective control and comprehensive risk reporting framework;

vii) separate risk management framework independent of operational Departments and with clear

delineation of levels of responsibility for management of risk; and

viii) periodical review and evaluation.

2. Risk Management Structure

2.1 A major issue in establishing an appropriate risk management organisation structure is

choosing between a centralised and decentralised structure. The global trend is towards

centralising risk management with integrated treasury management function to benefit from

information on aggregate exposure, natural netting of exposures, economies of scale and easier

reporting to top management. The primary responsibility of understanding the risks run by the

bank and ensuring that the risks are appropriately managed should clearly be vested with the

Board of Directors. The Board should set risk limits by assessing the bank’s risk and risk bearing

capacity. At organisational level, overall risk management should be assigned to an independent

Risk Management Committee or Executive Committee of the top Executives that reports directly

to the Board of Directors. The purpose of this top level committee is to empower one group with

full responsibility of evaluating overall risks faced by the bank and determining the level of risks

which will be in the best interest of the bank. At the same time, the Committee should hold the

line management more accountable for the risks under their control, and the performance of the

bank in that area. The functions of Risk Management Committee should essentially be to

identify, monitor and measure the risk profile of the bank. The Committee should also develop

policies and procedures, verify the models that are used for pricing complex products, review the

risk models as development takes place in the markets and also identify new risks. The risk

policies should clearly spell out the quantitative prudential limits on various segments of banks’

operations. Internationally, the trend is towards assigning risk limits in terms of portfolio

standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk

(market risk). The Committee should design stress scenarios to measure the impact of unusual

market conditions and monitor variance between the actual volatility of portfolio value and that

predicted by the risk measures. The Committee should also monitor compliance of various risk

parameters by operating Departments.

2.2 A prerequisite for establishment of an effective risk management system is the existence of a

robust MIS, consistent in quality. The existing MIS, however, requires substantial upgradation

and strengthening of the data collection machinery to ensure the integrity and reliability of data.

2.3 The risk management is a complex function and it requires specialised skills and expertise.

Banks have been moving towards the use of sophisticated models for measuring and managing

risks. Large banks and those operating in international markets should develop internal risk

management models to be able to compete effectively with their competitors. As the domestic

market integrates with the international markets, the banks should have necessary expertise and

skill in managing various types of risks in a scientific manner. At a more sophisticated level, the

core staff at Head Offices should be trained in risk modelling and analytical tools. It should,

therefore, be the endeavour of all banks to upgrade the skills of staff.

2.4 Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework for

management of risks in India. The design of risk management functions should be bank specific,

dictated by the size, complexity of functions, the level of technical expertise and the quality of

MIS. The proposed guidelines only provide broad parameters and each bank may evolve their

own systems compatible to their risk management architecture and expertise.

2.5 Internationally, a committee approach to risk management is being adopted. While the Asset

- Liability Management Committee (ALCO) deal with different types of market risk, the Credit

Policy Committee (CPC) oversees the credit /counterparty risk and country risk. Thus, market

and credit risks are managed in a parallel two-track approach in banks. Banks could also set-up a

single Committee for integrated management of credit and market risks. Generally, the policies

and procedures for market risk are articulated in the ALM policies and credit risk is addressed in

Loan Policies and Procedures.

2.6 Currently, while market variables are held constant for quantifying credit risk, credit

variables are held constant in estimating market risk. The economic crises in some of the

countries have revealed a strong correlation between unhedged market risk and credit risk. Forex

exposures, assumed by corporates who have no natural hedges, will increase the credit risk

which banks run vis-à-vis their counterparties. The volatility in the prices of collateral also

significantly affects the quality of the loan book. Thus, there is a need for integration of the

activities of both the ALCO and the CPC and consultation process should be established to

evaluate the impact of market and credit risks on the financial strength of banks. Banks may also

consider integrating market risk elements into their credit risk assessment process.

3. Credit Risk

3.1 General

3.1.1 Lending involves a number of risks. In addition to the risks related to creditworthiness of

the counterparty, the banks are also exposed to interest rate, forex and country risks.

3.1.2 Credit risk or default risk involves inability or unwillingness of a customer or counterparty

to meet commitments in relation to lending, trading, hedging, settlement and other financial

transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio

risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a

bank’s portfolio depends on both external and internal factors. The external factors are the state

of the economy, wide swings in commodity/equity prices, foreign exchange rates and interest

rates, trade restrictions, economic sanctions, Government policies, etc. The internal factors are

deficiencies in loan policies/administration, absence of prudential credit concentration limits,

inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in

appraisal of borrowers’ financial position, excessive dependence on collaterals and inadequate

risk pricing, absence of loan review mechanism and post sanction surveillance, etc.

3.1.3 Another variant of credit risk is counterparty risk. The counterparty risk arises from

nonperformance of the trading partners. The non-performance may arise from counterparty’s

refusal/inability to perform due to adverse price movements or from external constraints that

were not anticipated by the principal. The counterparty risk is generally viewed as a transient

financial risk associated with trading rather than standard credit risk.

3.1.4 The management of credit risk should receive the top management’s attention and the

process should encompass:

a) Measurement of risk through credit rating/scoring;

b) Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses that

bank would experience over a chosen time horizon (through tracking portfolio behavior over 5 or

more years) and unexpected loan losses i.e. the amount by which actual losses exceed the

expected loss (through standard deviation of losses or the difference between expected loan

losses and some selected target credit loss quantile);

c) Risk pricing on a scientific basis; and

d) Controlling the risk through effective Loan Review Mechanism and portfolio management.

3.1.5 The credit risk management process should be articulated in the bank’s Loan Policy, duly

approved by the Board. Each bank should constitute a high level Credit Policy Committee, also

called Credit Risk Management Committee or Credit Control Committee etc. to deal with issues

relating to credit policy and procedures and to analyse, manage and control credit risk on a bank

wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise

heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the

Chief Economist. The Committee should, inter alia, formulate clear policies on standards for

presentation of credit proposals, financial covenants, rating standards and benchmarks,

delegation of credit approving powers, prudential limits on large credit exposures, asset

concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk

concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal

compliance, etc. Concurrently, each bank should also set up Credit Risk Management

Department (CRMD), independent of the Credit Administration Department. The CRMD should

enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The

CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify

problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks

may consider separate set up for loan review/audit. The CRMD should also be made accountable

for protecting the quality of the entire loan portfolio. The Department should undertake portfolio

evaluations and conduct comprehensive studies on the environment to test the resilience of the

loan portfolio.

3.2 Instruments of Credit Risk Management

Credit Risk Management encompasses a host of management techniques, which help the banks

in mitigating the adverse impacts of credit risk.

3.2.1 Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers. The banks should

also evolve multi-tier credit approving system where the loan proposals are approved by an

‘Approval Grid’ or a ‘Committee’. The credit facilities above a specified limit may be approved

by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers and invariably one officer

should represent the CRMD, who has no volume and profit targets. Banks can also consider

credit approving committees at various operating levels i.e. large branches (where considered

necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating

powers for sanction of higher limits to the ‘Approval Grid’ or the ‘Committee’ for better rated /

quality customers. The spirit of the credit approving system may be that no credit proposals

should be approved or recommended to higher authorities, if majority members of the ‘Approval

Grid’ or ‘Committee’ do not agree on the creditworthiness of the borrower. In case of

disagreement, the specific views of the dissenting member/s should be recorded. The banks

should also evolve suitable framework for reporting and evaluating the quality of credit decisions

taken by various functional groups. The quality of credit decisions should be evaluated within a

reasonable time, say 3 – 6 months, through a well-defined Loan Review Mechanism.

3.2.2 Prudential Limits

In order to limit the magnitude of credit risk, prudential limits should be laid down on various

aspects of credit:

a) stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio or

other ratios, with flexibility for deviations. The conditions subject to which deviations are

permitted and the authority therefor should also be clearly spelt out in the Loan Policy;

b) single/group borrower limits, which may be lower than the limits prescribed by Reserve Bank

to provide a filtering mechanism;

c) substantial exposure limit i.e. sum total of exposures assumed in respect of those single

borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital

funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds,

depending upon the degree of concentration risk the bank is exposed;

d) maximum exposure limits to industry, sector, etc. should be set up. There must also be systems

in place to evaluate the exposures at reasonable intervals and the limits should be adjusted

especially when a particular sector or industry faces slowdown or other sector/industry specific

problems. The exposure limits to sensitive sectors, such as, advances against equity shares, real

estate, etc., which are subject to a high degree of asset price volatility and to specific industries,

which are subject to frequent business cycles, may necessarily be restricted. Similarly, high-risk

industries, as perceived by the bank, should also be placed under lower portfolio limit. Any

excess exposure should be fully backed by adequate collaterals or strategic considerations; and

e) banks may consider maturity profile of the loan book, keeping in view the market risks

inherent in the balance sheet, risk evaluation capability, liquidity, etc.

3.2.3 Risk Rating

Banks should have a comprehensive risk scoring / rating system that serves as a single point

indicator of diverse risk factors of a counterparty and for taking credit decisions in a consistent

manner. To facilitate this, a substantial degree of standardisation is required in ratings across

borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical

input for setting pricing and non-price terms of loans as also present meaningful information for

review and management of loan portfolio. The risk rating, in short, should reflect the underlying

credit risk of the loan book. The rating exercise should also facilitate the credit granting

authorities some comfort in its knowledge of loan quality at any moment of time. The risk rating

system should be drawn up in a structured manner, incorporating, inter alia, financial analysis,

projections and sensitivity, industrial and management risks. The banks may use any number of

financial ratios and operational parameters and collaterals as also qualitative aspects of

management and industry characteristics that have bearings on the creditworthiness of

borrowers. Banks can also weigh the ratios on the basis of the years to which they represent for

giving importance to near term developments. Within the rating framework, banks can also

prescribe certain level of standards or critical parameters, beyond which no proposals should be

entertained. Banks may also consider separate rating framework for large corporate / small

borrowers, traders, etc. that exhibit varying nature and degree of risk. Forex exposures assumed

by corporates who have no natural hedges have significantly altered the risk profile of banks.

Banks should, therefore, factor the unhedged market risk exposures of borrowers also in the

rating framework. The overall score for risk is to be placed on a numerical scale ranging between

1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a quantitative definition

of the borrower, the loan’s underlying quality, and an analytic representation of the underlying

financials of the borrower should be presented. Further, as a prudent risk management policy,

each bank should prescribe the minimum rating below which no exposures would be undertaken.

Any flexibility in the minimum standards and conditions for relaxation and authority therefor

should be clearly articulated in the Loan Policy. The credit risk assessment exercise should be

repeated biannually (or even at shorter intervals for low quality customers) and should be

delinked invariably from the regular renewal exercise. The updating of the credit ratings should

be undertaken normally at quarterly intervals or at least at half-yearly intervals, in order to gauge

the quality of the portfolio at periodic intervals. Variations in the ratings of borrowers over time

indicate changes in credit quality and expected loan losses from the credit portfolio. Thus, if the

rating system is to be meaningful, the credit quality reports should signal changes in expected

loan losses. In order to ensure the consistency and accuracy of internal ratings, the responsibility

for setting or confirming such ratings should vest with the Loan Review function and examined

by an independent Loan Review Group. The banks should undertake comprehensive study on

migration (upward – lower to higher and downward – higher to lower) of borrowers in the

ratings to add accuracy in expected loan loss calculations.

3.2.4 Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers

with weak financial position and hence placed in high credit risk category should be priced high.

Thus, banks should evolve scientific systems to price the credit risk, which should have a bearing

on the expected probability of default. The pricing of loans normally should be linked to risk

rating or credit quality. The probability of default could be derived from the past behaviour of the

loan portfolio, which is the function of loan loss provision/charge offs for the last five years or

so. Banks should build historical database on the portfolio quality and provisioning / charge off

to equip themselves to price the risk. But value of collateral, market forces, perceived value of

accounts, future business potential, portfolio/industry exposure and strategic reasons may also

play important role in pricing. Flexibility should also be made for revising the price (risk premia)

due to changes in rating / value of collaterals over time. Large sized banks across the world have

already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans,

which calls for data on portfolio behaviour and allocation of capital commensurate with credit

risk inherent in loan proposals. Under RAROC framework, lender begins by charging an interest

mark-up to cover the expected loss – expected default rate of the rating category of the borrower.

The lender then allocates enough capital to the prospective loan to cover some amount of

unexpected loss- variability of default rates. Generally, international banks allocate enough

capital so that the expected loan loss reserve or provision plus allocated capital covers 99% of

the loan loss outcomes. There is, however, a need for comparing the prices quoted by

competitors for borrowers perched on the same rating /quality. Thus, any attempt at price-cutting

for market share would result in mispricing of risk and ‘Adverse Selection’.

3.2.5 Portfolio Management

The existing framework of tracking the Non Performing Loans around the balance sheet date

does not signal the quality of the entire Loan Book. Banks should evolve proper systems for

identification of credit weaknesses well in advance. Most of international banks have adopted

various portfolio management techniques for gauging asset quality. The CRMD, set up at Head

Office should be assigned the responsibility of periodic monitoring of the portfolio. The portfolio

quality could be evaluated by tracking the migration (upward or downward) of borrowers from

one rating scale to another. This process would be meaningful only if the borrower-wise ratings

are updated at quarterly / half-yearly intervals. Data on movements within grading categories

provide a useful insight into the nature and composition of loan book. The banks could also

consider the following measures to maintain the portfolio quality:

1) stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e. certain

percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5,

etc.;

2) evaluate the rating-wise distribution of borrowers in various industry, business segments, etc.;

3) exposure to one industry/sector should be evaluated on the basis of overall rating distribution

of borrowers in the sector/group. In this context, banks should weigh the pros and cons of

specialisation and concentration by industry group. In cases where portfolio exposure to a single

industry is badly performing, the banks may increase the quality standards for that specific

industry;

4) target rating-wise volume of loans, probable defaults and provisioning requirements as a

prudent planning exercise. For any deviation/s from the expected parameters, an exercise for

restructuring of the portfolio should immediately be undertaken and if necessary, the entry level

criteria could be enhanced to insulate the portfolio from further deterioration;

5) undertake rapid portfolio reviews, stress tests and scenario analysis when external

environment undergoes rapid changes (e.g. volatility in the forex market, economic sanctions,

changes in the fiscal/monetary policies, general slowdown of the economy, market risk events,

extreme liquidity conditions, etc.). The stress tests would reveal undetected areas of potential

credit risk exposure and linkages between different categories of risk. In adverse circumstances,

there may be substantial correlation of various risks, especially credit and market risks. Stress

testing can range from relatively simple alterations in assumptions about one or more financial,

structural or economic variables to the use of highly sophisticated models. The output of such

portfolio-wide stress tests should be reviewed by the Board and suitable changes may be made in

prudential risk limits for protecting the quality. Stress tests could also include contingency plans,

detailing management responses to stressful situations.

6) introduce discriminatory time schedules for renewal of borrower limits. Lower rated

borrowers whose financials show signs of problems should be subjected to renewal control

twice/thrice an year.

Banks should evolve suitable framework for monitoring the market risks especially forex risk

exposure of corporates who have no natural hedges on a regular basis. Banks should also appoint

Portfolio Managers to watch the loan portfolio’s degree of concentrations and exposure to

counterparties. For comprehensive evaluation of customer exposure, banks may consider

appointing Relationship Managers to ensure that overall exposure to a single borrower is

monitored, captured and controlled. The Relationship Managers have to work in coordination

with the Treasury and Forex Departments. The Relationship Managers may service mainly high

value loans so that a substantial share of the loan portfolio, which can alter the risk profile,

would be under constant surveillance. Further, transactions with affiliated companies/groups

need to be aggregated and maintained close to real time. The banks should also put in place

formalised systems for identification of accounts showing pronounced credit weaknesses well in

advance and also prepare internal guidelines for such an exercise and set time frame for deciding

courses of action. Many of the international banks have adopted credit risk models for evaluation

of credit portfolio. The credit risk models offer banks framework for examining credit risk

exposures, across geographical locations and product lines in a timely manner, centralising data

and analysing marginal and absolute contributions to risk. The models also provide estimates of

credit risk (unexpected loss) which reflect individual portfolio composition. The Altman’s Z

Score forecasts the probability of a company entering bankruptcy within a 12-month period. The

model combines five financial ratios using reported accounting information and equity values to

produce an objective measure of borrower’s financial health. J. P. Morgan has developed a

portfolio model ‘CreditMetrics’ for evaluating credit risk. The model basically focus on

estimating the volatility in the value of assets caused by variations in the quality of assets. The

volatility is computed by tracking the probability that the borrower might migrate from one

rating category to another (downgrade or upgrade). Thus, the value of loans can change over

time, reflecting migration of the borrowers to a different risk-rating grade. The model can be

used for promoting transparency in credit risk, establishing benchmark for credit risk

measurement and estimating economic capital for credit risk under RAROC framework. Credit

Suisse developed a statistical method for measuring and accounting for credit risk which is

known as CreditRisk+. The model is based on actuarial calculation of expected default rates and

unexpected losses from default. The banks may evaluate the utility of these models with suitable

modifications to Indian environment for fine-tuning the credit risk management. The success of

credit risk models impinges on time series data on historical loan loss rates and other model

variables, spanning multiple credit cycles. Banks may, therefore, endeavour building adequate

database for switching over to credit risk modelling after a specified period of time.

3.2.6 Loan Review Mechanism (LRM)

LRM is an effective tool for constantly evaluating the quality of loan book and to bring about

qualitative improvements in credit administration. Banks should, therefore, put in place proper

Loan Review Mechanism for large value accounts with responsibilities assigned in various areas

such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit

grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and

scope of LRM normally vary based on banks’ size, type of operations and management practices.

It may be independent of the CRMD or even separate Department in large banks.

The main objectives of LRM could be:

● to identify promptly loans which develop credit weaknesses and initiate timely corrective

action;

● to evaluate portfolio quality and isolate potential problem areas;

● to provide information for determining adequacy of loan loss provision;

● to assess the adequacy of and adherence to, loan policies and procedures, and to monitor

compliance with relevant laws and regulations; and

● to provide top management with information on credit administration, including credit

sanction process, risk evaluation and post-sanction follow-up.

Accurate and timely credit grading is one of the basic components of an effective LRM. Credit

grading involves assessment of credit quality, identification of problem loans, and assignment of

risk ratings. A proper Credit Grading System should support evaluating the portfolio quality and

establishing loan loss provisions. Given the importance and subjective nature of credit rating, the

credit ratings awarded by Credit Administration Department should be subjected to review by

Loan Review Officers who are independent of loan administration.

3.2.7 Banks should formulate Loan Review Policy and it should be reviewed annually by the

Board. The Policy should, inter alia, address:

Qualification and Independence

The Loan Review Officers should have sound knowledge in credit appraisal, lending practices

and loan policies of the bank. They should also be well versed in the relevant laws/regulations

that affect lending activities. The independence of Loan Review Officers should be ensured and

the findings of the reviews should also be reported directly to the Board or Committee of the

Board.

Frequency and Scope of Reviews

The Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to

identify incipient deterioration in portfolio quality. Reviews of high value loans should be

undertaken usually within three months of sanction/renewal or more frequently when factors

indicate a potential for deterioration in the credit quality. The scope of the review should cover

all loans above a cut-off limit. In addition, banks should also target other accounts that present

elevated risk characteristics. At least 30-40% of the portfolio should be subjected to LRM in a

year to provide reasonable assurance that all the major credit risks embedded in the balance sheet

have been tracked.

Depth of Reviews

● The loan reviews should focus on:

● Approval process;

● Accuracy and timeliness of credit ratings assigned by loan officers;

● Adherence to internal policies and procedures, and applicable laws / regulations;

● Compliance with loan covenants;

● Post-sanction follow-up;

● Sufficiency of loan documentation;

● Portfolio quality; and

● Recommendations for improving portfolio quality

3.2.8 The findings of Reviews should be discussed with line Managers and the corrective actions

should be elicited for all deficiencies. Deficiencies that remain unresolved should be reported to

top management.

3.2.9 The Risk Management Group of the Basle Committee on Banking Supervision has released

a consultative paper on Principles for the Management of Credit Risk. The Paper deals with

various aspects relating to credit risk management. The Paper is enclosed for information of

banks.

4. Credit Risk and Investment Banking

4.1 Significant magnitude of credit risk, in addition to market risk, is inherent in investment

banking. The proposals for investments should also be subjected to the same degree of credit risk

analysis, as any loan proposals. The proposals should be subjected to detailed appraisal and

rating framework that factors in financial and non-financial parameters of issuers, sensitivity to

external developments, etc. The maximum exposure to a customer should be bank-wide and

include all exposures assumed by the Credit and Treasury Departments. The coupon on non

sovereign papers should be commensurate with their risk profile. The banks should exercise due

caution, particularly in investment proposals, which are not rated and should ensure

comprehensive risk evaluation. There should be greater interaction between Credit and Treasury

Departments and the portfolio analysis should also cover the total exposures, including

investments. The rating migration of the issuers and the consequent diminution in the portfolio

quality should also be tracked at periodic intervals.

4.2 As a matter of prudence, banks should stipulate entry level minimum ratings/quality

standards, industry, maturity, duration, issuer-wise, etc. limits in investment proposals as well to

mitigate the adverse impacts of concentration and the risk of illiquidity.

5. Credit Risk in Off-balance Sheet Exposure

5.1 Banks should evolve adequate framework for managing their exposure in off-balance sheet

products like forex forward contracts, swaps, options, etc. as a part of overall credit to individual

customer relationship and subject to the same credit appraisal, limits and monitoring procedures.

Banks should classify their off-balance sheet exposures into three broad categories - full risk

(credit substitutes) - standby letters of credit, money guarantees, etc, medium risk (not direct

credit substitutes, which do not support existing financial obligations) - bid bonds, letters of

credit, indemnities and warranties and low risk - reverse repos, currency swaps, options, futures,

etc.

5.2 The trading credit exposure to counterparties can be measured on static (constant percentage

of the notional principal over the life of the transaction) and on a dynamic basis. The total

exposures to the counterparties on a dynamic basis should be the sum total of:

1) the current replacement cost (unrealised loss to the counterparty); and

2) the potential increase in replacement cost (estimated with the help of VaR or other methods to

capture future volatilities in the value of the outstanding contracts/ obligations). The current and

potential credit exposures may be measured on a daily basis to evaluate the impact of potential

changes in market conditions on the value of counterparty positions. The potential exposures also

may be quantified by subjecting the position to market movements involving normal and

abnormal movements in interest rates, foreign exchange rates, equity prices, liquidity conditions,

etc.

6. Inter-bank Exposure and Country Risk

6.1 A suitable framework should be evolved to provide a centralised overview on the aggregate

exposure on other banks. Bank-wise exposure limits could be set on the basis of assessment of

financial performance, operating efficiency, management quality, past experience, etc. Like

corporate clients, banks should also be rated and placed in range of 1-5, 1-8, as the case may be,

on the basis of their credit quality. The limits so arrived at should be allocated to various

operating centres and followed up and half-yearly/annual reviews undertaken at a single point.

Regarding exposure on overseas banks, banks can use the country ratings of international rating

agencies and classify the countries into low risk, moderate risk and high risk. Banks should

endeavour for developing an internal matrix that reckons the counterparty and country risks. The

maximum exposure should be subjected to adherence of country and bank exposure limits

already in place. While the exposure should at least be monitored on a weekly basis till the banks

are equipped to monitor exposures on a real time basis, all exposures to problem countries should

be evaluated on a real time basis.

7. Market Risk

7.1 Traditionally, credit risk management was the primary challenge for banks. With progressive

deregulation, market risk arising from adverse changes in market variables, such as interest rate,

foreign exchange rate, equity price and commodity price has become relatively more important.

Even a small change in market variables causes substantial changes in income and economic

value of banks. Market risk takes the form of:

1) Liquidity Risk

2) Interest Rate Risk

3) Foreign Exchange Rate (Forex) Risk

4) Commodity Price Risk and

5) Equity Price Risk

8. Market Risk Management

8.1 Management of market risk should be the major concern of top management of banks. The

Boards should clearly articulate market risk management policies, procedures, prudential risk

limits, review mechanisms and reporting and auditing systems. The policies should address the

bank’s exposure on a consolidated basis and clearly articulate the risk measurement systems that

capture all material sources of market risk and assess the effects on the bank. The operating

prudential limits and the accountability of the line management should also be clearly defined.

The Asset-Liability Management Committee (ALCO) should function as the top operational unit

for managing the balance sheet within the performance/risk parameters laid down by the Board.

The banks should also set up an independent Middle Office to track the magnitude of market

risk on a real time basis. The Middle Office should comprise of experts in market risk

management, economists, statisticians and general bankers and may be functionally placed

directly under the ALCO. The Middle Office should also be separated from Treasury Department

and should not be involved in the day to day management of Treasury. The Middle Office should

apprise the top management / ALCO / Treasury about adherence to prudential / risk parameters

and also aggregate the total market risk exposures assumed by the bank at any point of time.

8.2 Liquidity Risk

8.2.1 Liquidity Planning is an important facet of risk management framework in banks. Liquidity

is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund

loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate

liquidity when sufficient funds can be raised, either by increasing liabilities or converting assets,

promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and

borrowings from money, capital and forex markets. Thus, liquidity should be considered as a

defence mechanism from losses on fire sale of assets.

8.2.2 The liquidity risk of banks arises from funding of long-term assets by short-term liabilities,

thereby making the liabilities subject to rollover or refinancing risk.

8.2.3 The liquidity risk in banks manifest in different dimensions:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/nonrenewal of

deposits (wholesale and retail);

ii) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e. performing

assets turning into non-performing assets; and

iii) Call Risk - due to crystallisation of contingent liabilities and unable to undertake profitable

business opportunities when desirable.

8.2.4 The first step towards liquidity management is to put in place an effective liquidity

management policy, which, inter alia, should spell out the funding strategies, liquidity planning

under alternative scenarios, prudential limits, liquidity reporting / reviewing, etc.

8.2.5 Liquidity measurement is quite a difficult task and can be measured through stock or cash

flow approaches. The key ratios, adopted across the banking system are:

i) Loans to Total Assets

ii) Loans to Core Deposits

iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus)

Temporary Investments, where large liabilities represent wholesale deposits which are market

sensitive and temporary Investments are those maturing within one year and those investments

which are held in the trading book and are readily sold in the market;

iv) Purchased Funds to Total Assets, where purchased funds include the entire inter-bank and

other money market borrowings, including Certificate of Deposits and institutional deposits; and

v) Loan Losses/Net Loans.

8.2.6 While the liquidity ratios are the ideal indicator of liquidity of banks operating in

developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks

which are operating generally in an illiquid market. Experiences show that assets commonly

considered as liquid like Government securities, other money market instruments, etc. have

limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves

tracking of cash flow mismatches. For measuring and managing net funding requirements, the

use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected

maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard

under ALM System should be adopted for measuring cash flow mismatches at different time

bands. The cash flows should be placed in different time bands based on future behaviour of

assets, liabilities and off-balance sheet items. In other words, banks should have to analyse the

behavioural maturity profile of various components of on / off-balance sheet items on the basis

of assumptions and trend analysis supported by time series analysis. Banks should also undertake

variance analysis, at least, once in six months to validate the assumptions. The assumptions

should be fine-tuned over a period which facilitate near reality predictions about future

behaviour of on / off-balance sheet items. Apart from the above cash flows, banks should also

track the impact of prepayments of loans, premature closure of deposits and exercise of options

built in certain instruments which offer put/call options after specified times. Thus, cash outflows

can be ranked by the date on which liabilities fall due, the earliest date a liability holder could

exercise an early repayment option or the earliest date contingencies could be crystallised.

8.2.7 The difference between cash inflows and outflows in each time period, the excess or deficit

of funds, becomes a starting point for a measure of a bank’s future liquidity surplus or deficit, at

a series of points of time. The banks should also consider putting in place certain prudential

limits to avoid liquidity crisis:

1. Cap on inter-bank borrowings, especially call borrowings;

2. Purchased funds vis-à-vis liquid assets;

3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and

Loans;

4. Duration of liabilities and investment portfolio;

5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time

bands;

6. Commitment Ratio – track the total commitments given to corporates/banks and other

financial institutions to limit the off-balance sheet exposure;

7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

8.2.8 Banks should also evolve a system for monitoring high value deposits (other than interbank

deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out

of contingent liabilities in normal situation and the scope for an increase in cash flows during

periods of stress should also be estimated. It is quite possible that market crisis can trigger

substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent

liabilities like letters of credit, etc.

8.2.9 The liquidity profile of the banks could be analysed on a static basis, wherein the assets and

liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern

and the sensitivity of these items to changes in market interest rates and environment are duly

accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due

importance to:

1) Seasonal pattern of deposits/loans;

2) Potential liquidity needs for meeting new loan demands, unavailed credit limits, loan policy,

potential deposit losses, investment obligations, statutory obligations, etc.

8.2.10 Alternative Scenarios

The liquidity profile of banks depends on the market conditions, which influence the cash flow

behaviour. Thus, banks should evaluate liquidity profile under different conditions, viz. normal

situation, bank specific crisis and market crisis scenario. The banks should establish benchmark

for normal situation, cash flow profile of on / off balance sheet items and manages net funding

requirements.

8.2.11 Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It

should be assumed that the purchased funds could not be easily rolled over; some of the core

deposits could be prematurely closed; a substantial share of assets have turned into

nonperforming and thus become totally illiquid. These developments would lead to rating down

grades and high cost of liquidity. The banks should evolve contingency plans to overcome such

situations.

8.2.12 The market crisis scenario analyses cases of extreme tightening of liquidity conditions

arising out of monetary policy stance of Reserve Bank, general perception about risk profile of

the banking system, severe market disruptions, failure of one or more of major players in the

market, financial crisis, contagion, etc. Under this scenario, the rollover of high value customer

deposits and purchased funds could extremely be difficult besides flight of volatile deposits /

liabilities. The banks could also sell their investment with huge discounts, entailing severe

capital loss.

8.2.13 Contingency Plan

Banks should prepare Contingency Plans to measure their ability to withstand bank-specific or

market crisis scenario. The blue-print for asset sales, market access, capacity to restructure the

maturity and composition of assets and liabilities should be clearly documented and alternative

options of funding in the event of bank’s failure to raise liquidity from existing source/s could be

clearly articulated. Liquidity from the Reserve Bank, arising out of its refinance window and

interim liquidity adjustment facility or as lender of last resort should not be reckoned for

contingency plans. Availability of back-up liquidity support in the form of committed lines of

credit, reciprocal arrangements, liquidity support from other external sources, liquidity of assets,

etc. should also be clearly established.

9. Interest Rate Risk (IRR)

9.1 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 banks’ NII or

NIM to variations. The earning of assets and the cost of liabilities are now closely related to

market interest rate volatility.

9.2 Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity

(MVE), caused by unexpected changes in market interest rates. Interest Rate Risk can take

different forms:

9.3 Types of Interest Rate Risk

9.3.1 Gap or Mismatch Risk:

A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet items with

different principal amounts, maturity dates or repricing dates, thereby creating exposure to

unexpected changes in the level of market interest rates.

9.3.2 Basis Risk

Market interest rates of various instruments seldom change by the same degree during a given

period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet

items may change in different magnitude is termed as basis risk. The degree of basis risk is fairly

high in respect of banks that create composite assets out of composite liabilities. The Loan book

in India is funded out of a composite liability portfolio and is exposed to a considerable degree of

basis risk. The basis risk is quite visible in volatile interest rate scenarios. When the variation in

market interest rate causes the NII to expand, the banks have experienced favourable basis shifts

and if the interest rate movement causes the NII to contract, the basis has moved against the

banks.

9.3.3 Embedded Option Risk

Significant changes in market interest rates create another source of risk to banks’ profitability

by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put

options on bonds/debentures and/or premature withdrawal of term deposits before their stated

maturities. The embedded option risk is becoming a reality in India and is experienced in volatile

situations. The faster and higher the magnitude of changes in interest rate, the greater will be the

embedded option risk to the banks’ NII. Thus, banks should evolve scientific techniques to

estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest

Rate Sensitivity) to realistically estimate the risk profiles in their balance sheet. Banks should

also endeavour for stipulating appropriate penalties based on opportunity costs to stem the

exercise of options, which is always to the disadvantage of banks.

9.3.4 Yield Curve Risk

In a floating interest rate scenario, banks may price their assets and liabilities based on different

benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks

use two different instruments maturing at different time horizon for pricing their assets and

liabilities, any non-parallel movements in yield curves would affect the NII. The movements in

yield curve are rather frequent when the economy moves through business cycles. Thus, banks

should evaluate the movement in yield curves and the impact of that on the portfolio values and

income.

9.3.5 Price Risk

Price risk occurs when assets are sold before their stated maturities. In the financial market, bond

prices and yields are inversely related. The price risk is closely associated with the trading book,

which is created for making profit out of short-term movements in interest rates. Banks which

have an active trading book should, therefore, formulate policies to limit the portfolio size,

holding period, duration, defeasance period, stop loss limits, marking to market, etc.

9.3.6 Reinvestment Risk

Uncertainty with regard to interest rate at which the future cash flows could be reinvested is

called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in

NII as the market interest rates move in different directions.

9.3.7 Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing towards

profitability of banks. When banks have more earning assets than paying liabilities, interest rate

risk arises when the market interest rates adjust downwards. Thus, banks with positive net

interest positions will experience a reduction in NII as the market interest rate declines and

increases when interest rate rises. Thus, large float is a natural hedge against the variations in

interest rates.

9.4 Measuring Interest Rate Risk

9.4.1 Before interest rate risk could be managed, they should be identified and quantified.

Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to measure

the degree of risks to which banks are exposed. It is also equally impossible to develop effective

risk management strategies/hedging techniques without being able to understand the correct risk

position of banks. The IRR measurement system should address all material sources of interest

rate risk including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and

net interest position risks exposures. The IRR measurement system should also take into account

the specific characteristics of each individual interest rate sensitive position and should capture

in detail the full range of potential movements in interest rates.

9.4.2 There are different techniques for measurement of interest rate risk, ranging from the

traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration

(to measure interest rate sensitivity of capital), Simulation and Value at Risk. While these

methods highlight different facets of interest rate risk, many banks use them in combination, or

use hybrid methods that combine features of all the techniques.

9.4.3 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 Investment or Banking Books. While the assets in

the trading book are held primarily for generating profit on short-term differences in

prices/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.

9.5 Trading Book

The top management of banks should lay down policies with regard to volume, maximum

maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for

classifying securities in the trading book. While the securities held in the trading book should

ideally be marked to market on a daily basis, the potential price risk to changes in market risk

factors should be estimated through internally developed Value at Risk (VaR) models. The VaR

method is employed to assess potential loss that could crystalise on trading position or portfolio

due to variations in market interest rates and prices, using a given confidence level, usually 95%

to 99%, within a defined period of time. The VaR method should incorporate the market factors

against which the market value of the trading position is exposed. The top management should

put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold

positions, derivative products, etc.) which is then disaggregated across different desks and

departments. The loss making tolerance level should also be stipulated to ensure that potential

impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis

Points should be matched by the Middle Office on a daily basis vis-à-vis the prudential limits set

by the Board. The advantage of using VaR is that it is comparable across products, desks and

Departments and it can be validated through ‘back testing’. However, VaR models require the

use of extensive historical data to estimate future volatility. VaR model also may not give good

results in extreme volatile conditions or outlier events and stress test has to be employed to

complement VaR. The stress tests provide management a view on the potential impact of large

size market movements and also attempt to estimate the size of potential losses due to stress

events, which occur in the ’tails’ of the loss distribution. Banks may also undertake scenario

analysis with specific possible stress situations (recently experienced in some countries) by

linking hypothetical, simultaneous and related changes in multiple risk factors present in the

trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could

also be modified to reflect liquidity risk differences observed across assets over time.

International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming

variable time horizons based on position size and relative turnover. In an environment where

VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and

gross/net positions can be used.

9.6 Banking Book

The changes in market interest rates have earnings and economic value impacts on the banks’

banking book. Thus, given the complexity and range of balance sheet products, banks should

have IRR measurement systems that assess the effects of the rate changes on both earnings and

economic value. The variety of techniques ranges from simple maturity (fixed rate) and repricing

(floating rate) to static simulation, based on current on-and-off-balance sheet positions, to highly

sophisticated dynamic modelling techniques that incorporate assumptions on behavioural pattern

of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures

against basis risk, embedded option risk, yield curve risk, etc.

9.7 Maturity Gap Analysis

9.7.1 The simplest analytical techniques for calculation of IRR exposure begins with maturity

Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet

positions into a certain number of pre-defined time-bands according to their maturity (fixed rate)

or time remaining for their next repricing (floating rate). Those assets and liabilities lacking

definite repricing intervals (savings bank, cash credit, overdraft, loans, export finance, refinance

from RBI etc.) or actual maturities vary from contractual maturities (embedded option in bonds

with put/call options, loans, cash credit/overdraft, time deposits, etc.) are assigned time-bands

according to the judgement, empirical studies and past experiences of banks.

9.7.2 A number of time bands can be used while constructing a gap report. Generally, most of the

banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly or one year.

It is very difficult to take a view on interest rate movements beyond a year. Banks with large

exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter

intervals like overnight, 1-7 days, 8-14 days, etc.

9.7.3 In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each

time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a repricing

‘Gap’ for that time band. The positive Gap indicates that banks have more RSAs than RSLs. A

positive or asset sensitive Gap means that an increase in market interest rates could cause an

increase in NII. Conversely, a negative or liability sensitive Gap implies that the banks’ NII

could decline as a result of increase in market interest rates. The negative gap indicates that

banks have more RSLs than RSAs. The Gap is used as a measure of interest rate sensitivity. The

Positive or Negative Gap is multiplied by the assumed interest rate changes to derive the

Earnings at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be

impacted by an adverse movement in interest rates. The changes in interest rate could be

estimated on the basis of past trends, forecasting of interest rates, etc. The banks should fix EaR

which could be based on last/current year’s income and a trigger point at which the line

management should adopt on-or off-balance sheet hedging strategies may be clearly defined.

9.7.4 The Gap calculations can be augmented by information on the average coupon on assets

and liabilities in each time band and the same could be used to calculate estimates of the level of

NII from positions maturing or due for repricing within a given time-band, which would then

provide a scale to assess the changes in income implied by the gap analysis.

9.7.5 The periodic gap analysis indicates the interest rate risk exposure of banks over distinct

maturities and suggests magnitude of portfolio changes necessary to alter the risk profile.

However, the Gap report quantifies only the time difference between repricing dates of assets

and liabilities but fails to measure the impact of basis and embedded option risks. The Gap report

also fails to measure the entire impact of a change in interest rate (Gap report assumes that all

assets and liabilities are matured or repriced simultaneously) within a given time-band and effect

of changes in interest rates on the economic or market value of assets, liabilities and offbalance

sheet position. It also does not take into account any differences in the timing of payments that

might occur as a result of changes in interest rate environment. Further, the assumption of

parallel shift in yield curves seldom happen in the financial market. The Gap report also fails to

capture variability in non-interest revenue and expenses, a potentially important source of risk to

current income.

9.7.6 In case banks could realistically estimate the magnitude of changes in market interest rates

of various assets and liabilities (basis risk) and their past behavioural pattern (embedded option

risk), they could standardise the gap by multiplying the individual assets and liabilities by how

much they will change for a given change in interest rate. Thus, one or several assumptions of

standardised gap seem more consistent with real world than the simple gap method. With the

Adjusted Gap, banks could realistically estimate the EaR.

9.8 Duration Gap Analysis

9.8.1 Matching the duration of assets and liabilities, instead of matching the maturity or repricing

dates is the most effective way to protect the economic values of banks from exposure to IRR

than the simple gap model. Duration gap model focuses on managing economic value of banks

by recognising the change in the market value of assets, liabilities and off-balance sheet (OBS)

items. When weighted assets and liabilities and OBS duration are matched, market interest rate

movements would have almost same impact on assets, liabilities and OBS, thereby protecting the

bank’s total equity or net worth. Duration is a measure of the percentage change in the economic

value of a position that will occur given a small change in the level of interest rates.

9.8.2 Measuring the duration gap is more complex than the simple gap model. For approximation

of duration of assets and liabilities, the simple gap schedule can be used by applying weights to

each time-band. The weights are based on estimates of the duration of assets and liabilities and

OBS that fall into each time band. The weighted duration of assets and liabilities and OBS

provide a rough estimation of the changes in banks’ economic value to a given change in market

interest rates. It is also possible to give different weights and interest rates to assets, liabilities

and OBS in different time buckets to capture differences in coupons and maturities and

volatilities in interest rates along the yield curve.

9.8.3 In a more scientific way, banks can precisely estimate the economic value changes to

market interest rates by calculating the duration of each asset, liability and OBS position and

weigh each of them to arrive at the weighted duration of assets, liabilities and OBS. Once the

weighted duration of assets and liabilities are estimated, the duration gap can be worked out with

the help of standard mathematical formulae. The Duration Gap measure can be used to estimate

the expected change in Market Value of Equity (MVE) for a given change in market interest rate.

9.8.4 The difference between duration of assets (DA) and liabilities (DL) is bank’s net duration.

If the net duration is positive (DA>DL), a decrease in market interest rates will increase the

market value of equity of the bank. When the duration gap is negative (DL> DA), the MVE

increases when the interest rate increases but decreases when the rate declines. Thus, the

Duration Gap shows the impact of the movements in market interest rates on the MVE through

influencing the market value of assets, liabilities and OBS.

9.8.5 The attraction of duration analysis is that it provides a comprehensive measure of IRR for

the total portfolio. The duration analysis also recognises the time value of money. Duration

measure is additive so that banks can match total assets and liabilities rather than matching

individual accounts. However, Duration Gap analysis assumes parallel shifts in yield curve. For

this reason, it fails to recognise basis risk.

9.9 Simulation

9.9.1 Many of the international banks are now using balance sheet simulation models to gauge

the effect of market interest rate variations on reported earnings/economic values over different

time zones. Simulation technique attempts to overcome the limitations of Gap and Duration

approaches by computer modelling the bank’s interest rate sensitivity. Such modelling involves

making assumptions about future path of interest rates, shape of yield curve, changes in business

activity, pricing and hedging strategies, etc. The simulation involves detailed assessment of the

potential effects of changes in interest rate on earnings and economic value. The simulation

techniques involve detailed analysis of various components of on-and off-balance sheet

positions. Simulations can also incorporate more varied and refined changes in the interest rate

environment, ranging from changes in the slope and shape of the yield curve and interest rate

scenario derived from Monte Carlo simulations.

9.9.2 The output of simulation can take a variety of forms, depending on users’ need. Simulation

can provide current and expected periodic gaps, duration gaps, balance sheet and income

statements, performance measures, budget and financial reports. The simulation model provides

an effective tool for understanding the risk exposure under variety of interest rate/balance sheet

scenarios. This technique also plays an integral-planning role in evaluating the effect of

alternative business strategies on risk exposures.

9.9.3 The simulation can be carried out under static and dynamic environment. While the current

on and off-balance sheet positions are evaluated under static environment, the dynamic

simulation builds in more detailed assumptions about the future course of interest rates and the

unexpected changes in bank’s business activity.

9.9.4 The usefulness of the simulation technique depends on the structure of the model, validity

of assumption, technology support and technical expertise of banks.

9.9.5 The application of various techniques depends to a large extent on the quality of data and

the degree of automated system of operations. Thus, banks may start with the gap or duration gap

or simulation techniques on the basis of availability of data, information technology and

technical expertise. In any case, as suggested by RBI in the guidelines on ALM System, banks

should start estimating the interest rate risk exposure with the help of Maturity Gap approach.

Once banks are comfortable with the Gap model, they can progressively graduate into the

sophisticated approaches.

9.10 Funds Transfer Pricing

9.10.1 The Transfer Pricing mechanism being followed by many banks does not support good

ALM Systems. Many international banks which have different products and operate in various

geographic markets have been using internal Funds Transfer Pricing (FTP). FTP is an internal

measurement designed to assess the financial impact of uses and sources of funds and can be

used to evaluate the profitability. It can also be used to isolate returns for various risks assumed

in the intermediation process. FTP also helps correctly identify the cost of opportunity value of

funds. Although banks have adopted various FTP frameworks and techniques, Matched Funds

Pricing (MFP) is the most efficient technique. Most of the international banks use MFP. The FTP

envisages assignment of specific assets and liabilities to various functional units (profit centres)

– lending, investment, deposit taking and funds management. Each unit attracts sources and uses

of funds. The lending, investment and deposit taking profit centres sell their liabilities to and

buys funds for financing their assets from the funds management profit centre at appropriate

transfer prices. The transfer prices are fixed on the basis of a single curve (MIBOR or derived

cash curve, etc) so that asset-liability transactions of identical attributes are assigned identical

transfer prices. Transfer prices could, however, vary according to maturity, purpose, terms and

other attributes.

9.10.2 The FTP provides for allocation of margin (franchise and credit spreads) to profit centres

on original transfer rates and any residual spread (mismatch spread) is credited to the funds

management profit centre. This spread is the result of accumulated mismatches. The margins of

various profit centres are:

Deposit profit centre:

Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads.

Lending profit centre:

Loan yields + TP on deposits – TP on loan financing – cost of deposits – deposit insurance -

overheads – loan loss provisions.

Investment profit centre:

Security yields + TP on deposits – TP on security financing – cost of deposits – deposit

insurance - overheads – provisions for depreciation in investments and loan loss.

Funds Management profit centre:

TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads. For illustration,

let us assume that a bank’s Deposit profit centre has raised a 3 month deposit @ 6.5% p.a. and

that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and 10.5% p.a.,

respectively. Let us also assume that the bank’s Loan profit centre created a one year loan @

13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as under:

Profit Centres

Deposit Funds Loan

Total

Interest Income 8.0 10.5 13.5 13.5

Interest Expenditure 6.5 8.0 10.5 6.5

Margin 1.5 2.5 3.0 7.0

Loan Loss Provision (expected) - - 1.0 1.0

Deposit Insurance 0.1 - - 0.1

Reserve Cost (CRR/ SLR) - 1.0 - 1.0

Overheads 0.6 0.5 0.6 1.7

NII 0.8 1.0 1.4 3.2

Under the FTP mechanism, the profit centres (other than funds management) are precluded from

assuming any funding mismatches and thereby exposing them to market risk. The credit or

counterparty and price risks are, however, managed by these profit centres. The entire market

risks, i.e interest rate, liquidity and forex are assumed by the funds management profit centre.

9.10.3 The FTP allows lending and deposit raising profit centres determine their expenses and

price their products competitively. Lending profit centre which knows the carrying cost of the

loans needs to focus on to price only the spread necessary to compensate the perceived credit risk

and operating expenses. Thus, FTP system could effectively be used as a way to centralize the

bank’s overall market risk at one place and would support an effective ALM modeling system.

FTP also could be used to enhance corporate communication; greater line management control

and solid base for rewarding line management.

10. Foreign Exchange (Forex) Risk

10.1 The risk inherent in running open foreign exchange positions have been heightened in

recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the

risk profile of banks’ balance sheets.

10.2 Forex risk is 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.

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

risk. While such type of risk crystallisation 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 centre and the settlement of another currency in another

timezone. The forex transactions with counterparties from another country also trigger sovereign

or country risk.

10.4 Forex Risk Management Measures

1. Set appropriate limits – open positions and gaps.

2. Clear-cut and well-defined division of responsibility between front, middle and back offices.

The top management should also adopt the VaR approach to measure the risk associated with

exposures. Reserve Bank of India has recently introduced two statements viz. Maturity and

Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of forex risk exposures.

Banks should use these statements for periodical monitoring of forex risk exposures.

11. Capital for Market Risk

11.1 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.

11.2 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 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. In the

meanwhile, banks are advised to study the Basle Committee’s paper on ‘Overview of the

Amendment to the Capital Accord to Incorporate Market Risks’ – January 1996 (copy enclosed).

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.

11.3 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 finalises 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.

12. Operational Risk

12.1 Managing operational risk is becoming an important feature of sound risk management

practices in modern financial markets in the wake of phenomenal increase in the volume of

transactions, high degree of structural changes and complex support systems. The most important

type of operational risk involves breakdowns in internal controls and corporate governance. Such

breakdowns can lead to financial loss through error, fraud, or failure to perform in a timely

manner or cause the interest of the bank to be compromised.

12.2 Generally, operational risk is defined as any risk, which is not categoried as market or credit

risk, or the risk of loss arising from various types of human or technical error. It is also

synonymous with settlement or payments risk and business interruption, administrative and legal

risks. Operational risk has some form of link between credit and market risks. An operational

problem with a business transaction could trigger a credit or market risk.

12.3 Measurement

There is no uniformity of approach in measurement of operational risk in the banking system.

Besides, the existing methods are relatively simple and experimental, although some of the

international banks have made considerable progress in developing more advanced techniques

for allocating capital with regard to operational risk. Measuring operational risk requires both

estimating the probability of an operational loss event and the potential size of the loss. It relies

on risk factor that provides some indication of the likelihood of an operational loss event

occurring. The process of operational risk assessment needs to address the likelihood (or

frequency) of a particular operational risk occurring, the magnitude (or severity) of the effect of

the operational risk on business objectives and the options available to manage and initiate

actions to reduce/ mitigate operational risk. The set of risk factors that measure risk in each

business unit such as audit ratings, operational data such as volume, turnover and complexity and

data on quality of operations such as error rate or measure of business risks such as revenue

volatility, could be related to historical loss experience. Banks can also use different analytical or

judgmental techniques to arrive at an overall operational risk level. Some of the international

banks have already developed operational risk rating matrix, similar to bond credit rating. The

operational risk assessment should be bank-wide basis and it should be reviewed at regular

intervals. Banks, over a period, should develop internal systems to evaluate the risk profile and

assign economic capital within the RAROC framework. Indian banks have so far not evolved

any scientific methods for quantifying operational risk. In the absence any sophisticated models,

banks could evolve simple benchmark based on an aggregate measure of business activity such

as gross revenue, fee income, operating costs, managed assets or total assets adjusted for

off-balance sheet exposures or a combination of these variables.

12.4 Risk Monitoring

The operational risk monitoring system focuses, inter alia, on operational performance measures

such as volume, turnover, settlement facts, delays and errors. It could also be incumbent to

monitor operational loss directly with an analysis of each occurrence and description of the

nature and causes of the loss.

12.5 Control of Operational Risk

Internal controls and the internal audit are used as the primary means to mitigate operational risk.

Banks could also explore setting up operational risk limits, based on the measures of operational

risk. The contingent processing capabilities could also be used as a means to limit the adverse

impacts of operational risk. Insurance is also an important mitigator of some forms of operational

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

operational risk.

12.6 Policies and Procedures

Banks should have well defined policies on operational risk management. The policies and

procedures should be based on common elements across business lines or risks. The policy

should address product review process, involving business, risk management and internal control

functions.

12.7 Internal Control

12.7.1 One of the major tools for managing operational risk is the well-established internal

control system, which includes segregation of duties, clear management reporting lines and

adequate operating procedures. Most of the operational risk events are associated with weak

links in internal control systems or laxity in complying with the existing internal control

procedures.

12.7.2 The ideal method of identifying problem spots is the technique of self-assessment of

internal control environment. The self-assessment could be used to evaluate operational risk

alongwith internal/external audit reports/ratings or RBI inspection findings. Banks should

endeavour for detection of operational problem spots rather than their being pointed out by

supervisors/internal or external auditors.

12.7.3 Alongwith activating internal audit systems, the Audit Committees should play greater

role to ensure independent financial and internal control functions.

12.7.4 The Basle Committee on Banking Supervision proposes to develop an explicit capital

charge for operational risk.

13. Risk Aggregation and Capital Allocation

13.1 Most of internally active banks have developed internal processes and techniques to assess

and evaluate their own capital needs in the light of their risk profiles and business plans. Such

banks take into account both qualitative and quantitative factors to assess economic capital. The

Basle Committee now recognises that capital adequacy in relation to economic risk is a

necessary condition for the long-term soundness of banks. Thus, in addition to complying with

the established minimum regulatory capital requirements, banks should critically assess their

internal capital adequacy and future capital needs on the basis of risks assumed by individual

lines of business, product, etc. As a part of the process for evaluating internal capital adequacy, a

bank should be able to identify and evaluate its risks across all its activities to determine whether

its capital levels are appropriate.

13.2 Thus, at the bank’s Head Office level, aggregate risk exposure should receive increased

scrutiny. To do so, however, it requires the summation of the different types of risks.

Banks,across the world, use different ways to estimate the aggregate risk exposures. The most

commonly used approach is the Risk Adjusted Return on Capital (RAROC). The RAROC is

designed to allow all the business streams of a financial institution to be evaluated on an equal

footing. Each type of risks is measured to determine both the expected and unexpected losses

using VaR or worst-case type analytical model. Key to RAROC is the matching of revenues,

costs and risks on transaction or portfolio basis over a defined time period. This begins with a

clear differentiation between expected and unexpected losses. Expected losses are covered by

reserves and provisions and unexpected losses require capital allocation which is determined on

the principles of confidence levels, time horizon, diversification and correlation. In this

approach, risk is measured in terms of variability of income. Under this framework, the

frequency distribution of return, wherever possible is estimated and the Standard Deviation (SD)

of this distribution is also estimated. Capital is thereafter allocated to activities as a function of

this risk or volatility measure. Then, the risky position is required to carry an expected rate of

return on allocated capital, which compensates the bank for the associated incremental risk. By

dimensioning all risks in terms of loss distribution and allocating capital by the volatility of the

new activity, risk is aggregated and priced.

13.3 The second approach is similar to the RAROC, but depends less on capital allocation and

more on cash flows or variability in earnings. This is referred to as EaR, when employed to

analyse interest rate risk. Under this analytical framework also frequency distribution of returns

for any one type of risk can be estimated from historical data. Extreme outcome can be estimated

from the tail of the distribution. Either a worst case scenario could be used or Standard Deviation

1/2/2.69 could also be considered. Accordingly, each bank can restrict the maximum potential

loss to certain percentage of past/current income or market value. Thereafter, rather than moving

from volatility of value through capital, this approach goes directly to current earnings

implications from a risky position. This approach, however, is based on cash flows and ignores

the value changes in assets and liabilities due to changes in market interest rates. It also depends

upon a subjectively specified range of the risky environments to drive the worst case scenario.

13.4 Given the level of extant risk management practices, most of Indian banks may not be in a

position to adopt RAROC framework and allocate capital to various businesses units on the basis

of risk. However, at least, banks operating in international markets should develop, by March 31,

2001, suitable methodologies for estimating economic capital.

Guidelines for Asset Liability Management (ALM) System in Financial Institutions (FIs)

In the normal course, FIs are exposed to credit and market risks in view of the asset-liability

transformation. With liberalisation in Indian financial markets over the last few years and

growing integration of domestic markets with external markets, the risks, particularly the market

risks, associated with FIs’ operations have become complex and large, requiring strategic

management. FIs are operating in a fairly deregulated environment and are required to determine

interest rates on various products in their liabilities and assets portfolios, both in domestic as well

as foreign currencies, on a dynamic basis. Intense competition for business involving both the

assets and liabilities, together with increasing volatility in the domestic interest rates as also in

foreign exchange rates, has brought pressure on the management of FIs to maintain a good

balance amongst spreads, profitability and long-term viability.

These pressures call for structured and comprehensive measures for institutionalising an

integrated risk management system and not just ad hoc action. The FIs are exposed to several

major risks in the course of their business – generically classified as credit risk, market risk and

operational risk – which underlines the need for effective risk management systems in FIs. The

FIs need to address these risks in a structured manner by upgrading the quality of their risk

management and adopting more comprehensive ALM practices than has been done hitherto.

2. The envisaged ALM system seeks to introduce a formalised framework for management of

market risks through measuring, monitoring and managing liquidity, exchange rate and interest

rate risks of a FI that need to be closely integrated with the FIs’ business strategy. This note lays

down broad guidelines for FIs in respect of liquidity, exchange rate and interest rate risk

management systems which form part of the ALM function. The initial focus of the ALM

function would be to enforce the discipline of market risk management viz. managing business

after assessing the market risks involved. The objective of a good risk management systems

should be to evolve into a strategic tool for effective management of FIs.

3. The ALM process rests on three pillars:

ALM Information System

Management Information System

● Information availability, accuracy, adequacy and expediency

● ALM Organisation

● Structure and responsibilities

● Level of top management involvement

● ALM Process

● Risk parameters

● Risk identification

● Risk measurement

● Risk management

● Risk policies and tolerance levels.

4. ALM Information System

ALM has to be supported by a management philosophy which clearly specifies the risk policies

and tolerance limits. This framework needs to be built on sound methodology with necessary

supporting information system as the central element of the entire ALM exercise is the

availability of adequate and accurate information with expedience. Thus, information is the key

to the ALM process. There are various methods prevalent world-wide for measuring risks. These

range from the simple Gap Statement to extremely sophisticated and data intensive Risk

Adjusted Profitability Measurement methods. The present guidelines would require

comparatively simpler information system for generating liquidity gap and interest rate gap

reports.

5. ALM Organisation

5.1 Successful implementation of the risk management process would require strong

commitment on the part of the senior management in the FI, to integrate basic operations and

strategic decision making with risk management. The Board should have overall responsibility

for management of market risks and should decide the risk management policy of the FI and set

limits for liquidity, interest rate, exchange rate

and equity price risks.

5.2 The ALCO is a decision-making unit, consisting of the FI's senior management including

CEO, responsible for integrated balance sheet management from risk-return perspective

including the strategic management of interest rate and liquidity risks. While each FI will have to

decide the role of its ALCO, its powers and responsibilities as also the decisions to be taken by

it, its responsibilities would normally include:

● monitoring the market risk levels of the FI by ensuring adherence to the various risk-limits

set by the Board;

● articulating the current interest rate view and a view on future direction of interest rate

movements and base its decisions for future business strategy on this view as also on other

parameters considered relevant.

● deciding the business strategy of the FI, both - on the assets and liabilities sides, consistent

with the FI’s interest rate view, budget and pre-determined risk management objectives. This

would, in turn, include:

● determining the desired maturity profile and mix of the assets and liabilities;

● product pricing for both - assets as well as liabilities side;

● deciding the funding strategy i.e. the source and mix of liabilities or sale of assets; the

proportion of fixed vs floating rate funds, wholesale vs retail funds, money market vs capital

market funding, domestic vs foreign currency funding, etc.

● reviewing the results of and progress in implementation of the decisions made in the previous

meetings

5.3 The ALM Support Groups consisting of operating staff should be responsible for analysing,

monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts

(simulations) reflecting the impact of various possible changes in market conditions on the

balance sheet and recommend the action needed to adhere to FI's internal limits.

5.4 Composition of ALCO

The size (number of members) of ALCO would depend on the size of each institution, business

mix and organisational complexity. To ensure commitment of the Top Management and timely

response to market dynamics, the CEO/CMD/DMD or the ED should head the Committee.

Though the composition of ALCO could vary across the FIs as per their respective set up and

business profile, it would be useful to have the Chiefs of Investment, Credit, Resources

Management or Planning, Funds Management / Treasury (forex and domestic), International

Business and Economic Research as the members of the Committee. In addition, the Head of the

Technology Division should also be an invitee for building up of MIS and related

computerisation. Some FIs may even have Sub-committees and Support Groups.

5.5 Committee of Directors

The Management Committee of the Board or any other Specific Committee constituted by the

Board should oversee the implementation of the ALM system and review its functioning

periodically.

6. ALM Process

The scope of ALM function can be described as follows:

● Liquidity risk management

● Management of market risks

● Trading risk management

● Funding and capital planning

● Profit planning and growth projection

The guidelines contained in this note mainly address Liquidity and Interest Rate risks.

6.1 Liquidity Risk Management

Measuring and managing liquidity needs are vital for effective operation of FIs. By assuring a

FI's ability to meet its liabilities as they become due, liquidity management can reduce the

probability of an adverse situation developing. The importance of liquidity transcends individual

institutions, as liquidity shortfall in one institution can have repercussions on the entire system.

FIs’ management should measure not only the liquidity positions of FIs on an ongoing basis but

also examine how liquidity requirements are likely to evolve under different assumptions.

Experience shows that assets commonly considered to be liquid, such as Government securities

and other money market instruments, could also become illiquid when the market and players are

unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches.

For measuring and managing net funding requirements, the use of a maturity ladder and

calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a

standard tool. The format of the Statement of Liquidity is furnished in Annexure I.

6.2 The Maturity Profile, as detailed in Appendix I, could be used for measuring the future cash

flows of FIs in different time buckets. The time buckets, may be distributed as under:

i) 1 to 14 days

ii) 15 to 28 days

iii) 29 days and upto 3 months

iv) Over 3 months and upto 6 months

v) Over 6 months and upto 1 year

vi) Over 1 year and upto 3 years

vii) Over 3 years and upto 5 years

viii) Over 5 years and upto 7 years

ix) Over 7 years andupto 10 years

x) Over 10 years.

6.3 The investments are assumed as illiquid due to lack of depth in the secondary market and are,

therefore, generally shown, as per their residual maturity, under respective time buckets.

However, some of the FIs may be maintaining securities in the ‘Trading Book’, which are kept

distinct from other investments made for retaining relationship with customers. Securities held in

the 'Trading Book’ should be subject to the following preconditions:

i) The composition and volume of the Trading Book should be clearly defined;

ii) Maximum maturity/duration of the trading portfolio should be restricted;

iii) The holding period of the trading securities should not exceed 90 days;

iv) Cut-loss limit(s) should be prescribed;

v) Product-wise defeasance periods (i.e. the time taken to liquidate the ‘position’ on the basis of

liquidity in the secondary market) should be prescribed;

vi) Such securities should be marked-to-market on a daily/weekly basis and the revaluation

gain/loss should be charged to the profit and loss account; etc.

FIs which maintain such ‘Trading Books’ consisting of securities that comply with the above

standards, are permitted to show the trading securities under 1-14 days, 15-28 days and 29-90

days buckets on the basis of the defeasance periods. The Board/ALCO of the banks should

approve the volume, composition, maximum maturity/duration, holding/defeasance period, cut

loss limits, etc., of the ‘Trading Book’. FIs, which are better equipped, will have the option of

evolving with the approval of the Board / ALCO, an integrated Value at Risk (VaR) limit for

their entire balance sheet including the “Banking Book” and the “Trading Book”, for the rupee as

well as foreign currency portfolio. A copy of the approved policy note in this regard, should be

forwarded to the Department of Banking Supervision, FID, RBI.

6.4 Within each time bucket there could be mismatches depending on cash inflows and outflows.

While the mismatches upto one year would be relevant since these provide early warning signals

of impending liquidity problems, the main focus should be on the short-term mismatches viz.,

1-14 days and 15-28 days. FIs however, are expected to monitor their cumulative mismatches

(running total) across all time buckets by establishing internal prudential limits with the approval

of the Board / ALCO. The negative gap during 1-14 days and 15-28 days time-buckets, in

normal course, should not exceed 10 per cent and 15 per cent respectively, of the cash outflows

in each time bucket. If a FI in view of its current assetliability profile and the consequential

structural mismatches needs higher tolerance level, it could operate with higher limit sanctioned

by its Board / ALCO giving specific reasons on the need for such higher limit. The discretion to

allow a higher tolerance level is intended for a temporary period, i.e. till March 31, 2001. While

determining the tolerance levels, the FIs may take into account all relevant factors based on their

asset-liability base, nature of business, future strategy, etc. The RBI is interested in ensuring that

the tolerance levels are determined keeping all necessary factors in view and further refined with

experience gained in Liquidity Management.

6.5 The Statement of Liquidity (Annexure I ) may be prepared by placing all cash inflows and

outflows in the maturity ladder according to the expected timing of cash flows. A maturing

liability will be a cash outflow while a maturing asset will be a cash inflow. It would also be

necessary to take into account the rupee inflows and outflows on account of forex operations.

Thus, the foreign currency resources raised abroad but swapped into rupees and deployed in

rupee assets, would be reflected in the rupee liquidity statement. Some of the FIs have the

practice of disbursing rupee loans to their exporter clients but denominating such loans in foreign

currency in their books which are extinguished by the export proceeds. Such foreign currency

denominated loans too would be a part of rupee liquidity statement since such loans are created

out of rupee resources. As regards the foreign currency loans granted out of foreign currency

resources on a back-to-back basis, a currency-wise liquidity statement for each of the foreign

currencies in which liabilities and assets have been created, will need to be prepared in

formats at Annexure I-A and Annexure II-A, which are similar to the formats prescribed for

rupee resources.

7. Currency Risk

7.1 Floating exchange rate arrangement has brought in its wake pronounced volatility adding a

new dimension to the risk profile of FIs’ balance sheets. The increased capital flows across free

economies following deregulation have contributed to increase in the volume of transactions.

Large cross border flows together with the volatility has rendered the FIs' balance sheets

vulnerable to exchange rate movements.

7.2 Dealing in different currencies brings opportunities as also risks. If the liabilities in one

currency exceed the level of assets in the same currency, then the currency mismatch can add

value or erode value depending upon the currency movements. Mismatched currency position,

besides exposing the balance sheet to movements in exchange rate, also exposes it to country risk

and settlement risk. FIs undertake operations in foreign exchange such as borrowings and

making loans in foreign currency, which exposes them to currency or exchange rate risk. The

simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or

near zero. However, irrespective of the strategies adopted, it may not be possible to eliminate

currency mismatches altogether.

7.3 At present, only five FIs (viz. EXIM Bank, ICICI, IDBI, IFCI and IIBI) have been granted by

RBI (ECD) restricted authorisation to deal in foreign exchange under FERA 1973 while other

FIs are not authorised to deal in foreign exchange. The FIs are, therefore, unlike banks, are not

subject to the full rigour of the reporting requirements under Exchange Control regulations.

Hence, the MAP and SIR statements prescribed for banks vide AD (MA Series) circular no. 52

dated 27 December 1997 issued by RBI (ECD), are not applicable to FIs. In order, however, to

capture the liquidity and interest rate risk inherent in the foreign currency portfolio of the FIs, it

would be necessary to compile, on an ongoing basis, currency-wise Statement of Liquidity and

IRS Statement, separately for each of the currencies in which the FIs have an exposure. These

statements should be compiled in the formats prescribed at

Annexure I-A and Annexure II-A – which are similar to the formats prescribed for the rupee

resources, at Annexure I and Annexure II to these guidelines.

8. Interest Rate Risk (IRR)

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

FI's financial condition. The immediate impact of changes in interest rates is on FI's earnings (i.e.

reported profits) by changing its Net Interest Income (NII). A long-term impact of changing

interest rates is on FI's Market Value of Equity (MVE) or Net Worth as the economic value of

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. The risk from the earnings

perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin

(NIM). There are many analytical techniques for measurement and management of Interest Rate

Risk. In the context of poor MIS, slow pace of computerisation in FIs, the traditional Gap

analysis is considered to be a suitable method to measure the Interest Rate Risk in the initial

phase of the ALM system. However, the FIs, which are better equipped, would have the option

of deploying advanced IRR management techniques with the approval of their Board / ALCO, in

addition to the Gap Analysis prescribed under the guidelines. It is the intention of RBI to move

over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis,

Simulation and Value at Risk over time when FIs acquire sufficient expertise and sophistication

in acquiring and handling MIS. The Gap or Mismatch risk can be measured by calculating Gaps

over different time intervals as at a given date. Gap analysis measures mismatches between rate

sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or

liability is normally classified as rate sensitive if:

i) within the time interval under consideration, there is a cash flow;

ii) the interest rate resets/reprices contractually during the interval;

iii) it is contractually pre-payable or withdrawable before the stated maturities;

iv) It is dependent on the changes in the Bank Rate by RBI.

8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets and

off-balance sheet positions into time buckets according to residual maturity or next re-pricing

period, whichever is earlier. All investments, advances, deposits, borrowings, purchased funds,

etc. that mature/re-price within a specified timeframe are interest rate sensitive. Similarly, any

principal repayment of loan is also rate sensitive if the FI expects to receive it within the time

horizon. This includes final principal repayment and interim instalments. Certain assets and

liabilities carry floating rates of interest that vary with a reference rate and hence, these items get

re-priced at pre-determined intervals. Such assets and liabilities are rate sensitive at the time of

re-pricing. While the interest rates on term deposits and bonds are generally fixed during their

currency, the interest rates on advances could be re-priced any number of occasions, on the

pre-determined reset / re-pricing dates and the new rate would normally correspond to the

changes in PLR.

The interest rate gaps may be identified in the following time buckets:

i) 1-28 days

ii) 29 days and upto 3 months

iii) Over 3 months and upto 6 months

iv) Over 6 months and upto 1 year

v) Over 1 year and upto 3 years

vi) Over 3 years and upto 5 years

vii) Over 5 years and upto 7 years

viii) Over 7 years and upto 10 years

ix) Over 10 years

x) Non-sensitive

The various items of rate sensitive assets and liabilities and off-balance sheet items may be

classified into various time-buckets, as explained in Appendix - II and the Reporting Format for

interest rate sensitive assets and liabilities is given in Annexure II.

8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities

(RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs

whereas the negative Gap indicates that it has more RSLs. The Gap reports indicate whether the

institution is in a position to benefit from rising interest rates by having a positive Gap (RSA >

RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap

(RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity.

8.4 Each FI should set prudential limits on interest rate gaps in various time buckets with the

approval of the Board/ALCO. Such prudential limits should have a relationship with the Total

Assets , Earning Assets or Equity. In addition to the interest rate gap limits, the FIs which are

better equipped would have the option of setting the prudential limits in terms of Earnings at

Risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements with

the approval of the Board/ALCO.

9. General

9.1 The classification of various components of assets and liabilities into different time buckets

for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in

Appendices I & II is the benchmark. FIs which are better equipped to reasonably estimate the

behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets

and liabilities on the basis of past data / empirical studies could classify them in the appropriate

time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the

ALCO / Board may be sent to the Department of Banking Supervision, Financial Institutions

Division.

9.2 The impact of embedded options (i.e. the customers exercising their options for premature

closure of term deposits, premature encashment of bonds and pre-payment of loans and

advances) on the liquidity and interest rate risks profile of FIs and the magnitude of embedded

option risk during the periods of volatility in market interest rates, is quite substantial. FIs should

therefore evolve suitable mechanism, supported by empirical studies and behavioural analysis, to

estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in

market variables and estimate the impact of embedded options. In the absence of adequate

historical database, the entire amount payable under the embedded options should be slotted as

per the residual period to the earliest exercise date.

9.3 A scientifically evolved internal transfer pricing model by assigning values on the basis of

current market rates to funds provided and funds used is an important component for effective

implementation of ALM System. The transfer price mechanism can enhance the management of

margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also

helps centralising interest rate risk at one place which facilitate effective control and

management of interest rate risk. A well defined transfer pricing system also provide a rational

framework for pricing of assets and liabilities.

CAPITAL FUNDS & CAPITAL REQUIREMENTS

General Guidelines

1 General

Capital adequacy standards for standalone Primary Dealers (PDs) in Government Securities

(G-Sec) market have been in vogue since December 2000. The guidelines were revised on

January 07, 2004, keeping in view the market developments, experience gained over time and

introduction of new products like exchange traded derivatives. The present circular has been

updated with the guidelines on capital funds and capital requirements issued since then.

2 Capital Funds

2.1 Capital funds include Tier-I and II capital.

2.2 Tier-I Capital

Tier-I capital means paid-up capital, statutory reserves and other disclosed free reserves.

Investment in subsidiaries (where applicable), intangible assets, losses in current accounting

period, deferred tax asset and losses brought forward from previous accounting periods will be

deducted from the Tier-I capital.

In case any PD is having substantial interest/exposure (as defined for NBFCs) by way of loans

and advances not related to business relationship in other Group companies, such amounts will

be deducted from its Tier-I capital.

2.3 Tier-II Capital

Tier-II capital includes the following:

(i) Undisclosed reserves and cumulative preference shares1 (other than those which are

compulsorily convertible into equity). Cumulative preferential shares should be fully paid-up and

should not contain clauses which permit redemption by the holder.

(ii) Revaluation reserves, discounted at a rate of fifty five percent.

(iii) General provisions and loss reserves (to the extent these are not attributable to actual

diminution in value or identifiable potential loss in any specific asset and are available to meet

unexpected losses), up to a maximum of 1.25 percent of total risk weighted assets.

(iv) Hybrid debt capital instruments, which combine certain characteristics of equity and debt.

(v) Subordinated Debt (SD):

The instrument should be fully paid-up, unsecured, subordinate to the claims of other creditors,

free of restrictive clauses, and should not be redeemable at the initiative of the holder or without

the consent of the Reserve Bank of India (RBI).

SD instruments with an initial maturity of less than 5 years or with a remaining maturity of one

year or less should not be included as part of Tier-II capital.

SD instruments eligible to be reckoned as Tier-II capital will be limited to 50 percent of Tier-I

capital.

The SD instruments may be subjected to progressive discount at the rates shown below:

Residual Maturity of Instruments

Rate of Discount (%)

Less than one year 100

One year and more but less than two years 80

Two years and more but less than three years60

Three years and more but less than four years 40

Four years and more but less than five years 20

2.4 Guidelines on SD Bonds (Tier-II Capital)

The amount to be raised may be decided by the Board of Directors of the PD. The PDs may fix

coupon rates as decided by their Board. The instruments should be 'plain vanilla' with no special

features like options, etc. The debt securities should carry a credit rating from a Credit Rating

Agency registered with the Securities and Exchange Board of India (SEBI). The issue of SD

instruments should comply with the guidelines issued by SEBI vide their circular

SEBI/MRD/SE/AT/36/2003/30/09 dated September 30, 2003 (ref: www.sebi.gov.in/circulars), as

amended from time to time, wherever applicable. In case of unlisted issues of SD, the disclosure

requirements as prescribed by the SEBI for listed companies in terms of the above guidelines

should be complied with. Necessary permission from the Foreign Exchange Department of the

RBI should be obtained for issuing the instruments to Non-Resident Indians/Foreign Institutional

Investors (FIIs). PDs should comply with the terms and conditions, if any, prescribed by SEBI /

other regulatory authorities with regard to issue of the instruments.

Investments by PDs in SD of other PDs/banks will be assigned 100% risk weight for capital

adequacy purpose. Further, the PD’s aggregate investments in Tier-II bonds issued by other PDs,

banks and financial institutions should be restricted to 10 percent of the investing PD's total

capital funds. The capital funds for this purpose will be the same as those reckoned for the

purpose of capital adequacy.

The PDs should submit a report to the Chief General Manager, Department of Non-Banking

Regulation (DNBR), RBI, , giving details of the capital raised, such as, amount raised, maturity

of the instrument, rate of interest together with a copy of the offer document, soon after the issue

is completed.

2.5 Minimum CRAR ratio

PDs are required to maintain a minimum Capital to Risk-Weighted Assets Ratio (CRAR) of 15

percent on an ongoing basis.

3 Measurement of Risk Weighted Assets

The details of credit risk weights for various on-balance sheet and off-balance sheet items and

methodology of computing the risk weighted assets for the credit risk are listed in Annex A. The

procedure for calculating capital charge for market risk is detailed in Annex B.

4. Capital Adequacy requirements

4.1 The capital charge for credit risk and market risk as indicated in Annex A and Annex B, need

to be maintained at all times.

4.2 In calculating eligible capital, it will be necessary first to calculate the PD’s minimum capital

requirement for credit risk, and thereafter its market risk requirement, to establish how much

Tier-I and Tier-II capital is available to support market risk. Of the 15% capital charge for credit

risk, at least 50% should be met by Tier-I capital, that is, the total of Tier-II capital, if any, should

not exceed one hundred per cent of Tier-I capital, at any point of time, for meeting the capital

charge for credit risk.

4.3 Subordinated debt as Tier-II capital should not exceed 50 per cent of Tier-I capital.

4.4 The total of Tier-II capital should not exceed 100% of Tier-I capital.

4.5 Eligible capital will be the sum of the whole of the PD’s Tier-I capital, plus all of its Tier-II

capital under the limits imposed, as summarized above.

4.6 The overall capital adequacy ratio will be calculated by establishing an explicit numerical

link between the credit risk and the market risk factors, by multiplying the market risk capital

charge with 6.67 i.e. the reciprocal of the minimum credit risk capital charge of 15 per cent.

4.7 The resultant figure is added to the sum of risk weighted assets worked out for credit risk

purpose. The numerator for calculating the overall ratio will be the PD’s total capital funds

(Tier-I and Tier-II capital, after applicable deductions, if any). The calculation of capital charge is

illustrated in PDR III format, enclosed as Annex C.

5 Regulatory reporting of Capital adequacy

All PDs should report the position of their capital adequacy in PDR III return (Annex C) on a

quarterly basis. Apart from the Appendices I to V which are to be submitted along with PDR III

return, PDs should also take into consideration the criteria for use of internal model to measure

market risk capital charge (Annex D) along with the "Back Testing" mechanism (Annex E).

6 Diversification of PD Activities

6.1 The guidelines on diversification of activities by stand-alone PDs have been issued vide

circular IDMD.PDRS.26/03.64.00/2006-07 dated July 4, 2006 and detailed in the Master

Circular on Prudential Guidelines for Primary Dealers dated July 1, 2015.

6.2 The capital charge for market risk {Value-at-Risk (VaR) calculated at 99 per cent confidence

level, 15-day holding period, with multiplier of 3.3} for the activities defined below should not

be more than 20 per cent of the Net Owned Fund2 (NOF) as per the last audited balance sheet:

Investment / trading in equity and equity derivatives

Investment in units of equity oriented mutual funds

Underwriting public issues of equity

6.3 PDs may calculate the capital charge for market risk on the stock positions/ underlying stock

positions /units of equity oriented mutual funds using Internal Models (VaR based) as per the

guidelines prescribed in Appendix III of Annex C. As regards credit risk arising out of exposure

in equity, equity derivatives and equity oriented mutual funds, PDs may calculate the capital

charge as per the guidelines prescribed in Annex A.

7 Risk reporting of derivative business

In order to capture interest rate risk arising out of Rupee interest rate derivative business, all PDs

are advised to report the Rupee interest rate derivative transactions, as per the format enclosed in

Annex F, to the Chief General Manager, IDMD, RBI, Central Office, Mumbai-400001, as on last

working day of every month.

Annex B

(See paras 3 and 4.1 of the main guidelines)

MEASUREMENT OF MARKET RISK

Market risk may be defined as the risk of loss arising from movements in market prices or rates

away from the rates or prices set out in a transaction or agreement. The objective in introducing

the capital adequacy for market risk is to provide an explicit capital cushion for the price risk to

which the PDs are exposed to in their portfolio.

2. The capital charge for market risks should be worked out by the standardised approach and the

internal risk management framework based Value at Risk (VaR) model. The capital charge for

market risk to be provided by PDs would be higher of the two requirements. However, where

price data is not available for specific category of assets, PDs may follow the standardised

approach for computation of market risk. In such a situation, PDs should disclose to RBI, details

of such assets and ensure that consistency of approach is followed. PDs should obtain RBI’s

permission before excluding any category of asset for calculations of market risk. PDs would

normally consider the instruments of the nature of fixed deposits, commercial bills etc., for this

purpose. Such items will be held in the books till maturity and any diminution in the value will

have to be provided for in the books.

Note: In case of underwriting commitments, following points should be adhered to:

In case of devolvement of underwriting commitment for G-Sec, 100% of the devolved amount

would qualify for the measurement of market risk.

In case of underwriting under merchant banking issues (other than G-Sec), where price has been

committed/frozen at the time of underwriting, the commitment is to be treated as a contingent

liability and 50% of the commitment should be included in the position for market risk.

However, 100% of devolved position should be subjected to market risk measurement.

3. The methodology for working out the capital charges for market risk on the portfolio is as

below:

A. Standardized Approach

Capital charge will be the measure of risk arrived at in terms of paras A1 – A3 below, summed

arithmetically.

A1. For Fixed Income Instruments

Duration method would continue to apply as hitherto. Under this, the price sensitivity of all

interest rate positions viz., Dated securities, Treasury bills, Commercial papers,

PSU/FI/Corporate Bonds, Special Bonds, Mutual Fund units and derivative instruments like IRS,

FRA, IRF etc., including underwriting commitments/devolvement and other contingent liabilities

having interest rate/equity risk will be captured.

In duration method, the capital charge is the sum of four components namely:

a) the net short or long position in the whole trading book;

b) a small proportion of the matched positions in each time-band (the “vertical disallowance’’);

c) a larger proportion of the matched positions across different time-bands (the “horizontal

disallowance’’) ;and

d) a net charge for positions in options, where appropriate.

Note 1: Since short position in India is allowed only in derivatives and G-Sec, netting as

indicated at (a) and the system of `disallowances’ as at (b) and (c) above are applicable currently

only to the PDs entering into FRAs / IRSs / exchange traded derivatives and G-Sec.

However, under the duration method, PDs with the necessary capability may, with RBI’s

permission use a more accurate method of measuring all of their general market risks by

calculating the price sensitivity of each position separately. PDs must select and use the method

on a consistent basis and the system adopted will be subjected to monitoring by the RBI. The

mechanics of this method are as follow:

first calculate the price sensitivity of all instruments in terms of a change in interest rates

between 0.6 and 1.0 percentage points depending on the duration of the instrument (as per Table

1 given below );

slot the resulting sensitivity measures into a duration-based ladder with the thirteen time-bands

set out in Table 1;

subject the lower of the long and short positions in each time-band to a 5% capital charge

towards vertical disallowance designed to capture basis risk;

carry forward the net positions in each time-band for horizontal offsetting across the zones

subject to the disallowances set out in Table 2.

Note 2: Points (iii) and (iv) above are applicable only where opposite positions exist as explained

at Note 1 above.

Table 1

Duration time-bands and assumed changes in yield (%)

Zone 1

0 to 1 month 1.00

1 to 3 months 1.00

3 to 6 months 1.00

6 to 12 months1.00

Zone 2

1 to 2 years 0.95

2 to 3 years 0.90

3 to 4 years 0.85

Zone 3

4 to 5 years 0.85

5 to 7 years 0.80

7 to 10 years 0.75

10 to 15 years 0.70

15 to 20 years 0.65

Over 20 years 0.60

Table 2

Horizontal disallowance

Zones Time-band Within the zone Between adjacent zones Between zones 1 and

3

Zone 1 0 – month 40% 40% 100%

1 – 3 months

3 – 6 months

6 – 12 months

Zone 2 1 – 2 years 30%

2 – 3 years

3 – 4 years

Zone 3 4 – 5 years 30%

5 – 7 years

7 – 10 years

10 – 15 years

15 – 20 years

Over 20 years

The gross positions in each time-band will be subject to risk weighting as per the assumed

change in yield set out in Table 1, with no further offsets.

A1.1 Capital charge for interest rate derivatives

The measurement system should include all interest rate derivatives and off balance-sheet

instruments in the trading book which react to changes in interest rates, (e.g. FRAs, other

forward contracts, bond futures, interest rate positions).

A1.2 Calculation of positions

Derivatives should be converted into positions in the relevant underlying and subjected to market

risk charges as described above. In order to calculate the market risk as per the standardized

approach described above, the amounts reported should be the market value of the principal

amount of the underlying or of the notional underlying.

A1.3 Futures and Forward Contracts (including FRAs)

These instruments are treated as a combination of a long and a short position in a notional

government security. The maturity of a future contract or an FRA will be the period until

delivery or exercise of the contract, plus - where applicable - the life of the underlying

instrument. For example, a long position in a June three-month IRF taken in April is to be

reported as a long position in a government security with a maturity of five months and a short

position in a government security with a maturity of two months. Where a range of deliverable

instruments may be delivered to fulfill the contract, the PD has flexibility to elect which

deliverable security goes into the maturity or duration ladder but should take account of any

conversion factor defined by the exchange. In the case of a future on a corporate bond index,

positions will be included at the market value of the notional underlying portfolio of securities.

A1.4 Swaps

Swaps will be treated as two notional positions in G-Sec with relevant maturities. For example,

an IRS under which a PD is receiving floating rate interest and paying fixed will be treated as a

long position in a floating rate instrument of maturity equivalent to the period until the next

interest fixing and a short position in a fixed-rate instrument of maturity equivalent to the

residual life of the swap. For swaps that pay or receive a fixed or floating interest rate against

some other reference price, e.g. a stock index, the interest rate component should be slotted into

the appropriate re-pricing maturity category, with the equity component being included in the

equity framework.

A1.5 Calculation of capital charges

Allowable offsetting of matched positions - PDs may exclude from the interest rate maturity

framework altogether (long and short positions, both actual and notional) in identical instruments

with exactly the same issuer, coupon and maturity. A matched position in a future or forward and

its corresponding underlying may also be fully offset, and thus excluded from the calculation.

When the future or the forward comprises a range of deliverable instruments, offsetting of

positions in the future or forward contract and its underlying is only permissible in cases where

there is a readily identifiable underlying security which is most profitable for the trader with a

short position to deliver. The leg representing the time to expiry of the future should, however, be

taken into account. The price of this security, sometimes called the "cheapest-to-deliver", and the

price of the future or forward contract should in such cases move in close alignment.

In addition, opposite positions in the same category of instruments can in certain circumstances

be regarded as matched and allowed to offset fully. To qualify for this treatment the positions

must relate to the same underlying instruments and be of the same nominal value. In addition:

(i) For futures: offsetting positions in the notional or underlying instruments to which the futures

contract relates must be for identical products and mature within seven days of each other;

(ii) For swaps and FRAs: the reference rate (for floating rate positions) must be identical and the

coupon closely matched (i.e. within 15 basis points); and

(iii) For swaps, FRAs and forwards: the next interest fixing date or, for fixed coupon positions or

forwards, the residual maturity must correspond within the following limits:

less than one month hence: same day;

between one month and one year hence: within seven days;

over one year hence: within thirty days.

PDs with large swap books may use alternative formulae for these swaps to calculate the

positions to be included in the duration ladder. One method would be to first convert the

payments required by the swap into their present values. For that purpose, each payment should

be discounted using zero coupon yields, and a single net figure for the present value of the cash

flows entered into the appropriate time-band using procedures that apply to zero (or low) coupon

bonds; these figures should be slotted into the general market risk framework as set out earlier.

An alternative method would be to calculate the sensitivity of the net present value implied by

the change in yield used in the duration method and allocate these sensitivities into the

time-bands set out in Table 1. Other methods which produce similar results could also be used.

Such alternative treatments will, however, only be allowed if:

the supervisory authority is fully satisfied with the accuracy of the systems being used;

the positions calculated fully reflect the sensitivity of the cash flows to interest rate changes and

are entered into the appropriate time-bands;

General market risk applies to positions in all derivative products in the same manner as for cash

positions, subject only to an exemption for fully or very closely-matched positions in identical

instruments as defined in above paragraphs. The various categories of instruments should be

slotted into the maturity ladder and treated according to the rules identified earlier.

A2 Capital charge for equity positions8

A2.1 Equity positions

This section sets out a minimum capital standard to cover the risk of holding or taking positions

in equities by the PDs. It applies to long and short positions in all instruments that exhibit market

behavior similar to equities, but not to non-convertible preference shares (which will be covered

by the interest rate risk requirements). Long and short positions in the same issue may be

reported on a net basis. The instruments covered include equity shares, convertible securities that

behave like equities, i.e., units of Mutual Funds and commitments to buy or sell equities. The

equity or equity like positions including those arrived at in relation to equity /index derivatives as

described in following sections may be included in the duration ladder below one month.

A2.2 Equity derivatives

Equity derivatives and off balance-sheet positions which are affected by changes in equity prices

should be included in the measurement system. This includes futures and swaps on both

individual equities and on stock indices. The derivatives are to be converted into positions in the

relevant underlying.

A2.3 Calculation of positions

In order to calculate the market risk as per the standardized approach for credit and market risk,

positions in derivatives should be converted into notional equity positions:

● futures and forward contracts relating to individual equities should in principle be reported at

current market prices;

● futures relating to stock indices should be reported as the marked-to-market value of the

notional underlying equity portfolio;

● equity swaps are to be treated as two notional positions

A3 Capital Charge for Foreign Exchange (FE) Position (if permitted):

PDs normally would not be dealing in FE transactions. However, as they have been permitted to

raise resources under FCNR (B) loan route, subject to prescribed guidelines, they may end up

holding open FE positions. Such open positions in equivalent rupees arrived at by marking to

market at FEDAI rates will be subject to a flat market risk charge of 15 per cent.

B. Internal risk management framework based method

The PDs should calculate the capital requirement based on their internal risk management

framework based VaR model for market risk, as per the following minimum parameters:

(a) VaR must be computed on a daily basis at a 99th percentile, one-tailed confidence interval.

(b) An instantaneous price shock equivalent to a 15-day movement in prices is to be used, i.e. the

minimum "holding period" will be fifteen trading days.

(c) Interest rate sensitivity of the entire portfolio should be captured on an integrated basis by

including all fixed income securities like G-Sec, Corporate/PSU bonds, CPs and derivatives like

IRS, FRAs, IRFs, etc., based on the mapping of the cash flows to work out the portfolio VaR.

Wherever data for calculating volatilities is not available, PDs may calculate the volatilities of

such instruments using the G-Sec yield curve with appropriate spread. However, the details of

such instruments and the spreads applied have to be reported and consistency of methodology

should be ensured.

(d) Instruments which are part of trading book, but found difficult to be subjected to

measurement of market risk may be applied a flat market risk measure of 15 per cent. These

include units of Mutual Funds, unquoted equity, etc., and should be added arithmetically to the

measure obtained under VaR in respect of other instruments.

(e) Underwriting commitments as explained at the beginning of the Annex should also be

mapped into the VaR framework for risk measurement purposes.

(f) The unhedged FE position arising out of the foreign currency borrowings under FCNR (B)

loans scheme would carry a market risk of 15 per cent as hitherto and the measure obtained will

be added arithmetically to the VaR measure obtained for other instruments.

(g) The choice of historical observation period (sample period) for calculating VaR will be

constrained to a minimum length of one year and not less than 250 trading days. For PDs who

use a weighting scheme or other methods for the historical observation period, the "effective"

observation period must be at least one year (that is, the weighted average time lag of the

individual observations cannot be less than 6 months).

(h) The capital requirement will be the higher of:

the previous day's VaR number measured according to the above parameters specified in this

section; and

the average of the daily VaR measures on each of the preceding sixty business days, multiplied

by a multiplication factor prescribed by the RBI (3.3 presently).

(i) No particular type of model is prescribed. So long as the model used captures all the material

risks run by the PDs, they will be free to use models, based for example, on variance-covariance

matrices, historical simulations, Monte Carlo simulations or Extreme Value Theory (EVT), etc.

(j) The criteria for use of internal model to measure market risk capital charge are given in

Annex D.

Annex D

(See para 5)

Criteria for use of internal model to measure market risk capital charge

A General criteria

1. In order that the internal model is effective, it should be ensured that :

the PD's risk management system is conceptually sound and its implementation is certified by

external auditors;

the PD has sufficient number of staff skilled in the use of sophisticated models not only in the

trading area but also in the risk control, audit, and back office areas;

the PD has a proven track record of reasonable accuracy in measuring risk (back testing);

the PD regularly conducts stress tests along the lines discussed in Para B.4 below

2. In addition to these general criteria, PDs using internal models for capital purposes will be

subject to the requirements detailed in Sections B.1 to B.5 below.

B.1 Qualitative standards

The extent to which PDs meet the qualitative criteria contained herein will influence the level at

which the RBI will ultimately set the multiplication factor referred to in Section B3 (b) below,

for the PDs. Only those PDs, whose models are in full compliance with the qualitative criteria,

will be eligible for use of the minimum multiplication factor. The qualitative criteria include:

a) A PD should have an independent risk control unit that is responsible for the design and

implementation of the system. The unit should produce and analyze daily reports on the output of

the PD's risk measurement model, including an evaluation of the relationship between measures

of risk exposure and trading limits. This unit must be independent from trading desks and should

report directly to senior management.

b) The unit should conduct a regular back testing programme, i.e. an ex-post comparison of the

risk measure generated by the model against actual daily changes in portfolio value over longer

periods of time, as well as hypothetical changes based on static positions.

c) Board and senior management should be actively involved in the risk control process and must

regard risk control as an essential aspect of the business to which significant resources need to be

devoted. The daily reports prepared by the independent risk control unit must be reviewed by a

level of management with sufficient seniority and authority to enforce both reductions in

positions taken by individual traders and reductions in the PD’s overall risk exposure.

d) The PD’s internal risk measurement model must be closely integrated into the day-to-day risk

management process of the institution. Its output should accordingly be an integral part of the

process of planning, monitoring and controlling the PD’s market risk profile.

e) The risk measurement system should be used in conjunction with internal trading and

exposure limits. Trading limits should be related to the PD’s risk measurement model in a

manner that is consistent over time and that it is well-understood by both traders and senior

management.

f) A routine and rigorous programme of stress testing should be in place as a supplement to the

risk analysis based on the day-to-day output of the PD’s risk measurement model. The results of

stress testing should be reviewed periodically by senior management and reflected in the policies

and limits set by management and the Board. Where stress tests reveal particular vulnerability to

a given set of circumstances, prompt steps should be taken to manage those risks appropriately.

g) PDs should have a routine in place for ensuring compliance with a documented set of internal

policies, controls and procedures concerning the operation of the risk measurement system. The

risk measurement system must be well documented, for example, through a manual that

describes the basic principles of the risk management system and that provides an explanation of

the empirical techniques used to measure market risk.

h) An independent review of the risk measurement system should be carried out regularly in the

PD’s own internal auditing process. This review should include the activities of the trading desks

as well as the risk control unit. A review of the overall risk management process should take

place at regular intervals (ideally not less than once a year) and should specifically address, at a

minimum:

● the adequacy of the documentation of the risk management system and process;

● the organization of the risk control unit ;

● the integration of market risk measures into daily risk management;

● the approval process for risk pricing models and valuation systems used by front andback-office personnel;

● the validation of any significant change in the risk measurement process;

● the scope of market risks captured by the risk measurement model;

● the integrity of the management information system;

● the accuracy and completeness of position data;

● the verification of the consistency, timeliness and reliability of data sources used to runinternal models, including the independence of such data sources;

● the accuracy and appropriateness of volatility and other assumptions;

● the accuracy of valuation and risk transformation calculations;

● the verification of the model's accuracy through frequent back testing as described in (b)above and in the Annex E.

i) The integrity and implementation of the risk management system in accordance with the

system policies/procedures laid down by the Board should be certified by the external auditors as

outlined at Para B.5.

j) A copy of the back testing result should be furnished to RBI.

B.2 Specification of market risk factors

An important part of a PD’s internal market risk measurement system is the specification of an

appropriate set of market risk factors, i.e. the market rates and prices that affect the value of the

PD’s trading positions. The risk factors contained in a market risk measurement system should

be sufficient to capture the risks inherent in the entire portfolio of the PD.

The following guidelines should be kept in view:

a) For interest rates, there must be a set of risk factors corresponding to interest rates in each

portfolio in which the PD has interest-rate-sensitive on-or-off-balance sheet positions. The risk

measurement system should model the yield curve using one of a number of generally accepted

approaches, for example, by estimating forward rates of zero coupon yields. The yield curve

should be divided into various maturity segments in order to capture variation in the volatility of

rates along the yield curve. For material exposures to interest rate movements in the major

instruments, PDs must model the yield curve using all material risk factors, driven by the nature

of the PD’s trading strategies. For instance, a PD with a portfolio of various types of securities

across many points of the yield curve and engaged in complex trading strategies would require a

greater number of risk factors to capture interest rate risk accurately. The risk measurement

system must incorporate separate risk factors to capture spread risk (e.g. between bonds and

swaps), i.e. risk arising from less than perfectly correlated movements between Government and

other fixed-income instruments.

b) For equity prices, at a minimum, there should be a risk factor that is designed to capture

market-wide movements in equity prices (e.g. a market index). Position in individual securities

or in sector indices could be expressed in "beta-equivalents" relative to this market-wide index.

More detailed approach would be to have risk factors corresponding to various sectors of the

equity market (for instance, industry sectors or cyclical, etc.), or the most extensive approach,

wherein, risk factors corresponding to the volatility of individual equity issues are assessed. The

method could be decided by the PDs corresponding to their exposure to the equity market and

concentrations.

B.3 Quantitative standards

a) PDs should update their data sets at least once every three months and should also reassess

them whenever market prices are subject to material changes. RBI may also require PDs to

calculate their VaR using a shorter observation period if, in its judgement, this is justified by a

significant upsurge in price volatility.

b) The multiplication factor will be set by RBI on the basis of the assessment of the quality of the

PD’s risk management system, as also the back testing framework and results, subject to an

absolute minimum of 3. The document `Back testing’ mechanism to be used in conjunction with

the internal risk based model for market risk capital charge’, enclosed as Annex E, presents in

detail the back testing mechanism.

PDs will have flexibility in devising the precise nature of their models, but the parameters

indicated at B.1, B.2 and B.3 above are the minimum which the PDs need to fulfill for

acceptance of the model for the purpose of calculating their capital charge. RBI will have the

discretion to apply stricter standards.

B.4 Stress testing

1. PDs that use the internal models approach for meeting market risk capital requirements must

have in place a rigorous and comprehensive stress testing program to identify events or

influences that could greatly impact them.

2. Stress scenarios of PDs need to cover a range of factors than can create extraordinary losses or

gains in trading portfolios, or make the control of risk in those portfolios very difficult. These

factors include low-probability events in all major types of risks, including the various

components of market, credit and operational risks.

3. Stress test of PDs should be both of a quantitative and qualitative nature, incorporating both

market risk and liquidity aspects of market disturbances. Quantitative criteria should identify

plausible stress scenarios to which PDs could be exposed. Qualitative criteria should emphasize

that two major goals of stress testing are to evaluate the capacity of the PD’s capital to absorb

potential large losses and to identify steps the PD can take to reduce its risk and conserve capital.

This assessment is integral to setting and evaluating the PD’s management strategy and the

results of stress testing should be regularly communicated to senior management and,

periodically, to the Board of the PD.

4. PDs should combine the standard stress scenarios with stress tests developed by PDs

themselves to reflect their specific risk characteristics. Specifically, RBI may ask PDs to provide

information on stress testing in three broad areas as discussed below.

(a) Scenarios requiring no simulations by a PD

PDs should have information on the largest losses experienced during the reporting period

available for RBI’s review. This loss information could be compared to the level of capital that

results from a PD’s internal measurement system. For example, it could provide RBI with a

picture of how many days of peak day losses would have been covered by a given VaR estimate.

(b) Scenarios requiring a simulation by a PD

PDs should subject their portfolios to a series of simulated stress scenarios and provide RBI with

the results. These scenarios could include testing the current portfolio against past periods of

significant disturbance, incorporating both the large price movements and the sharp reduction in

liquidity associated with these events. A second type of scenario would evaluate the sensitivity

of the PD’s market risk exposure to changes in the assumptions about volatilities and

correlations. Applying this test would require an evaluation of the historical range of variation

for volatilities and correlations and evaluation of the PD’s current positions against the extreme

values of the historical range. Due consideration should be given to the sharp variation that at

times has occurred in a matter of days in periods of significant market disturbance.

(c) Scenarios developed by a PD to capture the specific characteristics of its portfolio

In addition to the scenarios prescribed by RBI under (a) and (b) above, a PD should also develop

its own stress tests which it identified as most adverse based on the characteristics of its

portfolio. PDs should provide RBI with a description of the methodology used to identify and

carry out stress testing under the scenarios, as well as with a description of the results derived

from these scenarios.

The results should be reviewed periodically by senior management and should be reflected in the

policies and limits set by management and the Board. Moreover, if the testing reveals particular

vulnerability to a given set of circumstances, the RBI would expect the PD to take prompt steps

to manage those risks appropriately (e.g. by reducing the size of its exposures).

B.5 External Validation

PDs should get the internal model validated by external auditors, including at a minimum, the

following:

(a) Verifying that the internal validation processes described in B.1(h) are operating in a

satisfactory manner.

(b) Ensuring that the formulae used in the calculation process as well as for the pricing of

complex instruments are validated by a qualified unit, which in all cases should be independent

from the trading desks.

(c) Checking that the structure of internal model is adequate with respect to the PD’s activities

and geographical coverage.

(d) Checking the results of the PD’s back testing of its internal measurement system (i.e.

comparing VaR estimates with actual profits and losses) to ensure that the model provides a

reliable measure of potential losses over time. PDs should make the results as well as the

underlying inputs to their VaR calculations available to the external auditors.

(e) Making sure that data flows and processes associated with the risk measurement system are

transparent and accessible. In particular, it is necessary that auditors are in a position to have

easy access, wherever they judge it necessary and under appropriate procedures, to the model’s

specifications and parameters.

Annex E

(See para 5)

BACK TESTING

“Back Testing” mechanism to be used in conjunction with the internal risk

based model for market risk capital charge

The following are the parameters of the back testing framework for incorporating into the

internal models approach to market risk capital requirements.

2. PDs that have adopted an internal model-based approach to market risk measurement are

required routinely to compare daily profits and losses with model-generated risk measures to

gauge the quality and accuracy of their risk measurement systems. This process is known as

"back testing". The objective is the comparison of actual trading results with model-generated

risk measures. If the comparison uncovers sufficient differences, there may be problems, either

with the model or with the assumptions of the back test.

3. Description of the back testing framework

3.1 The back testing program consists of a periodic comparison of the PD’s daily VaR measures

with the subsequent daily profit or loss (“trading outcome”). Comparing the risk measures with

the trading outcomes simply means that the PD counts the number of times that the risk measures

were larger than the trading outcome. The fraction actually covered can then be compared with

the intended level of coverage to gauge the performance of the PD’s risk model.

3.2 Under the VaR framework, the risk measure is an estimate of the amount that could be lost on

a set of positions due to general market movements over a given holding period, measured using

a specified confidence level. The back tests are applied to compare whether the observed

percentage of outcomes covered by the risk measure is consistent with a 99% level of

confidence. That is, back tests attempt to determine if a PD’s 99th percentile risk measures truly

cover 99% of the firm’s trading outcomes.

3.3 Significant changes in portfolio composition relative to the initial positions are common at

end of trading day. For this reason, the back testing framework suggested involves the use of risk

measures calibrated to a one-day holding period. A more sophisticated approach would involve a

detailed attribution of income by source, including fees, spreads, market movements, and

intra-day trading results.

3.4 PDs should perform back tests based on the hypothetical changes in portfolio value that

would occur; presuming end-of-day positions remain unchanged.

3.5 Back testing using actual daily profits and losses is also a useful exercise since it can uncover

cases where the risk measures are not accurately capturing trading volatility in spite of being

calculated with integrity.

3.6 PDs should perform back tests using both hypothetical and actual trading outcomes. The

steps involve calculation of the number of times the trading outcomes are not covered by the risk

measures (“exceptions”). For example, over 200 trading days, a 99% daily risk measure should

cover, on average, 198 of the 200 trading outcomes, leaving two exceptions.

3.7 The back testing framework to be applied entails a formal testing and accounting of

exceptions on a quarterly basis using the most recent twelve months as on date. PDs may

however base the back test on as many observations as possible. Nevertheless, the most recent

250 trading days' observations should be used for the purposes of back testing. The usage of the

number of exceptions as the primary reference point in the back testing process is the simplicity

and straightforwardness of this approach.

3.8 Normally, in view of the 99% confidence level adopted, 2.5 exceptions may be acceptable in

the observation period of 250 days. However, in Indian context, a level of 4 exceptions would be

acceptable to consider the model as accurate. Exceptions above this, would invite supervisory

actions. Depending on the number of exceptions generated by the PD’s back testing model, both

actual as well as hypothetical, RBI may initiate a dialogue regarding the PD’s model, enhance

the multiplication factor, may impose an increase in the capital requirement or disallow use of

the model as indicated above depending on the number of exceptions.

3.9 In case large number of exceptions is being noticed, it may be useful for the PDs to

dis-aggregate their activities into sub sectors in order to identify the large exceptions on their

own. The reasons could be of the following categories:

a) Basic integrity of the model

(i) The PD’s systems simply are not capturing the risk of the positions themselves (e.g. the

positions of an office are being reported incorrectly).

(ii) Model volatilities and/or correlations were calculated incorrectly (e.g. the computer is

dividing by 250 when it should be dividing by 225).

b) Model’s accuracy could be improved

The risk measurement model is not assessing the risk of some instruments with sufficient

precision (e.g. too few maturity buckets or an omitted spread).

c) Bad luck or markets moved in fashion unanticipated by the model

(i) Random chance (a very low probability event).

(ii) Markets moved by more than the likely prediction of the model (i.e. volatility was

significantly higher than expected).

(iii) Markets did not move together as expected (i.e. correlations were significantly different than

what was assumed by the model).

d) Intra-day trading

There was a large (and money-losing) change in the PD’s position or some other income event

between the end of the first day (when the risk estimate was calculated) and the end of the

second day (when trading results were tabulated).