Potential Risks &

Risk Management Procedures

by

Management of Financial Institution

Submitted To: Suborna Barua

Course Instructor FIN-4116

United International University

School of Business

Submitted By: Mahin Ahmed

ID- 111 101 119

Sec- A

B.B.A.

Date of Submission: 14th January, 2013

United International University

FALL 2012

iii

Letter of Transmittal

January 14, 2013

Suborna Barua

Course Instructor- FIN-4116

United International University

School of Business

Subject: A term paper on potential risks exposer & risk management procedures by Prime

Bank Bangladesh Ltd.

Dear Sir,

I am submitting herewith my report entitled “A term paper on potential risks exposer & risk

management procedures by Prime Bank Bangladesh Ltd.

The main purpose of this report is to get a set of concepts on potential risks faced by Prime Bank

Bangladesh Ltd & how they manage those risks.

It is mainly a descriptive report completed with primary & secondary data. Though I have put

my best efforts yet it is very likely that the paper may have some mistakes and omissions that are

unintentional.

I hope that this report will merit your approval.

Respectfully yours

……………………………………………….

Mahin Ahmed

ID: 111101119

Sec: A

iv

ACKNOWLEDGMENT

I give thanks to the Almighty for giving me the understanding, knowledge and wisdom during

the course of our study.

Additionally, we thank our course instructor “Suborna Barua” who believed

that I could terminate this term paper on time. His moral guidelines, endless effort, and joyful

encouragement made me successful in this paper.

I would like to express my gratitude towards my parents & member of (Prime Bank Bangladesh

Ltd) for their kind co-operation and encouragement which help me in completion of this report. I

would like to express my special gratitude and thanks to Russel Ahmed for giving me such

attention and time.

v

TABLE of CONTENT

EXECUTIVE SUMMARY ......................................................................................................................... vi

OBJECTIVES OF THE STUDY .................................................................................................................. 8

METHODOLOGY OF THE STUDY .......................................................................................................... 8

Risk Management: ........................................................................................................................................ 9

Objectives of risk management ..................................................................................................................... 9

Prime Bank Limited .................................................................................................................................... 10

There are 5 (Five) Subsidiaries of Prime Bank Limited which is as under: ........................................... 10

Techniques of Risk Management by the Bank: .......................................................................................... 10

GAP Analysis.......................................................................................................................................... 10

Duration-GAP Analysis .......................................................................................................................... 11

Value at Risk (VaR) ................................................................................................................................ 11

Risk Adjusted Rate of Return on Capital (RAROC) .............................................................................. 12

Securitization .......................................................................................................................................... 12

Sensitivity Analysis ................................................................................................................................ 12

Internal Rating System ............................................................................................................................ 12

Market Discipline [Disclosures on Risk Based Capital (Basel II)] ............................................................. 13

Risk Management Process ...................................................................................................................... 13

Scope of Application: ............................................................................................................................. 14

Credit Risk: ................................................................................................................................................. 14

Qualitative Discloser: .............................................................................................................................. 15

Quantitative disclosures: ......................................................................................................................... 16

Interest Rate Risk in the Banking Book (IRRBB) ...................................................................................... 19

Interest Rate Risk Analysis ..................................................................................................................... 19

Market Risk:................................................................................................................................................ 20

Measurement Methodology: ................................................................................................................... 20

Quantitative Disclosers: .......................................................................................................................... 22

Operational Risk: ........................................................................................................................................ 22

Potential external events ......................................................................................................................... 23

Policies and processes for mitigating operational risk: ........................................................................... 24

Stress Testing in PBL: ............................................................................................................................ 26

Approach for calculating capital charge for operational risk: ................................................................. 26

Quantitative disclosures .......................................................................................................................... 27

CONCLUSIONS......................................................................................................................................... 27

vi

EXECUTIVE SUMMARY

It is a descriptive research & is the based on the primary data. The primary data, on types of risk,

techniques to measure risk etc. have been collected through a personal contact with an executive

in Prime Bank Ltd. Banking business is in most cases risk management. Banks have to make

profits for competitive survival. Their day to day activity is nothing other than management of

various risks associated with their businesses which include credit risk, liquidity risk, interest

rate risk, and foreign exchange risk. Here I mainly focused on Basel II [disclosers on risk based

capital].

There are several techniques that the Bank uses to manage risk- GAP analysis, Duration GAP

analysis, Value @ Risk, Risk Adjusted Rate of Return on Capital, Securitization, Sensitivity

Analysis, and Internal Rating System.

Credit risk arises from the potential that a bank's borrower will fail to meet its obligations in

accordance with agreed terms. Credit risk also refers the risk of negative effects on the financial

result and capital of the bank caused by borrower's default on its obligations to the bank. To

address this it follows CRG [Credit Risk Grading].

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's

financial condition. Changes in interest rates affect both the current earnings (earnings

perspective) as well as the net worth of the bank (economic value perspective). Re-pricing risk is

often the most apparent source of interest rate risk for a bank and is often gauged by comparing

the volume of a bank’s assets that mature or re-price within a given time period with the volume

of liabilities that do so. The short term impact of changes in interest rates is on the bank’s Net

Interest Income (NII). In a longer term, changes in interest rates impact the cash flows on the

assets, liabilities and off-balance sheet items, giving rise to a risk to the net worth of the bank

arising out of all re-pricing mismatches and other interest rate sensitive position.

Market risk is the possibility of losses of assets in balance sheet and off-balance sheet positions

arising out of volatility in market variables i.e., interest rate, exchange rate and price. Allocation

of capital is required in respect of the exposure to risks deriving from changes in interest rates

and equity prices in the bank’s trading book, in respect of exposure to risks deriving from

changes in foreign exchange rates and commodity price in the overall banking activity. Maturity

vii

Method has been prescribed by Bangladesh Bank in determining capital against market risk.

Treasury Division manages the market risk and ALCO monitors the activities of treasury

Division in managing such risk. To mitigate the several market risks the bank formed Asset

Liability Management Committee (ALCO) who monitors the Treasury Division’s activities to

minimize the market risk.

Operational risk is defined as the risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events. This definition includes legal risk but

excludes strategic and reputation risk. It is inherent in every business organization and covers a

wide spectrum of issues. The Board of Director (BOD) of the Bank and its Management firmly

believe that this risk through a control based environment in which processes see documented,

authorization as independent and transactions are reconciled and monitored. This is supported by

an independent program of periodic reviews undertaken by internal audit, and by monitoring

external operational risk events, which ensure that the group stays in line which industry best

practice and takes account or lessons learned from publicized operational failures within the

financial services industry. The Banks operating in Bangladesh shall compute the capital

requirements for operational risk under the Basic Indicator Approach (BIA). Under BIA, the

capital charge for operational risk is a fixed percentage, denoted by α (alpha) of average positive

annual gross income of the bank over the past three years.

8

INTRODUCTION:

In the past two decades, the banking industry has evolved from a financial intermediation

between depositors and borrowers, to a “one-stop” center for a range of financial services like

insurance, investments and mutual funds. The advancement of information and communicative

technology (ICT) is given credit for the evolution of banking services, in particular, online

banking. The development in ICT has not only provided vast banking opportunities previously

beyond reach, but also heightens the competition and risks faced by banks in the financial

system. Banking business is in most cases risk management. Banks have to make profits for

competitive survival. Their day to day activity is nothing other than management of various risks

associated with their businesses which include credit risk, liquidity risk, interest rate risk, and

foreign exchange risk.

OBJECTIVES OF THE STUDY The main objective of the study is to diagnose the risk management practices of some selected

commercial banks operating in Bangladesh. To attain the key objective, the following are listed

as the specific objectives:

To identify the risks faced by the Prime Bank

To trace out the process and system of risk management.

To examine the techniques of risk management by the Bank.

To evaluate whether the banks under study follow the guidelines of Bangladesh Bank

regarding risk management.

METHODOLOGY OF THE STUDY It is a descriptive research & is the based on the primary data. The primary data, on types of risk,

techniques to measure risk etc. have been collected through a personal contact with an executive

in Prime Bank Ltd.

9

Risk Management: Risk management is the deliberate acceptance of risk for profit-making. It requires informed

decisions on the tradeoff between risk and reward, and uses various financial and other tools to

maximize risk-adjusted returns within pre-established limits. Risk-taking is an inherent element

of the banking business and, indeed, profits are in part the reward for successful risk taking in

business. On the other hand, excessive and poorly managed risk can lead to losses and thus

endanger the safety of a bank's depositors.

Objectives of risk management The objective of risk management is to identify and analyze risks and manage their

consequences. The banking sector has perhaps the most specific focus on the management of

financial risks. The guiding standard that is a key influence on central banks and banking

regulations comes from the Swiss-based Bank for International Settlements (BIS), and

particularly it's BCBS. The update of the standards, known as Basel II, has been, or is in the

process of being, applied by bank regulators across the world. While Basel II introduces a new

and more complex method of calculating regulatory capital requirements, its implementation

requires that the bank adopt enhanced policies and procedures of risk management, in order to

generate the necessary data for the calculations.

Bangladesh Bank’s guidelines for Risk Management are structured on following four aspects:

a) Risk Management Objectives;

b) Risk Management Structure;

c) Risk Management Requirements;

d) Risk Management Process.

10

A brief description of the Bank and its subsidiaries are given below:

Prime Bank Limited

The Prime Bank Limited (PBL) was incorporated as a public limited company in Bangladesh

under Companies Act, 1994. It commenced its banking business with one branch from April 17,

1995 under the license issued by Bangladesh Bank. Presently the Bank has 102 (One hundred

two) branches, 17 (Seventeen) SME Branches Centers all over Bangladesh, and 2 (two) booths

located at Dhaka Club, Dhaka and at Chittagong Port, Chittagong. The Bank has 3 (Three)

Offshore Banking Units (OBU) operating at Savar, Chittagong and Adamjee EPZ areas. The

Bank went for Initial Public Offering in 1999 and its shares are listed with Dhaka Stock

Exchange Limited and Chittagong Stock Exchange Limited as a publicly traded company for its

general class of shares. The principal activities of the Bank are to provide all kinds of

commercial banking services to its customers through its branches.

There are 5 (Five) Subsidiaries of Prime Bank Limited which is as under:

Prime Exchange Co. Pte. Limited, Singapore

Prime Bank Investment Limited

PBL Exchange (UK) Limited

Prime Bank Securities Limited

Prime Finance (Hong Kong) Limited

Techniques of Risk Management by the Bank:

GAP Analysis It is an interest rate risk management tool based on the balance sheet which focuses on the

potential variability of net-interest income over specific time intervals. In this method a maturity/

re-pricing schedule that distributes interest-sensitive assets, liabilities, and off-balance sheet

positions into time bands according to their maturity (if fixed rate) or time remaining to their

next re-pricing (if floating rate), is prepared. These schedules are then used to generate indicators

of interest-rate sensitivity of both earnings and economic value to changing interest rates. After

11

choosing the time intervals, assets and liabilities are grouped into these time buckets according to

maturity (for fixed rates) or first possible re-pricing time (for flexible rates). The assets and

liabilities that can be re-priced are called rate sensitive assets (RSAs) and rate sensitive liabilities

(RSLs) respectively. Interest sensitive gap (DGAP) reflects the differences between the volume

of rate sensitive asset and the volume of rate sensitive liability and given by,

GAP = RSAs – RSLs

The information on GAP gives the management an idea about the effects on net-income due to

changes in the interest rate. Positive GAP indicates that an increase in future interest rate would

increase the net interest income as the change in interest income is greater than the change in

interest expenses and vice versa.

Duration-GAP Analysis

It is another measure of interest rate risk and managing net interest income derived by taking into

consideration all individual cash inflows and outflows. Duration is value and time weighted

measure of maturity of all cash flows and represents the average time needed to recover the

invested funds. Duration analysis can be viewed as the elasticity of the market value of an

instrument with respect to interest rate. Duration gap (DGAP) reflects the differences in the

timing of asset and liability cash flows and given by,

DGAP = DA - u DL

Where DA is the average duration of the assets, DL is the average duration of liabilities, and u is

the liabilities/assets ratio. When interest rate increases by comparable amounts, the market value

of assets decrease more than that of liabilities resulting in the decrease in the market value of

equities and expected net-interest income and vice versa.

Value at Risk (VaR)

It is one of the newer risk management tools. The Value at Risk (VaR) indicates how much a

firm can lose or make with a certain probability in a given time horizon. VaR summarizes

financial risk inherent in portfolios into a simple number. Though VaR is used to measure market

risk in general, it incorporates many other risks like foreign currency, commodities, and equities.

12

Risk Adjusted Rate of Return on Capital (RAROC)

It gives an economic basis to measure all the relevant risks consistently and gives managers tools

to make the efficient decisions regarding risk/return tradeoff in different assets. As economic

capital protects financial institutions against unexpected losses, it is vital to allocate capital for

various risks that these institutions face. Risk Adjusted Rate of Return on Capital (RAROC)

analysis shows how much economic capital different products and businesses need and

determines the total return on capital of a firm. Though Risk Adjusted Rate of Return can be

used to estimate the capital requirements for market, credit and operational risks, it is used as an

integrated risk management tool.

Securitization

It is a procedure studied under the systems of structured finance or credit linked notes.

Securitization of a bank’s assets and loans is a device for raising new funds and reducing bank’s

risk exposures. The bank pools a group of income-earning assets (like mortgages) and sells

securities against these in the open market, thereby transforming illiquid assets into tradable asset

backed securities. As the returns from these securities depend on the cash flows of the underlying

assets, the burden of repayment is transferred from the originator to these pooled assets.

Sensitivity Analysis

It is very useful when attempting to determine the impact, the actual outcome of a particular

variable will have if it differs from what was previously assumed. By creating a given set of

scenarios, the analyst can determine how changes in one variable(s) will impact the target

variable.

Internal Rating System An internal rating system helps financial institutions manage and control credit risks they face

through lending and other operations by grouping and managing the credit-worthiness of

borrowers and the quality of credit transactions.

13

Market Discipline [Disclosures on Risk Based Capital (Basel II)]

The purpose of Market Discipline in (Basel II) is to establish more transparent and more

disciplined financial market so that stakeholders can assess the position of a bank regarding

holding of assets and to identify the risks relating to the assets and capital adequacy to meet

probable loss of assets. For the said purpose, this “Disclosures on Risk Based Capital (Basel II)”

is made as per Bangladesh Bank’s Guideline.

Risk Management Process

Source: Prime Bank Ltd. [Web]

Risk Origination within the Bank Credit Risk Market Risk Operational Risk (As per Basel II Capital

Accord)

14

Scope of Application:

Qualitative disclosures

a) The name of the top corporate entity in the group to

which this guidelines applies.

Prime Bank Limited

b) An outline of differences on the basis of

consolidation for accounting and regulatory

purposes, with a brief description of the entities

within the group (a) that are fully consolidated; (b)

that are given a deduction treatment; and (c) that is

neither consolidated nor deducted (e.g. where the

investment is risk-weighted).

Prime Bank Limited has 5 (Five)

subsidiaries (i) Prime Exchange Co.

Pte. Limited, Singapore (ii) Prime

Bank Investment limited (iii) PBL

Exchange (UK) Limited (iv) Prime

Bank Securities Limited and (v)

PBL Finance (Hong Kong) Limited.

c) Any restrictions, or other major impediments, on

transfer of funds or regulatory capital within the

group.

Not applicable

Quantitative disclosures

d) The aggregate amount of capital deficiencies in all

subsidiaries not included in the consolidation that are

deducted and the name(s) of such subsidiaries.

Not applicable

Credit Risk: Credit risk arises from the potential that a bank's borrower will fail to meet its obligations in

accordance with agreed terms. Credit risk also refers the risk of negative effects on the financial

result and capital of the bank caused by borrower's default on its obligations to the bank.

Generally credits are the largest and most obvious source of credit risk. However, credit risk

could steam from both on-balance sheet and off-balance sheet activities. It may arise from either

an inability or an unwillingness to perform in the pre-committed contracted manner. Credit risk

comes from a bank's dealing with individuals, corporate, banks and financial institutions or a

sovereign.

The assessment of credit risk involves evaluating both the probability of default by the borrower

and the exposure or financial impact on the bank in the event of default.

15

For the Bank, the general qualitative disclosures requirement with respect to credit risk,

including:

Qualitative Discloser: With a view to strengthening credit discipline and bring classification and provisioning

regulation in the line with international standard, a phase wise program for classification and

provisioning was undertaken by the Bank as per Bangladesh Bank circulars issued from time to

time. In this regard, all the loans and advances are grouped into four (4) categories for the

purpose of classification, namely:

o Continuous Loan Demand Loan:

Sub-standard - if it is past due/overdue for 6 months or beyond but less

than 9 months;

Doubtful - if it is past due/overdue for 9 months or beyond but less than

12 months;

Bad/Loss - if it is past due/overdue for 12 months or beyond.

o Fixed Term Loan: (repayable within maximum 5 years of time)

Sub-standard - if the defaulted installment is equal to or more than the

amount of installment (s) due within 6 (six) months, the entire loans are

classified as “Sub-standard”.

Doubtful - if the defaulted installment is equal to or more than the amount

of installment (s) due within 12 (twelve) months, the entire loans are

classified as “Doubtful”

Bad/Loss - if the defaulted installment is equal to or more than the amount

of installment (s) due within 18 (eighteen) months, the entire loans are

classified as “Bad / Loss”.

o Fixed Term Loan: (repayable more than 5 years of time)

Sub-standard - if the defaulted installment is equal to or more that the

amount of installment (s) due within 12 (twelve) months, the entire loans

are classified as “Sub-standard”.

Doubtful - if the defaulted installment is equal to or more than the amount

of installment (s) due within 18 (eighteen) months, the entire loans are

classified as “Doubtful”.

Bad/Loss - if the defaulted installment is equal to or more than the amount

of installment (s) due within 24 (twenty four) months, the entire loans are

classified as “Bad/Loss”.

o Short-term Agricultural and Micro Credit:

Sub-standard - if the irregular status continue after a period of 12(twelve)

months, the credits are classified as “Sub-standard”.

16

Doubtful - if the irregular status continue after a period of 36 (thirty six)

months, the credits are classified as “Doubtful”.

Bad/Loss - if the irregular status continue after a period of 60 (sixty)

months, the credits are classified as “Bad / Loss”.

A Continuous Credit, Demand loan or Term Loan which will remain

overdue for a period of 90 days or more, are treated “Special Mention

Account (SMA)”.

The Bank is following the general and specific provision for loans and advances/ investments on

the basis of Bangladesh Bank guidelines issued from time to time.

Particular Rate

General provision on unclassified general loans and advances / investments. 1%

General provision on unclassified small enterprise financing. 1%

General provision on unclassified loans / investments for housing. 2%

General provision on unclassified consumer fi nuancing other than housing finance,

loan for professionals and loans to share business.

5%

General provision on special mention account. 5%

Specific provision on substandard loans and advances / investments. 20%

Specific provision on doubtful loans and advances / investments. 50%

Specific provision on bad/ loss loans and advances/ investments. 100%

Quantitative disclosures:

a) Total gross credit risk exposures broken down by major types of credit exposure of the

Bank:

Particular Taka in million

Secured Overdraft / Quard Against TDR 36,375.51

Cash Credit / Mudaraba 17,533.66

Loan (General) 22,300.16

House Building Loan 3,634.70

Loan Against Trust Receipts (LTR) 20,912.41

Payment Against Documents (PAD) 701.74

Retail Loan 10,938.78

Lease Finance / Izara 7,556.80

Credit Card 750.39

SME Loan 1,278.07

Hire Purchase 7,156.82

Other Loans & Advances 2,889.85

Term placement to PBL Finance (Hong Kong) Ltd. 560.46

Bill purchased / discounted-Inland 4,617.72

Bill purchased / discounted-Foreign 2,201.82

Total 1,39,408.89

17

b) Geographical distribution of exposures, broken down in significant areas by major types

of credit exposure of the Bank:

Particulars Taka in Million

Urban:

Dhaka Zone 1,02,064.22

Chittagong Zone 21,356.69

Khulna Zone 4,376.95

Rajshahi Zone 4,600.06

Barishal Zone 178.74

Sylhet Zone 4,210.68

Sub-Total 108,132.43

Rural:

Dhaka Zone 1,858.98

Chittagong Zone 519.70

Khulna Zone 25.70

Rajshahi Zone 57.54

Barishal Zone -

Sylhet Zone 598.74

Sub-Total 3,034.96

Grand Total (Urban and Rural) 111,167.39

c) Industry or counterparty type distribution of exposures, broken down by major types of

credit exposure of the Bank:

Particulars Taka in

Million

Commercial Lending 19,564.27

Export Financing 9,363.16

House Building Loan 3,435.34

Retail Loan 9,290.65

Small & Medium Enterprises (SME) 5,757.28

Special Program Loan -

Other Loans & Advances (SOD) 17,204.59

Staff Loan 13.78

Loans, Advances & Lease/Investments to Managing Director / CEO and other

senior executives

1,246.55

Industrial Loans/Investments (Details are given below) 45,291.77

Total 111,167.39

18

Industrial Loans/Investments

Agriculture 1,871.46

Textile Industries 11,676.55

Food and allied industries 2,014.45

Pharmaceutical Industries 1,446.40

Leather , Chemical, Cosmetics, etc. 1,278.59

Tobacco Industries 45.58

Cement and Ceramic Industries 2,140.14

Service Industries 2,915.10

Transport & Communication Industries 3,678.26

Other Industries including bills purchased and discounted 18,225.24

Total 45,291.77

d) Residual contractual maturity breaks down of the whole portfolios, broken down by

major types of credit exposure of the Bank:

Particulars Taka in Million

Repayable on Demand -

Up to 1 month 23,942.56

Over 1 month but not more than 3 months 21,204.14

Over 3 months but not more than 1 year 38,206.61

Over 1 year but not more than 5 years 25,680.57

Over 5 years 2,133.51

Total 111,167.39

e) The amount of classified and unclassified loans and advances/ investments of the Bank

are given below as per Bangladesh Bank guidelines.

Particulars Taka in Million

Continuous Loan 208.14

Demand Loans 369.48

Term Loans up to 5 years 745.20

Term Loans over 5 years 44.87

Short Term Agro Credit and Micro Credit -

Total 1,367.69

19

Interest Rate Risk in the Banking Book (IRRBB)

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank's

financial condition. Changes in interest rates affect both the current earnings (earnings

perspective) as well as the net worth of the bank (economic value perspective). Re-pricing risk is

often the most apparent source of interest rate risk for a bank and is often gauged by comparing

the volume of a bank’s assets that mature or re-price within a given time period with the volume

of liabilities that do so. The short term impact of changes in interest rates is on the bank’s Net

Interest Income (NII). In a longer term, changes in interest rates impact the cash flows on the

assets, liabilities and off-balance sheet items, giving rise to a risk to the net worth of the bank

arising out of all re-pricing mismatches and other interest rate sensitive position. Maturity

grouping of rate sensitive assets and liabilities of the bank shows significant positive gap in the

first quarter and moderate gap during the rest three quarters. The impact is very insignificant

compared to total revenue of the bank and also within the acceptable limit as stipulated by

Bangladesh Bank.

Interest Rate Risk Analysis

Quantitative Discloser Taka million

The increase

(decline) in

earnings or

economic value (or

relevant measure

used by

management) for

upward and

downward rate

shocks according

to management’s

method for

measuring IRRBB,

broken down by

currency (as

relevant).

Particulars

1-90

days

Over 3

months

to up to

6

months

Over 6

months

to up to 9

months

Over 9

months

to up

to

1 year

Rate Sensitive Assets 63,178 19,769 15,651 11,535

Rate Sensitive

Liabilities

59,820 22,473 11,032 8,504

GAP 3,358 (2,704) 4,619 3,031

Cumulative GAP 3,358 654 5,273 8,304

Adjusted Interest Rate

Changes (IRC)

1.00% 1.00% 1.00% 1.00%

Quarterly earnings

impact (Cum. GAP *

IRC)

8,280 1,613 13,001 20,475

Accumulated earning

impact to date

8,280 9,893 22,894 43,369

Earning Impact/ Avg.

Quarterly Net Profit

0.49% 0.58% 1.35% 2.55%

20

Market Risk:

Market risk is the possibility of losses of assets in balance sheet and off-balance sheet positions

arising out of volatility in market variables i.e., interest rate, exchange rate and price. Allocation

of capital is required in respect of the exposure to risks deriving from changes in interest rates

and equity prices in the bank’s trading book, in respect of exposure to risks deriving from

changes in foreign exchange rates and commodity price in the overall banking activity. The total

capital requirement for banks against their market risk shall be the sum of capital charges

against:

Interest rate risk

Equity position risk

Foreign exchange (including gold) position risk throughout the bank’s balance sheet and

Commodity risk.

Measurement Methodology:

As banks in Bangladesh are now in a stage of developing risk management models, Bangladesh

Bank suggested the banks for using Standardized Approach for credit risk capital requirement for

banking book and Standardized (rule based) Approach for market risk capital charge in their

trading book.

Maturity Method has been prescribed by Bangladesh Bank in determining capital against market

risk. In the maturity method, long or short positions in debt securities and other sources of

interest rate exposures, including derivative instruments, are slotted into a maturity ladder

comprising 13 time-bands (or 15 time-bands in case of low coupon instruments). Fixed-rate

instruments are allocated according to the residual term to maturity and floating-rate instruments

according to the residual term to the next reprising date.

In Standardized (rule based) Approach the capital requirement for various market risks (interest

rate risk, price, and foreign exchange risk) are determined separately.

The total capital requirement in respect of market risk is the sum of capital requirement

calculated for each of these market risk sub-categories. e.g.:

1. Capital Charge for Interest Rate Risk = Capital Charge for Specific Risk + Capital

Charge for General Market Risk;

2. Capital Charge for Equity Position Risk = Capital Charge for Specific Risk + Capital

21

Charge for General Market Risk;

3. Capital Charge for Foreign Exchange Risk = Capital Charge for General Market Risk;

4. Capital Charge for Commodity Position Risk = Capital charge for general market risk.

i. Market Risk Management system: Treasury Division manages the market risk and

ALCO monitors the activities of treasury Division in managing such risk.

ii. Policies and processes for mitigating market risk: To mitigate the several market risks

the bank formed Asset Liability Management Committee (ALCO) who monitors the

Treasury Division’s activities to minimize the market risk. ALCO is primarily

responsible for establishing the market risk management and asset liability management

of the Bank, procedures thereof, implementing core risk management framework issued

by the regulator, best risk management practices followed by globally and ensuring that

internal parameters, procedures, practices/ polices and risk management prudential limits

are adhere to.

a. The Treasury Division are taking following measures to minimize the several

market risks:

i. Foreign exchange risk management: it is the risk that the bank may

suffer losses as a result of adverse exchange rate movement during a

period in which it has an open position in an individual foreign currency.

This risk measured and monitored by the Treasury Division. To evaluate

the extent of foreign exchange risk, a liquidity Gap report prepare for each

currency.

ii. Equity Risk: Equity risk is defined as losses due to changes in market

price of the equity held. To measure and identify the risk, mark to market

valuation to the share investment portfolios are done. Mark to market

valuation is done against a predetermined limit. At the time of investment,

following factors are taken into consideration:

1. Security of Investment

2. Fundamentals of securities

3. Liquidity of securities

4. Reliability of securities

5. Capital appreciation

6. Risk factors and

7. Implication of taxes etc.

22

Quantitative Disclosers:

b) The Capital Requirements for:

Particulars Million taka

Solo Consolidated

1 Interest rate risk 370.27 370.27

2 Equity position risk 11.68 239.79

3 Foreign exchange risk and 148.5 148.5

Total Capital Requirement 530.45 758.56

Operational Risk:

Operational risk is defined as the risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events. This definition includes legal risk but

excludes strategic and reputation risk. It is inherent in every business organization and covers a

wide spectrum of issues. The Board of Director (BOD) of the Bank and its Management firmly

believe that this risk through a control based environment in which processes see documented,

authorization as independent and transactions are reconciled and monitored. This is supported by

an independent program of periodic reviews undertaken by internal audit, and by monitoring

external operational risk events, which ensure that the group stays in line which industry best

practice and takes account or lessons learned from publicized operational failures within the

financial services industry.

The BOD has also modified its operational risk management process by issuing a high level

standard like SOP, supplemented by more detailed formal guidance. This explains how the bank

manages operational risk by identifying, assessing, monitoring, controlling and mitigating the

risk, rectifying operational risk events, and implementing any additional procedures required for

compliance with local regulatory requirements.

The Bank maintains and tests contingency facilities to support operations in the event of

disasters. Additional reviews and tests are conducted in the event that any branch of the bank is

affected by a business disruption event, to incorporate lessons learned in the operational recovery

from those circumstances. Plans have been prepared for the continued operation of the bank’s

business, with reduced staffing levels.

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Potential external events

Risk factors / Potential external events: It is needless to say that there are certain risk

factors which are external in nature and can affect the business of the Bank. The factors

discussed below can significantly affect the business:

General business and political condition: PBL’s performance greatly depends on the

general economic conditions of the country. The effect of recession is still unfolding

which may result to slow down in business environment. Political stability is must for

growth in business activities.

Changes in credit quality of borrowers: Risk of deterioration of credit quality of

borrowers is inherent in banking business. This could result due to global economic crisis

and supply side distortion. The changes in the import prices affected the commodity

sectors and ship breaking industry. Deterioration in credit quality requires provisioning.

Changes in policies and practices of regulatory bodies to revise practices, pricing

and responsibilities of the financial institutions: PBL is subject to regulations and

compliance of regulation is must. Changes in policies with regard to interest rates, pricing

have significant effect on the performance of the Bank. Bangladesh Bank is expected to

continue its persuasion to reduce the spread and charges further which is likely to affect

the performance. Changes in provisioning requirement will also affect the performance of

the bank.

Implementation of Basel-II: Basel-II is fully effective from 2010 and PBL needs to be

complied with respect to credit risk management, its supervision and establishment of

effective internal control. The grading of the borrowers and its link with capital

requirement may slow down the credit expansion. The establishment of effective control

requires more investment in technology and operating expenses are likely to increase.

Volatility in equity market Securities and Exchange Commission and the stock

exchanges improved their supervisory role but the equity market is still volatile. The

recession fear also added to the volatility. If volatility continues it is likely to affect the

performance of the bank.

Changes in market conditions: Changes in market conditions particularly interest rates

on deposits and volatility in FX market is likely to affect the performance of the bank.

Depositors are becoming increasingly price sensitive and any unilateral upward change

24

by a bank will exert pressure on interest rate structure of the banking sector. It is feared

that wage earners remittances may decline due to fall in job opportunity in international

market. Unless offset by export performances, there may be pressure in the FX market.

The risk of litigation: In the ordinary course of business, legal actions, claims by and

against the bank may arise. The outcome of such litigation may affect the financial

performance of the bank.

Marketing Risk: This risk is related to the different aspects of the promotion and

branding of the bank, including image management, product promotion and advertising.

Human Resource Risk: This type of risk is generated within the bank from failure to

recruit the right people in the right place, inappropriate means of recruitment, failure to

provide feedback to the employees on performance, over-reliance on key personnel,

inappropriate training and development etc.

Success of strategies: PBL is proceeding with its strategic plan and its successful

implementation is very important for its financial performance. Major deviation due to

external and internal factors will affect the performance of the bank.

Policies and processes for mitigating operational risk:

Prime Bank limited (PBL) has formed a separate ‘Risk Management Unit’ under Chief Risk

Officer to ensure following things:

Designing of organizational structure by clearly defining roles and responsibilities of

individuals involved in risk taking as well as managing it;

Formulation of overall risk assessment and management policies, methodologies,

guidelines and procedures for risk identification, risk measurement, risk monitoring,

defining an acceptable level of risk, mitigation of all the core risks in line with their

respective guidelines provided by Bangladesh Bank;

Reviewing and updating all risks on systematic basis as necessary at least annually,

preferably twice a year, ensuring that adequate controls exist and that the related returns

reflect these risks and the capital allocated to support them.

o The main risk areas will be (i) Balance sheet Risk Management, (ii) Credit Risk,

(iii) Foreign Exchange Risk, (iv)Internal Control and Compliance Risk, (v)

Money Laundering Risk and (vi) IT Risk.

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o The following risks have also to be reviewed:

Operational Risk

Liquidity Risk

Reputation risk

Insurance Risk

Sustainability Risk

Setting the portfolio objectives and tolerance limits/parameters for each of the risks;

Formulation of strategies and different models in consistency with risk management

policy based on IT Policy and in house IT support which can measure, monitor and

maintain acceptable risk levels of the bank;

Development of information systems/MIS inflow and data management capabilities to

support the risk management functions of the bank.

Ensure compliance with the core risks management guidelines at the department level,

and at the desk level;

The unit will work under bank’s organizational structure and suggest to the CEO to take

appropriate measures to overcome any existing and potential financial crisis;

Analysis of self-resilience capability of the bank;

Initiation to measure different market conditions, vulnerability in investing in different

sectors;

The unit will also work for substantiality of capital to absorb the associated risk in

banking operation.

Activities Undertaken By “Risk Management Unit” Since Inception and Recent

Approaches:

Risk Management Unit of PBL is currently arranging monthly meeting on various issues

to determine strategies in consistency with risk management policy, which can measure,

monitor, and maintain acceptable risk level of the bank. Minutes of each meeting is

submitted to Bangladesh Bank on monthly basis;

Besides, Risk Management Paper has also been prepared on the basis of 03 months’

monthly minutes addressing different areas of risk and their mitigating tools & techniques

guided by the members of Risk Management Unit;

In order to perform the risk management function smoothly, RMU had invited all the

Operational Divisions vide letter to the Head of respective Divisions to form an internal

26

committee along with defined duties of concerned officials. It is to be noted here that due

to continuous and successful persuasion, all the Operational Divisions have formulated

and established internal risk management committees.

Stress Testing in PBL:

Risk Management Unit (RMU) of PBL has already prepared a stress testing model in line with

the Bangladesh Bank’s guideline which initially focused on “Simple Sensitivity and Scenario

Analysis” on the following five risk factors:

• Interest rate;

• Forced sale value of collateral;

• Non-performing loans (NPLs);

• Share prices; and Foreign Exchange rate.

Approach for calculating capital charge for operational risk:

The Banks operating in Bangladesh shall compute the capital requirements for operational risk

under the Basic Indicator Approach (BIA). Under BIA, the capital charge for operational risk is a

fixed percentage, denoted by α (alpha) of average positive annual gross income of the bank over

the past three years. Figures for any year in which annual gross income is negative or zero,

should be excluded from both the numerator and denominator when calculating the average. The

capital charge may be expressed as follows:

K = [(GI 1 + GI2 + GI3) α]/n

Where:

K = the capital charge under the Basic Indicator Approach

GI = only positive annual gross income over the previous three years (i.e., negative or zero gross

income if any shall be excluded)

α = 15 percent

n = number of the previous three years for which gross income is positive.

Gross income: Gross Income (GI) is defined as “Net Interest Income” plus “Net non-Interest

Income”. It is intended that this measure should:

i. be gross of any provisions;

ii. be gross of operating expenses, including fees paid to outsourcing service providers;

iii. exclude realized profits/losses from the sale of securities held to maturity in the banking

book;

iv. exclude extraordinary or irregular items;

v. Exclude income derived from insurance.

27

Quantitative disclosures

Particular Taka in Million

Solo Consolidated

The capital requirement for operational risk 1,541.17 1,638.65

CONCLUSIONS

On the basis of sample bankers’ opinions the following (statistically significant) results can be

concluded:

i. Of the various types of risks faced by the Prime Bank, credit risk, market risk and

operational risk are the major risks to the bankers.

ii. Regarding risk management oversight, it is seen that the Board of Director performs the

responsibility of the main risk oversight, the Executive Committee monitors risk and the

Audit Committee oversees all the activities of banking operations.

iii. Regarding credit risk management, it is revealed that bank uses the updated credit

policy approved by the Board of Director Credit risk management division and credit

administration division perform their activities separately, law and recovery team

monitors the performance of the loans. Internal control and compliance division directly

reports to the Board/Audit Committee about the overall credit risk status.

iv. In terms of opinions as to operational risk management, it is found that operational risk

is monitored and controlled within the bank through an operational risk management

framework.

v. Regarding money laundering risk management, it is noticed that the Central

Compliance Unit looks after the overall compliance with money laundering regulations.

vi. Regarding equity risk management, bank follows market–to-market valuations of the

share investment portfolio in measuring and identifying risk.

vii. Regarding information technology risk management, it is reported that IT Audit Team

audits the divisions and branches.

viii. Regarding managing the liquidity risk, it is found that bank maintains that customers’

confidence is maintained in ensuring liquidity.

ix. Regarding marketing risk management, it is revealed that bank adopts the appropriate

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promotional activities to preserve its image.

x. In human resource risk management it is found that bank complies with an effective

human resource policy.

xi. Regarding use of risk management techniques, it is found that internal rating system

and risk adjusted rate of return on capital are important.

xii. In the use of Bangladesh Bank guidelines for managing risks, it is revealed that asset

liability management, investment risk management and foreign exchange risk

management are much significant to the bankers.

29

References

• https://www.primebank.com.bd/financial_report/Basel-II2010%2015_03_12.pdf

• http://bankinfobd.com/banks/35/Prime_Bank

• http://othesis4u.wordpress.com/category/prime-bank-ltd/

• https://www.primebank.com.bd/index.php/home/basel

• https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&sqi=

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• http://www.icai.org/resource_file/11490p841-851.pdf

• http://www.bizresearchpapers.com/24.%20Afsheen.pdf

• http://entrepreneurship.thunderbird.edu/sites/default/files/files/bank_management.pdf