REVISED - banking system survey

8/7/2019 REVISED - banking system survey

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Risk analysis on Indian Banking Sector

Submitted in partial fulfillment of the requirements for

MASTER IN MANAGEMENT STUDIES

M.M.S II

2009-2011

SUBMITTED BY

Name: AMREEN PARKAR

M.M.S 2nd year

Roll No. 35

Batch: 2009 - 2011

H K Institute of Management Studies and Research,

Jogeshwari,

Mumbai 400102


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CERTIFICATE

This is to certify that the dissertation submitted in partial

fulfillment for the award of M.M.S of HKIMSR is the result

of the bonafide research work carried out by Ms. AMREEN

PARKAR under my supervision and guidance, no part of

this report has been submitted for award of any other

degree, diploma, fellowship or other similar titles or

prizes. The work has also not been published in anyjournals/ magazines.

Date: 29/01/2011

Place : MUMBAI

Project Guide:

Prof. NEHA GORADIA

Core Faculty

HKIMSR


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ACKNOWLEDGEMENT

During The Perseverance Of This Project, I Was Supported By

Different People, Whose Names If Not Mentioned Would Be

Inconsiderate On My Part. I Would Like To Extend My Sincere

Gratitude And Appreciation To Prof. NEHA GORADIA Who

Initiated Me Into The Study Of RISK ANALYSIS ON INDIAN

BANKING SECTOR

It Has Indeed Been A Great Experience Working Under Them

During The Course Of The Project For Their Invaluable Advice And

Guidance Provided Through Out This Project. I Also Owe My

Sincere Gratitude To Mr. K. C. PANDEY Director Of Our College.

I Would Also Like To Thank The Following People Who Through

Their Experience Have Enlightened Me On The Practical Aspects

Of This Subject Without Whom The Study Would Not Have Been

Carried Out Successfully. I Would Also Like To Give My Sincere

Gratitude To All My College Librarian Staff Because Of Whom I Am

Able To Complete MyProject.

EXECUTIVE SUMMARY


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The pace of development for the Indian banking industry has been tremendous

over thepast decade. As the world reels from the global financial meltdown,

Indias banking sectorhas been one of the very few to actually maintain

resilience while continuing to providegrowth opportunities, a feat unlikely to be

matched by other developed markets around theworld. A majority of the

respondents, almost 69% of them, felt that the Indian bankingIndustry was in avery good to excellent shape, with a further 25% feeling it was ingo od shape and

only 6.25% of the respondents feeling that the performance of the

industry was just average.This optimism is reflected in the fact that 53.33% of

respondents were confident ina growth rate of 15-20% for the banking industry

in 2009-10 and a greater than20% growth rate for 2014-15. Some of the major

strengths of the Indian banking industry, which makes itresilient in the current

economic climate wereregulatory system (93.75%), economic growth (75%),

and relative insulation fromexternal market (68.75%).

The new decade is predicted to be more transformational than the first decade

of this millennium for the Indian economy and the Indian financial system. If the

last ten years have seen transformation in terms of consistently higher growth

rates, adoption of core banking solutions, transformation in the payments

systems and greater integration with the global economy, the coming decade

will see unprecedented volume of business for the Indian financial system as it

tries to meet the challenges and requirements of rapid and inclusive growth.

Information Technology (IT) has made it possible for banks to deal with large

numbers and such growth in volume and value of business will obviously imply

huge challenges for risk management, which in turn will have to depend on

human resources. Respondents perceived ever rising customer expectations and

risk management asthe greatest challenge for the industry in the current

climate.93.75% of our respondents saw expansion of operations as important in

thefuture, with branch expansion and strategic alliances the most important

organicand inorganic means for global expansion respectively.

The characteristics of present banking system is exposed to diverse market andnon-market risks, which has put risk management in these sectors to a core

functionary within the financial institutions. This has been essentially done to

protect not only the interests of the stakeholders, but more obviously, in

protection to the shareholders and creditors. The growing economy demands a

safe and sound banking system, and as such, risk management has become a

critical task for the banking sectors, bringing in stability in the financial markets.


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A good supervision of all the factors involved, would lead to identifying,

assessing, and promoting a secured risk management system.

The banking sector is increasingly faced with tougher challenges in meeting

various risk management requirements, and no matter how tough it is, the

present day operations requires the risk managers to be vigilant, and unusually

diligently perceptive towards the causes of protecting the interest of the people

concerned. In the practical scenario, risk management is very much fragmented,

spread across in pockets, resulting in inconsistency in reporting, inadequate

measurements, and poor quality of management. Poor data availability is one of

the major causes in inefficient risk management, making it difficult for the bank

to manage and control in an institution-wide environment.

In order that a consolidated step could be taken towards a better risk

management, there has been much interaction between the public and private

sectors, with an attempt to evolve techniques, mostly pertinent to the bankingsector, which represents the largest and most internationally active industry in

the world. Through these deliberations, Basel Committee (BCBS) in Basel,

Switzerland, in 1988, came out with Basel I framework proposal, which brought

together closer ties between the banks capital holding, and the risks that are

involved. This brought in higher capital level. The banking sector is growing

rapidly, and with its large and complex operations, Basel I have become

inadequate in continuing with the improvement of the advanced method of risk

management that the banking sectors have today. A more comprehensive

guideline was evolved in Basel II. This regulation envisaged that, the banking

sector should ensure a proper handling of the capital, separate the operational

risk from the credit risk while quantifying both, and distribute capital vis--vis

the economic risk.

INTRODUCTION


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Recent time has witnessed the world economy develop serious difficulties in

terms of lapseof banking & financial institutions and plunging demand.

Prospects became very uncertaincausing recession in major economies.

However, amidst all this chaos Indias banking sectorhas been amongst the few

to maintain resilience.

A progressively growing balance sheet, higher pace of credit expansion,expandingprofitability and productivity similar to banks in developed markets,

lower incidence of nonperformingassets and focus on financial inclusion have

contributed to making Indianbanking vibrant and strong. Indian banks have

begun to revise their growth approach andre-evaluate the prospects on hand to

keep the economy rolling. The way forward for theIndian banks is to innovate to

take advantage of the new business opportunities and at thesame time ensure

continuous assessment of risks.

A rigorous evaluation of the health of commercial banks, recently undertaken by

theCommittee on Financial Sector Assessment (CFSA) also shows that thecommercial banks arerobust and versatile. The single -factor stress tests

undertaken by the CFSA divulge that thebanking system can endure

considerable shocks arising from large possible changes in creditquality, interest

rate and liquidity conditions. These stress tests for credit, market andliquidity

risk show that Indian banks are by and large resilient.Thus, it has become far

more imperative to contemplate the role of the Banking Indus try infostering the

long term growth of the economy. With the purview of economic stability

andgrowth, greater attention is required on both political and regulatory

commitment to longterm development programme.

Liberalization and de-regulation process started in 1991-92 has made a sea

change in the banking system. From a totally regulated environment, we have

gradually moved into a market driven competitive system. Our move towards

global benchmarks has been, by and large, calibrated and regulator driven. The

pace of changes gained momentum in the last few years. Globalization would

gain greater speed in the coming years particularly on account of expected

opening up of financial services under WTO. Four trends change the banking

industry world over, viz. 1) Consolidation of players through mergers and

acquisitions, 2) Globalization of operations, 3) Development of new technology

and 4) Universalisation of banking. With technology acting as a catalyst, we

expect to see great changes in the banking scene in the coming years. It entails

emergence of an integrated and diversified financial system. The move towards

universal banking has already begun. This will gather further momentum

bringing non-banking financial institutions also, into an integrated financia l

system.


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The traditional banking functions would give way to a system geared to meet all

the financial needs of the customer. We could see emergence of highly varied

financial products, which are tailored to meet specific needs of the customers in

the retail as well as corporate segments. The advent of new technologies could

see the emergence of new financial players doing financial intermediation. For

example, we could see utility service providers offering say, bill paymentservices or supermarkets or retailers doing basic lending operations. The

conventional definition of banking might undergo changes.

The competitive environment in the banking sector is likely to result in

individual players working out differentiated strategies based on their strengths

and market niches. For example, some players might emerge as specialists in

mortgage products, credit cards etc. whereas some could choose to concentrate

on particular segments of business system, while outsourcing all other functions.

Some other banks may concentrate on SME segments or high net worth

individuals by providing specially tailored services beyond traditional bankingofferings to satisfy the needs of customers they understand better than a more

generalist competitor.

Industry overview


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The predi ent of the banks in the developed countries owing to excessive

leverage andnegligent regulatory system has time and again been compared with

somewhat unscathed IndianBanking Sector. An attempt has been made to

understand the general sentiment withregards to the performance, the challenges

and the opportunities ahead for the IndianBanking Sector.A majority of therespondents, almost 69% ofthem, feltthatthe Indian banking Industrywas in a

very good to excellent shape, with a further 25% feeling it was in good shape

andonly 6% ofthe respondents feeling thatthe performance ofthe industry was

just average. Infact, an overwhelming majority (93.33%) ofthe respondents felt

thatthe banking industrycompared with the best ofthe sectors ofthe economy,

including pharmaceuticals,infrastructure, etc.Most of the respondents were

positive with regard to the growth rate (Fig. 1) attainable bythe Indian banking

industry forthe year 2009-10 and 2014-15, with 53.33% ofthe view thatgrowth

would be between 15-20% forthe year 2009-10 and greater than 20% for 2014-15.

Fig. 1: Projected growth rates of banks

The major strength ofthe Indian banking industry, which makes itresilientin the

current economic climate; 93.75% respondents feel the regulatory system tobe


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the major strength, 75% economic growth, 68.75% relative insulation from

externalmarket, 56.25% credit quality, 25% technological advancement and

43.75% our riskassessment systems.

Change is the only constant feature in this dynamic world and banking is not an

exception.The changes staring in the face of bankers relates to the fundamental

way of banking-whichis going through rapid transformation in the world oftoday. Adjust, adapt and changeshould be the key mantra. The major challenge

faced by banks today (Fig. 2) is the everrising customer expectation as well as

risk management and maintaining growth rate.Following are the results of the

biggest challenge faced by the banking industry (on a mode scale of 1 to 7 with

1 being the biggest challenge):

Fig. 2: Challenges faced by the banking industry

India on certain essential banking parameters


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(Regulatory Systems, Risk Assessment Systems, Technological System and

Credit Quality) incomparison with other countries i.e. China, Japan, Brazil,

Russia, Hong Kong, Singapore, UKand USA.

Fig. 3: Comparison across Regulatory systems

The recent financial crisis has drawn attention to under-regulation of banks

(mainlyinvestment banks) in the US. Though, the Indian story is quite different.

Regulatory systemsof Indian banks (Fig. 3) were rated betterthan China, Brazil,

Russia, and UK; at par withJapan, Singapore and Hong Kong where as all our

respondents feel that we are above par orat par with USA. On comparing the

results with our previous survey where the respondentshad rated Indian

Regulatory system below par the US and UK system, we see that post

thefinancial crisis Indian Banks are more confident on the Indian Regulatory

Framework.


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Fig. 4: Comparison across Risk Assessment systems

Risk management framework is a key strength for sustainable growth of

banks.Indias Risk management systems (Fig. 4) ismore advanced than China,

Brazil and Russia.The perception of Indias Risk management systems being

below parthan Singapore, US andUK as had been highlighted.

Fig. 5: Comparison ofCredit Quality


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The global meltdown started as a banking crisis triggered by the credit quality.

Indian banksseem to have paced up in terms of Credit Quality (Fig. 5). Credit

quality of banks has beenrated above par than China, Brazil, Russia, UK and

USA but at par with Hong Kong andSingapore Thus,we see that the resilience

the Indian Banks showed at the time of financial crisis has led toan attitudinal

shift of our respondents with the past survey indicating Credit quality ofIndianbanks being below parthan that of US and UK.

Fig. 6: Comparison across Technological systems

As technology ingrains itselfin all aspects of a banks functioning, the challenge

lies inexploiting the potential for profiting from investments made in

technology. A lot needs tobe done on the technological front to keep in pace

with the global economies, as is evidentfrom the survey results (Fig. 6).

Technology systems of Indian banks have been rated moreadvanced than Brazil

and Russia but below par with China, Japan, Hong Kong, Singapore, UKandUSA. We find no change on introspection which also highlighted theneed for

Indian banks to pace up in adoption of advanced technology.


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BANKING ACTIVITIE

Over the last three decades, there has been a remarkable increase in the size,

spread andscope of activities of banks in India. The business profile of banks has

transformeddramatically to include non-traditional activities like merchant

banking, mutual funds, newfinancial services and products and the humanresource development.Our survey finds that within retail operations, banks rate

product development anddifferentiation; innovation and customization; cost

reduction; cross selling and technologicalupgradation as equally importantto the

growth of their retail operations. Additionally a fewrespondents also find pro-

active financialinclusion, credit discipline and income growth ofindividuals and

customer orientation to be significant factors fortheir retail growth.There is, at

the same time, an urgent need for Indian banks to move beyond retail

banking,and further grow and expand their fee- based operations, which has

globally remained oneofthe key drivers of growth and profitability. In fact, over80% of banks haveonly up to 15% of their total incomes constituted by fee-

based income; and barely 13%have 20-30% oftheirtotalincome constituted by

fee-based income.

Fig. 8: Most profitable non-interestincome opportunities

Out of avenues for non-interest income (Fig. 8), we see that Bancassurance

(85.71%) andForex Management (71.43%) remain most profitable for banks.


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Derivatives, understandably,remains the least profitable business opportunity for

banks as the market for derivatives isstill in its nascent stage in India.

There is nevertheless a visibly increased focus on fee based sources of income.

71% of banksin our survey saw an increase in their fee based income as a

percentage of their totalincome for the FY 2008-09 as compared to FY 2007-08.

Indian banks are fast realizing thatfee-based sources of income have to beactively looked at as a basis for future growth, if theindustry is to become a

global force to reckon with.


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CORE BANKING SOLUTIONS

Unlike their western counterparts, Indian banks had the opportunity to leapfrog

throughtechnologicalinnovations as they started off with a comparatively clean

slate. CBS enablesbanks to consolidate their technology platforms across

functions and geographiesleveraging cost and at the same time acquiringflexibility and scalability to adapt to a fastchanging and competitive

environment. The shiftto IFRS standards by 2011 with valuationof assets on the

basis of current rather than historical cost would be one of the majordriving

forces for the implementation of Core Banking Solutions.73.33% of our

respondents are cent per cent compliant with core banking solutionrequirements,

with the remainder, mostly public sector banks, lagging behind

inimplementation within rural areas. Integrating CBS with common inter-bank

paymentsystems can benefit banks and financialinstitutions in terms of facilities

such as CRM,customer profiling and differentiation for improved customerservice. Amongstthoserespondents that have not yetimplemented Core banking

solutions, 75% expect completeimplementation of CBS within 0-1 years, with

the rest expecting implementation within thenext 2 years atthe maximum.

Fig. 9: Benefits ofCore Banking Solutions


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The future would require banks to have increased business agility and

operationalefficiency, which makes the implementation of Core Banking

Systems (CBS) by banksincreasingly important. It found effective control and

monitoring bythe top management, lower business operation costs and instant

availability of accuratedata to be some of the valuable by products of Core

banking Solutions.

Fig. 10: Challenges in implementation ofCBS

As seen from the above graph (Fig. 10), CBS has not been smooth sailing for

banks. Amajority of the respondents (84.62%) found that the proper & timely

management ofchanges was their biggest test in the implementation of Core

Banking Solutions, closelyfollowed by the large number of transactions and

branches involved (76.92%), and BusinessProcess re-engineering (76.92%).

Availability of financing (23.08%), on the other hand, wasnot considered to be a

serious deterrentto implementation ofCBS processes.

HUMAN RESOURCES


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Up till now, PSU banks which are a dominating force in the Indian banking

system have lackeda proactive HR environment. However, much has changed

with the opening of other sectorsand increased competition from newer banks in

the system.

Banks are increasingly beginning to recognize Human resources as a possiblearea of corecompetence, and seek to pursue and retain the best talent in the

industry. There is arealization that skill developmentis extremely important for

staff retention as well as thequality of manpower, and had in place a system of

continuousprofessionallearning. A process of revamping theirtrainingprocesses

and emphasis is being laid on hard as well as soft skills. Banks are keen to tie

upwith externaltraining agencies forin-house training. Some have even roped in

topuniversities and business schools to help them in theirinitiative, while others

have their ownstaff colleges fortraining employees.81.25% feelthatthe current

economic situation is in factadvantageous for them, as it provides them withaccess to quality manpower. 62.50% ofbanks also feelthatthey have sufficient

autonomy to offer attractive incentivepackages to employees to ensure their

commitment levels.Major HR threats faced by their organization (Fig. 11) ona

scale of 1-4 (with 1 being the greatest threat). The results are presented inthe

following graph:


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Fig. 11: HRThreats forBanks

Thus, on the whole, we see that Public Sector Banks, Private Sector Banks as

well as ForeignBanks view difficulty in hiring highly qualified youngsters as

their biggest HR threat ahead ofhigh staff cost overheads, poaching of skilled

quality staff and high attrition rates.

CRE IT FLOW AND INDUSTRY


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India Inc is completely dependent on the Banking System for meeting its

fundingrequirement. One of the major complaints from the industry has in fact

been high lendingrates in spite of massive cuts in policy rates by the RBI. None

ofthe banks considered the cap on bank deposit rates to be one ofthecauses of

inflexible lending rates. Due to long-term maturity, the trend seems tobechanging. However, there are other factors which have led to the stickiness of

lending ratessuch as wariness of corporate credit risk (33.33%), competition

from government smallsavings schemes (26.67%). Benchmarking of SM and

export loans against PLR (20.00%) onthe other hand, do not seem to have as

significant an influence over lending rates accordingto banks.The great Indian

industrial engine has nevertheless continued to buzz its way through mostofthe

year long crisis.The sectors which banks consider to be mostprofitable in the

coming years (Fig. 12). All were confidentin the infrastructuresectorleading the

profitability forthe industry, followed by retailloans (73.33%) and others.

Fig. 12: Sectors profitable in the coming years

SM s, Cement, and the IT and Telecom sector were viewed as equally

profitable in the nearfuture by banks. Not surprisingly, the Real estate and

housing sector were ranked the lowestin terms of future profitability.

LOAN DISBURSEMENT AND LENDING PRACTICES


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Around 60% feel that there is an umbrella effect for credit disbursements for

individualcompanies, wherein companies are graded on the basis of the overall

performance of thegroup as a whole, and further 60% of the opinion that there a

need to revise the groupexposure limits imposed by the regulator.When quizzed

on farm lending practices, 87.50% disagreed with thenotion that banks view

lending to SMEs and farm sector as an avenue for forced lendingrather than aprofitable avenue. However, 75% of them agreed that a lack of sufficientsupport

systems to farmers such as inputs, irrigation, marketing facilities, etc is a

hinderingfactor for the farm sector lending, followed by 50% stressing on the

cost of reaching EndUser as a deterrent. A poor legal system for recovery was

another barrier to farm sectorlending.With regards to loan disbursement, 71.43%

felt that there was no need for standardizedcredit appraisal across the industry.

But at the same time, 73.33% felt thatthere is scope for a further reduction in

turnaround times for loan sanctioning. Stepsundertaken by participant banks to

this effect include effectively implementing the conceptof single level appraisaland mechanising the entire loans sanction process, EstablishingCentral

Processing Units for Retail and SMEs, as well as increased discretionary powers

across all levels.

CREDIT QUALITY


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The global financial meltdown which has its origins in the sub-prime mortgage

crisisoriginating in the United States has led banks to be more conservative in

their lendingpractices, and consequently a rise in capital costs for corporates.

The Reserve Bank of Indiahas however played a key role is assisting the

banking sector in managing its liquidity anddespite recent events, the medium-

to-long-term India growth story remains intact.Capital adequacy is seen asimportant to the stability of the banking system. The minimumCapital to Risk-

weighted Asset Ratio (CRAR) in India as required by the RBI is placed at

9%,one percentage point above the Basel II requirement. Public sector banks are

furtherrequired to maintain a CRARof 12% by the Government of India.In fact,

over 92% of the participants firmly concur with recent stress test results that

Indianbanks have the ability to absorb twice the amount of their current NPA

levels. However, thecurrent crisis has exposed certain vulnerabilities and

weaknesses within the system thatbanks continue to remain wary of.

Fig. 13: Segments expected to show increase in NPAs

Almost 80% of the banks see personal loans (Fig. 13) as having the greatest

potential fordefault, followed by corporate loans and credit cards. Many banksadditionally perceived alevel of riskiness in the SM and farm loan sector.

RISK MANAGEMENT


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The basic concept of risk management involves making an assessment of the

risk and then developing a strategy to manage that risk. Risks ensuing out of

physical or legal causes, such as, natural disasters or fires, accidents, death, and

lawsuits, are one of those which are traditionally focused. But, in banking

sectors, the focus is mainly on risk factors involved with traded financial

instruments. In an ideal situation, the risks concerned with substantial losses andthe high probability of its occurrence, are handled first, and given the highest

priority in risk management. The lesser probable ones comes next. In doing so, it

is quite difficult to maintain the balance between the combination of different

scenarios, viz., risks with a high probability of occurrence but lower loss vs. a

risk with high loss but lower probability of occurrence.

In meeting the basic characteristics in banking sectors, there is a need to provide

human and financial resources through-out the organisation, enough to meet the

purpose of an effective compliance risk management system. In proving such

resources, it is necessary to delegate proper authority and independence in the

working method. There needs to be a sense of ownership in the compliance

function, in order that the organisation can keep itself focused on its compliance

risk management responsibility. A comprehensive database should be in place,

along with monitoring and measuring of the risks involved in any k ind of

circumstances, which, in combination, may provide meaningful reports based on

the laws and regulations governing compliance risks, associated with existing or

new products, and new business activities.

The banking sector need to understand operation al risk exposure at the

organisational level, where the concerned risk factors are consolidated into one,

making it somewhat easier to have a verification of operational risk involved.

We shall examine in the consequent articles the problems that banking s ector

finds most difficult to address, which are deficient in the current methodology

used. There are gaps in analysis of risk elements in the current procedures

adapted, in establishing risk management and risk control.

Risk is inherent in any commercial activity and banking is no exception to this

rule. Rising global competition, increasing deregulation, introduction ofinnovative products and delivery channels have pushed risk management to the

forefront of todays financial landscape. Ability to gauge the risks and take

appropriate position will be the key to success. It can be said that risk takers

will survive, effective risk managers will prosper and risk averse are likely to

perish. In the regulated banking environment, banks had to primarily d eal with

credit or default risk. As we move into a perfect market economy, we have to


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deal with a whole range of market related risks like exchange risks, interest rate

risk, etc. Operational risk, which had always existed in the system, would

become more pronounced in the coming days as we have technology as a new

factor in todays banking. Traditional risk management techniques become

obsolete with the growth of derivatives and off-balance sheet operations,

coupled with diversifications. The expansion in E-banking will lead tocontinuous vigilance and revisions of regulations. Building up a proper risk

management structure would be crucial for the banks in the future. Banks would

find the need to develop technology based risk management tools. The com plex

mathematical models programmed into risk engines would provide the

foundation of limit management, risk analysis, computation of risk -adjusted

return on capital and active management of banks risk portfolio. Measurement

of risk exposure is essential for implementing hedging strategies.

Under Basel II accord, capital allocation will be based on the risk inherent in the

asset. The implementation of Basel II accord will also strengthen the regulatory

review process and, with passage of time, the review process will be more and

more sophisticated. Besides regulatory requirements, capital allocation would

also be determined by the market forces. External users of financial

information will demand better inputs to make investment decisions. More

detailed and more frequent reporting of risk positions to banks shareholders

will be the order of the day. There will be an increase in the growth of

consulting services such as data providers, risk advisory bureaus and risk

reviewers.These reviews will be intended to provide comfort to the bankmanagements and regulators as to the soundness of internal risk management

systems.

Risk management functions will be fully centralized and independent from the

business profit centres. The risk management process will be fully integrated

into the business process. Risk return will be assessed for new business

opportunities and incorporated into the designs of the new products. All risks

credit, market and operational and so on will be combined, reported and

managed on an integrated basis. The demand for Risk Adjusted Returns on

Capital (RAROC) based performance measures will increase. RAROC will beused to drive pricing, performance measurement, portfolio management and

capital management.

Risk management has to trickle down from the Corporate Office to branches or

operating units. As the audit and supervision shifts to a risk based approach

rather than transaction orientation, the risk awareness levels of line functionaries


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also will have to increase. Technology related risks will be another area where

the operating staff will have to be more vigilant in the coming days.

Banks will also have to deal with issues relating to Reputational Risk as they

will need to maintain a high degree of public confidence for raising capital and

other resources. Risks to reputation could arise on account of operational lapses,

opaqueness in operations and shortcomings in services. Systems and internalcontrols would be crucial to ensure that this risk is managed well.

The legal environment is likely to be more complex in the years to come.

Innovative financial products implemented on computers, new risk management

software, user interfaces etc., may become patentable. For some banks, this

could offer the potential for realizing commercial gains through licensing.

The major challenge is, clearly, having the human resources of the right kind

and numbers and the ability to retain skilled personnel. From having personnel

to deliver banking services to the po orest, to having the expertise to deliversophisticated financial products and adopt consistent risk management practices

across the organisation, will be the key to managing huge organisations

optimally.

If one of the reasons for the global financial crisis was that the financial sector

grew out of sync with the real sector in the advanced economies, in India the

position is different in that the financial system has to ensure that it meets the

requirements of the growing real sector. Risk is inherent in banking as banks

essentially trade in risk in the process of maturity transformation. Therefore,

banks cannot afford to be risk avoiders. At the same time bankers prudence,

something that is critical to safety of the depositors funds, has to be the

underlying philosophy at all times. The risk return relationship has to be

optimally balanced for welfare enhancing outcomes

The crisis has thrown up some critical issues relevant to risk management

policies:

Banks that were extremely aggressive in the trading books were clearly more

affected. Those that had a fair degree of traditional banking were less affected.

There has to be an intuitive approach to risk. Despite huge growth in leverage

and huge expansion of on and off-balance sheet items, complex risk models

threw up measures of risk that seemed to be quite capable of being absorbed.

There was obviously a clear limitation to these models especially in times of

stress. The inadequacies stemmed from two perspectives


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(a) Use of past data without adequately factoring in the data from acute periods

of stress and

(b) The presumption that the highly sophisticated mathematical models could be

as successful as they are in physical sciences.

The latter presumption is clearly wrong inasmuch as financial events are heavily

influenced by largely unpredictable or irrational human behaviour which modelscannot capture. Nevertheless, these are useful when considered as one of the

inputs supplemented by stress/ scenario analysis and informed judgement. The

other aspect which causes serious concern is that the comprehension of these

models remains confined to a small group of Quants and it becomes very

difficult for the top management and boards to comprehend th e actual risk

undertaken by the organization. These lessons will have to be kept in view now

that some of the banks will move towards advanced approaches.

Pricing of risk is important. There is a temptation to under-price risk wheneverthere is excess liquidity and pressure to generate profits. Pricing below cost can

be risky and the risk cost is very often not captured adequately. Moreover, this

gives rise to asset price bubbles with attendant implications.

While credit, market and operational risk are captured in the capital framework

under Pillar I of Basel II, liquidity risk, concentration risks, strategic risk,

reputation risk and risks arising out of securitization, off balance sheet vehicles,

valuation practices need to be recognized. Banks Boards need to focus on all

these risks and set firm wide limits on the principal risk relevant to banks

activities. Banks should focus on robust stress testing. Compensation packages

should also form part of risk management policies.

This crisis has also highlighted the importance of internal controls, good

corporate governance and risk management. As shown in the Senior Supervisors

Group Report on Risk Management, some banks with strong risk management

systems weathered the current crisis much better than many banks that had poor

or inadequate risk management systems.

For banks that are part of financial conglomerates, the process of risk

management must focus on intra group exposures and transactions as also group

wide exposures to sectors and borrowers.

The new element recognised in this crisis is that even while sound risk

management policies are observed at the firm level there could be systemic risks

over which individual banks have no control and this calls for risk management


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at the systemic level viz. ensuring financial stability by financial regulators

and policy makers.

I will now turn to the key areas where banks need to focus while planning their

businesses for higher growth, keeping in view the on-going international

regulatory initiatives. The Basel Committee has brought out on December 17,

2009, two consultative documents containing key proposals that will be taken up

for an impact study before adoption. These proposals cover raising quality and

coverage of capital to ensure loss absorbency on a going and gone concern basis,

greater stress on Tier-I and common equity component, introduction of leverage

ratio, measures to deal with pro cyclicality such as capital buffers and forward

looking provisioning, introduction of minimum liquid ity ratios and enhanced

capital for trading book securitisations and counterparty credit exposures.

While our assessment is that Indian banks will be generally able to meet these

enhanced requirements, it is useful to see on a rough and ready basis what thepresent position is in this regard. Our assessment shows that:

The common equity component as percent of total assets stood at 7 per cent in

March 2009 for Indian banking sector as against a range of 3 per cent to 4

percent for large international b anks. Total CRAR is 13.75 percent with Tier I at

9.4 per cent. Thus Indian banks are in a position to meet the growth

requirements currently and have reasonable period to plan and raise required

capital for future growth.

The leverage ratio for Indian banks including credit equivalents of off -balance

sheet) was about 17 per cent in March 2009 and can be considered reasonable.

While the SLR has stood us in good stead, banks would do well to assess their

liquidity risk against the more calibrated liquidity ratios put out in the

consultative document such as the proposed short term liquidity coverage ratio

and long term net stable funding ratio. This should be a regular exercise for

banks that have significant share of bulk deposits and CDs.

The Basel proposals for forward looking provisioning are based on advancedapproaches using through the cycle PDs etc. In India, banks ar e yet to adopt

advanced approaches. The gross NPAs for the banking sector have increased

from 2.4 per cent as on March 31, 2008 to 2.6 per cent as on September 30,

2009. In the context of the rising NPAs and the likely slippages in the

restructured accounts, we had introduced the 70 per cent provisioning coverage

ratio for NPAs as a forward looking requirement. Most banks currently meet this

ratio. For standard assets, in alignment with the Basel proposals for forward


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looking provisioning, more work needs to be done based on sectoral trends and

measurements of estimated loss based on something like the Spanish dynamic

provisioning model.

In the case of capital for trading book and counterparty exposures, while some

enhancements have been made for forex de rivatives, more work will be required

for counterparty exposures and other derivatives. Nevertheless, looking at the

interest rate risk for the entire balance sheet rather than the trading book alone,

duration gap analysis could be a useful tool for managi ng interest rate risk.

y The areas where banks need to be sensitive to risk:

While overall, credit growth in the banking sector has been slower in the

current year, certain sectors like real estate, infrastructure and NBFCs have seen

higher rates of growth. Credit to commercial real estate (CRE) has fallen in the

half year ended September 2009 evidencing higher risk perception. Howevercredit to NBFCs and infrastructure continues to be high. While the country

needs infrastructure financing of significant magnitude, banks that essentially

mobilise short term resources do face risk on account of ALM, large size

exposures and some risks beyond their control such as implementation hurdles.

The emergence of long term investors such as pension and insurance fund s,

development of corporate bond market, and single name CDS may help in de -

risking to a certain extent banks exposures to infrastructure.

A phenomenon that RBI has brought to attention of banks recently is the large

investments by banks into debt oriented mutual funds. MFs have invested large

amounts in bank CDs. Banks that have a significant part of their liabilities in

form of CDs have to be sensitive to the rollover risk. Equally, banks that have

large investments in MFs have to be sensitive to the l iquidity risk in the event of

the need for sudden redemption by large investors at the same time. This

distortion -whereby MFs are apparently acting as intermediaries in what should

otherwise have been intermediated in the interbank market - is something that

needs to be addressed. Besides there are concerns about the direction of flow of

resources through MF intermediation.

In the case of lending to NBFCs engaged in micro finance treated as priority

sector lending by banks, there is a risk that multiple lending and high interest

rates could lead to deterioration in asset quality. As originator of these loans no

longer have stake in them, banks would do well to assess the credit quality of

these loans by better oversight at the grass root level on a sample basis.


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While banks have been diversifying their operations and are into new

businesses, it is necessary to recognise the reputation risk, especially when

promoting VCFs and other such funds. As is now well known, internationally

many banks had previously offloaded certain items from their balance sheet to

specialised investment vehicles. During the market crunch the banks had to take

back those assets on their balance sheets.

Securitisation of assets by banks in India during the year ended March 31,

2009 showed a decline of about 30% over the previous year. This might affect

the profitability of banks which have been undertaking securitisation activity as

one of the main business lines. However, the securitisation activity may pick up

once the retail loan segment starts growing again. RBI would shortly issue

guidelines on minimum retention requirement and minimum holding period for

securitisable loans.

While hedging or remaining unhedged is the prerogative of the borrowers,banks must remember that the unhedged position of their borrowers can quickly

translate into severe stress on their asset quality and hence it is absolutely

necessary that the unhedged position of the corporates are closely monitored and

this is built into the credit and other rat ing assessment of the borrowers while

extending facilities to them.

Excess liquidity in the system has once again led to the familiar phenomenon

of sub PLR short-term lending; banks would do well to recognise re -pricing and

rollover risk.

To remove the credit information asymmetry, RBI has taken long term steps

inasmuch as it has issued in-principle authorisation for setting up four credit

information companies. This may take some time to become operational. It must

however be recognised that the system will function only to the extent timely

and accurate information is made available and made use of. I understand that

these are not happening both in providing information to CIBIL as well as

making full use of the range of information available particu larly for corporate

credit.

While introduction of technology in banking has increased the speed and

accuracy of service delivery, it has also increased banks vulnerability to cyber

frauds. Banks need to put in place appropriate control mechanisms to pr event

such frauds.

It is necessary for the banks now to take technology from the core banking

solution to a higher level to build up adequate MIS capability. Unless this is


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done, risk management cannot be of the highest order and banks will not be able

to meet the challenge of an increasingly sophisticated financial system.

In the area of housing loans, teaser rates are increasingly being offered which

is a cause for concern. I hope banks are ensuring that borrowers are well aware

of the implications of such rates and the appraisal takes into account repaying

capacity of the borrowers when the rates become normal.

Current experience worldwide has called for robust stress testing practices in

the banks. Stress testing alerts bank management to advers e unexpected

outcomes related to a variety of risks and provides an indication of how much

capital might be needed to absorb losses should large shocks occur. In India,

banks should not take stress testing exercise a mere compliance requirement but

accord due importance to it to facilitate the development of risk mitigation or

contingency plans across a range of stressed conditions.

To conclude, Indian banking system which has shown resilience in

withstanding the global crisis is well placed to meet the r equirements of the

rapid inclusive growth. Even in the new paradigm under Basel, the system is

well placed in terms of capital and liquidity. Strong HR and sound risk

management practices will stand the banks in good stead while they strive to

meet the challenges of the next decade.

RISK MANAGEMENT PROCESS


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The process of financial risk management is an ongoing one.Strategies need to

be implemented and refined as the market and requirements change.

Refinements may reflect changing expectations about market rates, changes to

the business environment, or changing international political conditions, for

example. In general, the process can be summarized as follows:

Identify and prioritize key financial risks.

Determine an appropriate level of risk tolerance.

Implement risk management strategy in accordance with policy.

Measure, report, monitor, and refine as needed.

Risk management needs to be looked at as an organizational approach, as

management of risks independently cannot have the desir ed effect over the long

term. This is especially necessary as risks result from various activities in thefirm and the personnel responsible for the activities do not always understand

the risk attached to them.

The steps in risk management process are:

1. Determining objectives: - determination of objectives is the first step in

the risk management function. The objective may be to protect profits, or to

develop competitive advantage. The objective of risk management needs to be

decided upon by the management. So that the risk manager may fulfill his

responsibilities in accordance with the set objectives.

2. Identifying Risks :- Every organization faces different risks, based on its

business, the economic, social and political factors, the features of the industry it

operates in like the degree of competition, the strengths and weakness of its

competitors, availability of raw material, factors internal to the company like the

competence and outlook of the management, state of industry relations,

dependence on foreign markets for inputs, sales or finances, capabilities of its

staff and other innumerable factors.

3. Risk Evaluation: - Once the risks are identified, they need to be evaluated

for ascertaining their significance. The significance of a particula r risk depends

upon the size of the loss that it may result in, and the probability of the

occurrence of such loss. On the basis of these factors, the various risks faced by

the corporate need to be classified as critical risks, important risks and not -so-

important risks. Critical risks are those that may result in bankruptcy of the firm.


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Important risks are those that may not result in bankruptcy, but may cause

severe financial distress.

4. Development of policy : - Based on the risk tolerance oevel of the firm,

the risk management policy needs to be developed. The time frame of the policy

should be comparatively long , so that the policy is relatively stable. A policy

generally takes the form of a declaration as to how much risk should be covered.

5. Development of strategy: - Based on the policy, the firm then needs to

develop the strategy to be followed for managing risk. A strategy is essentially

an action plan, which specifies the nature of risk to be managed and the timing.

It also specifies the tools, techniques and instruments that can be used to manage

these risks. A strategy also deals with tax and legal problems. Another important

issue that needs to be specified by the strategy is whether the company would try

to make profits out of risk management or would it stick to covering the existing

risks.

6. Implementation: - Once the policy and the strategy are in place, they are

to be implemented for actually managing the risks. This is the operational part of

risk management. It includes finding the best deal in case of risk transfer,

providing for contingencies in case of risk retention, designing and

implementing risk control programs etc.

7. Review: - The function of risk management needs to be reviewed

periodically, depending on the costs involved. T he factors that affect the risk

management decisions keep changing, thus necessitating the need to monitor the

effectiveness of the decisions taken previously .


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FINANCIAL RISK MANAGEMENT

Broadly speaking, risk management can be defined as a discipline for Living

with the possibility that future events may cause adverse effects. In the context

of risk management in financial institutions such as banks or insurance

companies these adverse effects usually correspond to large losses on a portfo lio

of assets. Specific examples include: losses on a portfolio of market -traded

securities such as stocks and bonds due to falling market prices (a so -called

market risk event); losses on a pool of bonds or loans, caused by the default of

some issuers or borrowers (credit risk); losses on a portfolio of insurance

contracts due to the occurrence of large claims (insurance - or underwriting risk).

An additional risk category is operational risk, which includes losses resulting

from inadequate or failed internal processes, fraud or litigation.

In financial markets, there is in general no so -called free lunch or, in other

words, no profit without risk. This is the reason why financial institutionsactively take on risks. The role of financial risk management i s to measure and

manage these risks. Hence risk management can

be seen as a core competence of an insurance company or a bank: by using its

expertise and its capital, a financial institution can take on risks and manage

them by various techniques such as d iversification, hedging, or repackaging

risks and transferring them back to markets, etc.


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Risk Management in INDIAN BANK

Risk faced by the bank can be segmented into three separable types from the

management perspective viz.

a. Risks that can be eliminated or avoided by simple business practices

b. Risks that can be transferred to other business participants (eg. Insurance

policy) and

c. Risks that can be actively managed at the Bank level.

Risk is any real or potential event, action or omission, internal or external, which

will have an adverse impact on the achievement of Banks defined objectives.

Risk is inherent in every business. Risk cannot be totally eliminated but is to be

managed. Risks are to be categorised into high risk, m edium risk and low risk

and then managed.

Risks can be classified into three broad categories:

1. Credit Risk

2. Market Risk (Interest Rate Risk, Liquidity Risk)

3. Operational Risk


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Types of risk faced by banks

A bank has many risks that must be managed carefully, especially since a bank

uses a large amount of leverage. Without effective management of its risks, it

could very easily become insolvent. If a bank is perceived to be in a financially

weak position, depositors will withdraw their funds, other banks won't lend to itnor will the bank be able to sell debt securities in the financial markets, which

will aggravate the bank's financial condition even more. The fear of bank failure

was one of the major causes of the 2007 2009 credit crisis and of other

financial panics in the past.

Although banks share many of the same risks as other businesses, the major

risks that especially affect banks are liquidity risk, interest rate risks, credit

default risks, and trading risks.

Major types of risks:-

Credit Risk:-

Credit Risk is defined as the possibility of losses associated with decrease in the

credit quality of borrowers or counterparties. In a banks portfolio, losses stem

from outright default due to inability or unwillingness of a customer or

counterparty to meet commitments in relation to lending, trading, settlement and

other financial transactions. Credit risk emanates from banks dealings withindividuals, Corporate, bank, financial institution or a sovereign.

Credit Risk may take the following forms :

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

repaid

In the case of treasury operations; the payment or series of payments due from

the counter parties under the respective contracts may not be forthcoming or

ceases

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

not be effected

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

foreign currency funds may either cease or restrictions may be imposed by the

sovereign


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Credit default risk occurs when a borrower cannot repay the loan. Eventually,

usually after a period of 90 days of nonpayment, the loan is written off. Banks

are required by law to maintain an account for loan loss reserves to cover these

losses.

Banks reduce credit risk by screening loan applicants, requiring collateral for a

loan, credit risk analysis, and by diversification.

Banks can substantially reduce their credit risk by lending to their customers,

since they have much more information on them than on others, which helps to

reduce adverse selection. Checking and savings accounts can reveal how well

the customer handles money, their minimum income and monthly expenses, and

the amount of their reserves to hold them over financially stressful times. Ban ks

will also verify incomes and employment history, and get credit reports and

credit scores from credit reporting agencies.

Collateral for a loan greatly reduces credit risk not only because the borrower

has greater motivation to repay the loan, but also because the collateral can be

sold to repay the debt in case of default.

When banks make loans to others who are not customers, then the bank has to

rely more on credit risk analysis to determine the credit risk of the loan

applicant. Credit risk analysis is the determination of how much risk a potential

borrower poses and what interest rate should be charged. The potential risk of a

borrower is quantified into a credit rating that depends on information about the

borrower and well as statistical models of the business or individual applicant.

There are credit rating agencies for businesses, such as Moody's or Standard

Poor for larger entities and Dun & Bradstreet for smaller businesses and

Experian, TransUnion, and Equifax for individuals. Most of these cre dit

reporting agencies assign a number or other code that signifies the potential risk

of the borrower. A bank will also look at other information, such as the

borrower's income and history.

A bank can also reduce credit risk by diversifyingmaking loans to businesses

in different industries or to borrowers in different locations.


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Market Risk:-

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

changes in the market variables. Market Risk is the risk to the banks earnings

and capital due to changes in the market level of interest rates or prices of

securities, foreign exchange and equities, as well as the volatilities of those

prices.

Segments of Market Risk:-

y Liquidity Risk:-

Liquidity risk is the potential inability to meet the banks liabilities as they

become due. It arises when the banks are unable to generate cash to cope

with a decline in deposits or increase in assets. It originates from the

mismatches in the maturity pattern of assets and liabilities

Liquidity is the ability to pay, whether it is to pay a bill, to give a depositor their

money, or to lend money as part of a credit line. A basic expectation of any bank

is to provide funds on demand, such as when a depositor withdraws money from

a savings account, or a business presents a check for payment, or borrowers may

want to draw on their credit lines. Another need for liquidity is simply to pay

bills as they come due.

The main problem in liquidity management for a b ank is that, while bills are

mostly predictable, both in timing and amount, customer demands for funds are

highly unpredictable, especially demand deposits (checking accounts).

Another major liquidity risk is off-balance sheet risks, such as loan

commitments, letters of credit, and derivatives. A loan commitment is a line of

credit that a bank provides on demand. Letters of credit include commercial

letters of credit, where the bank guarantees that an importer will pay the exporter

for imports and a standby letter of credit which guarantees that an issuer of

commercial paper or bonds will pay back the principal.

Derivatives are a significant off-balance sheet risk, as evidenced by the collapseof American International Group (AIG) in 2008. Banks participate in 2 major

types of derivatives: interest rate swaps and credit default swaps. Interest rate

swaps are agreements where one party exchanges fixed interest rate payments

for floating rates. Credit default swaps (CDSs) are agreements where one party

guarantees the principal payment of a bond to the bondholder.


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Liquidity management is achieved by asset and liability management. Asset

management requires keeping cash and keeping liquid assets that can be sold

quickly at little cost. Liability management is borr owing.

Types of liquidity risk:-

y Asset liquidity - An asset cannot be sold due to lack of liquidity in themarket - essentially a sub-set of market risk. This can be accounted for

by:

- Widening bid/offer spread

- Making explicit liquidity reserves

- Lengthening holding period for VaR calculations

y Funding liquidity - Risk that liabilities:

-Cannot be met when they fall due

- Can only be met at an uneconomic price

- Can be name-specific or systemic

Causes of liquidity risk:-

Liquidity risk arises from situations in which a party interested in trading

an asset cannot do it because nobody in the market wants to trade that asset.

Liquidity risk becomes particularly important to parties who are about to hold or

currently hold an asset, since it affects their ability to trade.

Liquidity risk is financial risk due to uncertain liquidity. An institution might

lose liquidity if its credit rating falls, it experiences sudden unexpected cash

outflows, or some other event causes counterparties to avoid trading with or

lending to the institution. A firm is also exposed to liquidity risk if markets onwhich it depends are subject to loss of liquidity.

Liquidity risk tends to compound other risks. If a trading organization has a

position in an illiquid asset, its limited ability to liquidate that position at short

notice will compound its market risk.

Suppose a firm has offsetting cash flows with two diffe rent counterparties on a

given day. If the counterparty that owes it a payment defaults, the firm will have


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y Liquidity risk elasticity:-

The change of net of assets over funded liabilities that occur when the liquidity

premium on the bank's marginal funding cost rises by a small amount as the

liquidity risk elasticity. For banks this would be measured as a spread over libor,

for nonfinancial the Liquidity Risk Elasticity would be measured as a spread

over commercial paper rates.

Problems with the use of liquidity risk elasticity are that it assumes parallel

changes in funding spread across all maturities and that it is only accurate for

small changes in funding spreads.

Interest Rate Risk:-

Interest rate risk is the risk where changes in market interest rates mightadversely affect a banks financial condition. The immediate impact of changes

in interest rates is on the Net Interest Income.

A bank's main source of profit is converting the liabilities of deposits and

borrowings into assets of loans and securities. It profits by paying a lower

interest on its liabilities than it earns on its assetsthe difference in these rates

is the net interest margin.

However, the terms of its liabilities are usually shorter than the terms of its

assets. In other words, the interest rate paid on deposits and short-term

borrowings are sensitive to short-term rates, while the interest rate earned on

long-term liabilities is fixed. This creates interest rate risk, which, in the case of

banks, is the risk that interest rates will rise, causing the bank to pay more for its

liabilities, and, thus, reducing its profits.

For instance:-

If a bank has a loan for $100 for which it receives $7 annually in interest, and a

deposit of $100 for which it pays $3 per year in interest, that is a net interestmargin of $4. But if current market interest rates for deposits rises to 4%, then

the bank will have to start paying $4 for the $100 deposit while still receiving

7% on the long-term loan, decreasing its profit in this scenario by $1.

All short-term and floating-rate assets and liabilities are interest-rate sensitive

the interest received on assets and paid on liabilities changes with ma rket rates.

Long-term and fixed-rate assets and liabilities are not interest-rate sensitive.


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Interest-rate sensitive assets include savings deposits and interest -paying

checking accounts. Long-term CDs are not interest-rate sensitive.

So for a bank to determine its overall risk to changing interest rates, it must

determine how its income will change when interest rates change.

Banks faces four types of interest rate risk:

y Basis risk:-

The risk presented when yields on assets and costs on liabilities are based on

different bases, such as the London Interbank Offered Rate (LIBOR) versus the

U.S. prime rate. In some circumstances different bases will move at different

rates or in different directions, which can cause erratic changes in revenues and

expenses.

y Yield curve risk:-

The risk presented by differences between short-term and long-term interest

rates. Short-term rates are normally lower than long-term rates, and banks earn

profits by borrowing short-term money (at lower rates) and investing in long-

term assets (at higher rates). But the relationship between short -term and long-

term rates can shift quickly and dramatically, which can cause erra tic changes in

revenues and expenses.

y Repricing risk:-

The risk presented by assets and liabilities that reprice at different times and

rates. For instance, a loan with a variable rate will generate more interest income

when rates rise and less interest income when rates fall. If the loan is funded

with fixed rated deposits, the bank's interest margin will fluctuate.

y Option risk:-

It is presented by optionality that is embedded in some assets and liabilities. For

instance, mortgage loans present significant option risk due

to prepayment speeds that change dramatically when interest rates rise and fall.

Falling interest rates will cause many borrowers to refinance and repay their

loans, leaving the bank with uninvested cash when interest rates have declined.


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Alternately, rising interest rates cause mortgage borrowers to repay slower,

leaving the bank with more loans based on prior, lower interest rates. Option

risk is difficult to measure and control.

Hedging interest rate risk

Interest rate risks can be hedged using fixed income instruments or interest rateswaps.

Interest rate risk can be reduced by buying bonds with shorter duration, or by

entering into a fixed-for-floating interest rate swap.

Measuring interest rate risk:-

Gap analysis and duration analysis are 2 common tools for measuring the

interest rate risk of bank portfolios.

Gap analysis:-

Gap analysis is the difference between the value of the interest rate sensitive

assets minus the value of the interest rate sensitive liabilities (the gap)

multiplied by a change in interest rate of 1%.

Gap = Value of Interest Rate Sensitive Assets Value of Interest Rate Sensitive

Liabilities.

Gap x Change in Interest Rate = Change in Bank's Profit.

Example :-

Gap Analysis - Calculating the Change in a Bank's Profit After a Change in the

Market Interest Rate

Consider $100 of the bank's assets bought with $100 worth of liabilities. How

much will a bank's profit decline if the interest rate on both assets and liabilities

that are interest rate sensitive increases by 1% and if:

y Value of Interest Rate Sensitive Assets = $20

o Bank has $80 worth of assets that are not interest rate sensitive, but

we won't consider either the assets or liabilities that are not interest

rate sensitive, since they will not be affected by a change in interest

rates.

o Bank receives 7% interest on the $20.


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$20 x 7% = $1.40

After interest rate rises by 1%, revenue increases to:

$20 x 8% = $1.60

y Value of Interest Rate Sensitive Liabilities = $60

o Bank initially pays 3% on its liabilities.

$60 x 3% = $1.80

Although this is more than what it is earning on its interest

rate sensitive assets, it is making a lot more on its assets that

aren't interest rate sensitive. Remember, we are only

interested in the change in profits.

After the interest rate rises by 1%, the equation becomes:

$60 x 4% = $2.40

y Originally, the difference in revenue was:

o $1.40 - $1.80 = - $0.40

y After the interest rate increase, the revenue becomes:

o $1.60 - $2.40 = - $0.80

y Thus, the profit declines by $0.40 from -$0.40 to - $0.80 for every $100 in

assets.

But there is a much simpler way to calculate the change in profits. Since the gap

in interest rate sensitive assets and liabilities is -$40, we simply multiply this gap

by the change in interest rate to obtain the same result as above :

y Gap = $20 - $60 = -$40

y Change in Profit = -$40 x 1% = -$0.40.

Remember, this profit is negative because the value of the interest rate sensitive

liabilities is much larger than the value of the interest rate sensitive assets. The

bank is, however, making much more profit overall because the proportion of

assets that are not sensitive to interest rates is twice as large as the corresponding


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liabilities. So considering only the assets and liabilities that are not interest rate

sensitive, we have:

y Interest received on assets = $80 x 7% = $5.60

y Interest paid on liabilities = $40 x 3% = $1.20

y Profit on assets which aren't interest rate sensitive to corresponding

liabilities: $5.60 - $1.20 = $4.40

When the interest rate margin is added from both categories of assets and

liabilities, then, before the interest rate change:

y Profit = $4.40 - $0.40 = $4.00

After the interest rate rises by 1%:

y

Profit = $4.40 - $0.80 = $3.60

So the bank's overall profit decreases by 40 cents for every $100 in assets, which

is a change of 40 basis points (1 basis point = 0.01%).

More sophisticated gap analysis takes into account the different terms of the

different assets and also convexity, but the calculations are far more

complicated.

Since interest rates affect the prices of bank assets and liabilities in the same

way that they affect bonds, bankers also use a tool commonl y used in bondportfolio analysisduration analysis.

Duration measures the change in the price of a bond when the interest rate

changes by 1%. A bank calculates its duration gap by subtracting the weighted

average duration of its assets minus the weighted average duration of its

liabilities.

Reducing Interest Rate Risk:-

Banks could reduce interest rate risk by matching the terms of its interest rate

sensitive assets to it liabilities, but this would reduce profits. It could also make

long-term loans based on a floating rate, but many borrowers demand a fixed

rate to lower their own risks. In addition, floating-rate loans increase credit risk

when rates rise because the borrowers have to pay more each month on their

loans, and, thus, may not be able to afford it. This is best exemplified by the

many homeowners who defaulted because of rising interest rates on their

adjustable rate mortgages (ARMs) during the 2007 2009 credit crisis.


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Increasingly, banks are using interest rate swaps to reduce their credit risk,

where banks pay the fixed interest rate they receive on their a ssets to a

counterparty in exchange for a floating rate payment.

y Foreign Exchange Risk:-

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

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

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

individual foreign currency.

International banks trade large amounts of currencies, which introduces foreign

exchange risk, when the value of a currency falls with respect to another. A bank

may hold assets denominated in a foreign currency while holding liabilities in

their own currency. If the exchange rate of the foreign currency falls, then both

the interest payments and the principal repayment will be worth less than when

the loan was given, which reduces a bank's profits.

Banks can hedge this risk with forward contracts, futures, or currency

derivatives which will guarantee an exchange rate at some future date or provide

a payment to compensate for losses arising from an adverse move in currency

exchange rates. A bank, with a foreign branch or subsidiary in the country, c an

also take deposits in the foreign currency, which will match their assets with

their liabilities.

Operational Risk:-

Operational risk, as defined by the Basel Committee, is 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

reputational risks.

Operational risk is the risk of direct or indirect loss resulting from inadequate or

failed internal processes, people and systems or from external events. Internal

processes include activities relating to accounting, reporting, operations, tax,

legal, compliance and personnel management etc.

Broadly the following can be grouped under Operational Risk

1. Internal Fraud


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2. External Fraud

3. Non adherence of systems and procedures

4. Poor documentation

5. Business disruption due to Computer Systems failure

6. Lack of succession planning

7. Failure of customer due diligence

Some of the important causes of operational risk are: -

y Internal frauds due to employees' intentional involvement;

y External frauds due mainly to robbery and forgery/falsification ofdocuments;

y Workers compensation claims, violation of employee health and safetyrules;

y Misuse of confidential customer information, money-laundering, sale ofunauthorized and unfamiliar products;

y Damage to physical assets due to terrorism, earthquakes, fires and floods;

y Business disruption and system failures due to software, power ornetwork problems,

y Execution errors on account of wrong data entry or incomplete legaldocumentation.

Operational risk arises from faulty business practices or when buildings,equipment, and other property required to run the business are damaged or

destroyed. For instance, banks in the vicinity of the Worl d Trade Center suffered

considerable losses as a result of the terrorist attacks on September, 11, 2001,

which knocked out power and communications in the surrounding area. Barings

Bank collapsed because its audit controls did not detect the calamitous los ses

suffered by its rogue trader, Nick Leeson, early enough to prevent its

collapse.Many types of operational risk, such as the destruction of property, are

covered by insurance. However, good management is required to prevent losses

due to faulty business practices, since such losses are not insurable.

Other types of risks faced by banks:-


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y Asset Management:-

The primary key to using asset management to provide liquidity is to keep both

cash and liquid assets. Liquid assets can be sold quickly for what they are worth

minus a transaction cost or bid/ask spread. Hence, liquid assets can be convertedinto a means of payment for little cost.

The primary liquidity solution for banks is to have reserves, which are also

required by law. Reserves are the amount of money held either as vault cash or

as cash held in the bank's account at the Federal Reserve, often referred to as

federal funds. It can also include cash that a bank has in an account at a

correspondent bank. In the United States, the Federal Reserve determines the

amount of required reserves (aka legal reserves, primary reserves), which is

expressed as a required reserve ratio, which is the amount of reserves as apercentage of the bank's demand deposits. A bank may even k eep excess

reserves in its Federal Reserve account for greater liquidity, especially since the

Federal Reserve has started paying interest on these accounts since October,

2008.

Although reserves provide liquidity, they earn little or no money. Vault cash

pays no interest at all and Federal Reserve accounts have paid 1% or less. By

buying liquid assets, a bank can earn money while maintaining liquidity. The

most liquidand safestasset is United States Treasuries, of which banks are

major buyers.

Banks can also sell loans, especially those that are regularly securitized, such as

mortgages, credit card and auto loan receivables.

A bank can also increase liquidity by not renewing loans. Many loans are short -

term loans that are constantly renewed, such as when a bank buys commercial

paper from a business. By not renewing the loan, the bank receives the principal.

However, most banks do not want to use this method because most short -term

borrowers are business customers, and not renewing a loan could alienate thecustomer, prompting them to take their business elsewhere.

y Liability Management:-


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A bank can increase liquidity by borrowing, either by taking out a loan or by

issuing securities. Banks predominantly borrow from each other in an interbank

market known as the federal funds market where banks with excess reserves

loan to banks with insufficient reserves. Banks can also borrow directly from the

Federal Reserve, but they only do so as a last resort.

Banks are big users of a debt instrument known as a repurchase agreement (aka

repo), which is a short-term collateralized loan where the borrower exchanges

collateral for the loan with the intent of reversing the transaction at a specified

time, along with the payment of interest. Most repos are overnight l oans, and the

most common collateral is Treasury bills. Repos are usually made with

institutional investors, such as investment and pension funds, who often have

cash to invest.

The major security that banks sell is the large certificate of deposit (CD), which

is highly negotiable, and can be easily sold in the money markets. A large CD isa time deposit of $100,000 or more. (Banks also sell small CDs to retail

customers, but these can't be sold in the financial markets.) Other major

securities sold by banks include commercial paper and bonds.

The Necessity of Asset Liability Management:-

The asset-liability management in the Indian banks is still in its nascent stage.

With the freedom obtained through reform process, the Indian banks have

reached greater horizons by exploring new avenues. The government ownership

of most banks resulted in a carefree attitude towards risk management. This

complacent behavior of banks forced the Reserve Bank to use regulatory tactics

to ensure the implementation of the ALM. Al so, the post-reform banking

scenario is marked by interest rate deregulation, entry of new private banks, and

gamut of new products and greater use of information technology. To cope with

these pressures banks were required to evolve strategies rather than ad hoc fire

fighting solutions. Imprudent liquidity management can put banks earnings and

reputation at great risk. These pressures call for structured and comprehensive

measures and not just ad hoc action. The Management of banks has to base theirbusiness decisions on a dynamic and integrated risk management system and

process, driven by corporate strategy. Banks are exposed to several major risks

in the course of their business credit risk, interest rate risk, foreign exchange

risk, equity / commodity price risk, liquidity risk and operational risk. It is,

therefore, important that banks introduce effective risk management systems that

address the issues related to interest rate, currency and liquidity risks.


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Implementation of asset liability management (ALM) system:-

ALM framework rests on three pillars

y ALM Organisation: The ALCO consisting of the banks senior

management including CEO should be responsible for adhering to the

limits set by the board as well as for deciding the business strategy of thebank in line with the banks budget and decided risk management

objectives. ALCO is a decision-making unit responsible for balance sheet

planning from a risk return perspective including strategic management of

interest and liquidity risk. Consider the procedure for sanctioning a loan.

The borrower, who approaches the bank, is appraised by the credit

department on various parameters like industry prospects, operational

efficiency, financial efficiency, management evaluation and others which

influence the working of the client company. On the basis of this appraisal

the borrower is charged certain rate of interest to cover the credit risk. Forexample, a client with credit appraisal AAA will be charged PLR. While

somebody with BBB rating will be charged PLR + 2.5 %, say. Naturally,

there will be certain cut-off for credit appraisal, below which the bank

will not lend e.g. Bank will not like to lend to D rated client even at a

higher rate of interest. The guidelines for the loan sanctioning procedure

are decided in the ALCO meetings with targets set and goals established

y ALM Information System: ALM Information System is used for the

collection of information accurately, adequately and expeditiously.Information is the key to the ALM process. A good information system

gives the bank management a complete picture of the banks balance

sheet.

y ALM Process: The basic ALM process involves identification,

measurement and management of risk parameters. The RBI in its

guidelines has asked Indian banks to use traditional techniques like Gap

Analysis for monitoring interest rate and liquidity risk. However RBI is

expecting Indian banks to move towards sophisticated techniques likeDuration, Simulation, VaR in the future.

y Trading Risk:-


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Generally, greater profits can be made by taking greater risks. A bank's leverage

ratio is limited by law, but it can try to earn greater profits by trading securities.

Although United States banks cannot, by law, own stocks, they can buy debt

securities and derivatives. For this, banks hire traders for a separate department

that specializes in trading securities.

The risk of trades is measured by standard statistical tools for measuring

investment risk: standard deviations and value at risk (VaR). However, many

banks use more sophisticated financial models to gauge risk and to increase their

profits, but the 2007 2009 credit crisis showed that many of these models were

faulty.

Also, rogue traders can cause stupendous losses for banks, even causing their

bankruptcy. Consider Barings Bank that started in 1762, and was considered to

be the most stable and safest bank for centuries. In 1995, Nick Leeson lost more

than 860 million pounds trading Japanese equities in Singapore. Barings was

unable to provide the cash to cover the losses, so it collapsed.

The 2007 - 2009 credit crisis has also shown the tremendous risks presented by

derivatives, which are securities whose value depends on an underlying asset or

index. The most common derivatives bought and sold by banks are mortgage -

backed securities (MBS), interest-rate swaps, and credit default swaps (aka

credit derivatives).

y Sovereign Risk:-

Many foreign loans are paid in U.S. dollars and repaid with dollars. Some of

these foreign loans are to countries with unstable governments. If political

problems arise in the country that threatens investments, investors will pull their

money out to prevent losses arising from sovereign risk. In t

REVISED - banking system survey

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