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
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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.
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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
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• http://www.bizresearchpapers.com/24.%20Afsheen.pdf
• http://entrepreneurship.thunderbird.edu/sites/default/files/files/bank_management.pdf