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CERTIFICATE
Certified that the research project MARKET RISK MANAGEMENT IN
BANKS Done by GURPREET SINGH during the period of his study under
my guidance, and that the research project has not previously the basis for
the award of any degree, diploma, associate ship , fellowship or similar this
titles and that it is independent work done by his. It may beset for
evaluation.
Date Dr.M.S. Kanchi
Place
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CONTENTS
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CONTENTS
Chapter no. Chapter name
Declaration
Certificate
Acknowledgement
Preface
Executive summary
Chapter 1 Introduction
Indian Banking System
Risk Management
Chapter 2 Review of literature
Chapter 3 Research methodology
Objectives of study
Research design
Collection of data
Limitations of study
Chapter 4 Analysis & interpretationChapter 5 Findings & suggestion
BIBLIOGRAPHY
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Complementing the roles of the nationalized and private banks are the specialized
financial institutions or Non Banking Financial Institutions (NBFCs). With their focused
portfolio of products and services, these Non Banking Financial Institutions act as an
important catalyst in contributing to the overall growth of the financial services sector.
NBFCs offer loans for working capital requirements; facilitate mergers and acquisitions,
IPO finance, etc. apart from financial consultancy services. Trends are now changing as
banks (both public and private) has now started focusing on NBFC domains like long and
medium-term finance, working cap requirements. IPO financing to etc. to meet the
multifarious needs of the business community.
Nationalized banks are banks on which government has its ownership. These banks are
controlled and regulated by government. The government of India nationalized 14 major
banks in 1969, which has deposits of more than 50 crores. On April 15, 1980six more
banks were nationalized which has deposits of more than Rs. 200 crores. Nationalization
has increased public confidence in banking system. Presently there are 19 nationalized
banks excluding SBI and its associates. SBI, the biggest commercial bank stands in a
class by itself was formed on 1st July 1955 on recommendation of All India Rural Credit
Survey Committee. After then in 1950, according to SBI act, following banks were
declared as subsidiary banks of SBI.
RISK MANAGEMENT IN BANKS
Jonathan Charkhan in Guidance for the Directors of Banks (2003) issued by the Global
Corporate Governance Forum defined risk management as under:
Risk management is the systematic process for identifying the risks the business
faces; evaluating them according to the likelihood of their occurring and the damage that
could ensue; deciding whether to bear, avoid, control or insure against them (or any
combination of these four); allocating responsibility for dealing with them; ensuring that
the process actually works and reporting material problems as quickly as possible to the
right level.
The operation of a bank or financial institution inevitably means facing risks of
many kinds. The board will know that handling risks of any kind will start with a
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systematic analysis of the two elements of materiality: probability and impact. Probability
is likelihood of the event occurring, and impact is the damage that might be caused if it
did.
There are major three types of risks that banks manage viz. credit risk, market risk
and operational risk.
Credit Risk Management
Credit risk is the most fundamental of all the risks faced by a bank. The lender always
faces the risk of counterparty not repaying the loan or not making due payment in time.
Banks are in the business of taking credit risk in exchange for a certain return above the
risk-free rate. This is mainly due to Portfolio Risk and Transaction Risk. Transaction
Risk arises from fraud, error and inability to deliver products and services. Itencompasses product development and delivery, transaction processing, system
management, complexity of products and internal control environment.
Market Risk Management
Market Risk may be defined as the possibility of loss to a bank caused by changes in
the market variables. The Bank for Internal Settlements (BIS) defines market risk as
the risk that the value of on or off balance sheet ;positions will be adversely affected
by movements in equity and interest rate markets, currency exchange rates and
commodity prices. Thus, 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 changes. Besides it is equally concerned
about the banks ability to meet its obligation as and when they fall due. In other words, it
should be ensured that the bank is not exposed to Liquidity Risk. This Guidance Note
would, thus, focus on the management of Liquidity Risk and Market Risk, further
categorized into interest rate risk, foreign exchange risk, commodity price risk and
equity price risk, liquidity risk.
Interest Rate Risk: Refers to exposure of the banks earnings or economic value of
assets, liabilities and off-Balance sheet instruments to adverse movement in interest rates.
Forex Risk: Arisesfrom conversion of Banks financial statements from one currency to
another.
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Liquidity Risk: Arises from inability of bank to accommodate decrease in liabilities or
to fund increase in assets.
Commodity Price Risk: Arises due change in commodity price and positions in the
market.
Equity Price Risk: Arises due to change in prices of equity.
Operational Risk Management
Operational Risk results from inadequate or failed internal processes, people and system
or from external events. Of three major types of risks, operational risk is least developed
as the conceptual framework and database is still in its infancy. As such, management of
operational risk poses a major challenge for the banks. However the process is likely to
gather momentum in view of phenomenal increase in the volume of transactions, highdegree of structural changes and complex support systems. Capital requirement for
operational risk under Basel II capital adequacy norms will accelerate the process.
Measuring operational risk requires both estimating the probability of an operational risk
requires both estimating the probability of an operational loss event. For this purpose,
several quantitative methods are being employed on experimental basis, but the difficulty
lies in identification of the right statistical distribution that captures the severity and
frequently of the particular category of operational risk. As of present, internal control
and internal audit are the principle tools for controlling operational risk. It is categorized
into Reputational risk, IT risk, legal risk, management risk.
Reputational Risk: Arises from operational failures, failure to comply with relevant
laws, regulations and negative public opinion impacting depositors and market
confidence on the banks.
IT Risk or Technology Risk: Results from system failure, breach in system security,
programming errors, telecommunication failure, absence of disaster recovery plan,
computer related fraud etc.
Legal Risk: Arises from inadequate or incorrect legal advice or documentation resulting
in enforceable contracts or adverse judgments.
Management Risk: Arises from incompetent board or senior management and
breakdown incorporate governance.
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Chapter-2
MARKET RISK MANAGEMENT
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MARKET RISK MANAGEMENT
Market Risk may be defined as the possibility of loss to a bank caused by changes in the
market variables. The Bank for Internal Settlements (BIS) defines market risk as the risk that
the value of on or off balance sheet ; positions will be adversely affected by movements in
equity and interest rate markets, currency exchange rates and commodity prices. Thus, 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
changes. Besides it is equally concerned about the banks ability to meet its obligation as and
when they fall due. This Guidance Note would, thus, focus on the management of Liquidity Risk
and Market Risk, further categorized into interest rate risk, foreign exchange risk, commodity
price risk and equity price risk.
RISK MANAGEMENT PROCESS
An effective market risk management framework in a bank comprises risk identification, setting
up of limits and triggers, risk monitoring, models of analysis that value positions or measure
marked risk, risk reporting, etc. These aspects are elaborately discussed in the ensuring
paragraphs.
1) Risk Identification
All Risk Taking Units must operate within an approved Market Risk Product Programme:
this should define procedures, limits and controls for all aspects of the product.
New products may operate under a Product Transaction Memorandum on a temporary basis
while a full Market Risk Product Programme is being prepared. At the minimum this should
include procedures, limits and controls. The final product transaction program should include
market risk measurement at an individual product and aggregate portfolio level.
2) Limits and Trigger
All trading transactions will be booked on systems capable of accurately calculating relevant
sensitivities on a daily basis: usage of Sensitivity and value at Risk limits for trading portfolios
and limits for accrual portfolios (as prescribed for ALM) must be measured daily. Where market
risk is not measured daily, Risk Taking Units must have procedures that monitor activity to
ensure that they remain within approved limits at all times.
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Mandatory market risk limits are required for Factor Sensitivities and Value at Risk for mark of
trading and appropriate limits for accrual positions including Available-for-Sale portfolios.
Requests for limits should be submitted annually for approval by the Risk Policy Committee.
The approval will take into consideration the Risk Taking Units capacity and capability to
perform within those limits evidenced by the experience of the Traders, controls and risk
management, audit ratings and trading revenues.
Approved Management Action Triggers or stop loss are required for all mark to market risk
taking activities.
Risk Taking Units are expected to apply additional, appropriate market risk limits, including
limits for basis risk, to the p0roducts involved: these should be detailed in the Market Risk
Product Programme.
3) Risk Monitoring
A rate reasonability process is required to ensure that all transactions are executed and revalued
at prevailing market rates: rates used at inception or for periodic marking to market for risk
management or accounting purposes must be independently verified.
Financial Models used for revaluations for income recognition purposes or to measure or
monitor Price Risk must be independently tested and certified.
Stress tests must be performed preferably quarterly for both trading and accrual portfolios. This
may be done when the underlying assumptions of the model/ market conditions significantly
change as decided by the Asset Liability Committee.
4) Models of analysis
Line Management must ensure that the software used in Financial Models that value positions or
measure market risk is performing appropriate calculations accurately.
The risk Policy Committee is responsible for administering the model control and certification
policy. Providing technical advice through qualified and competent personnel. It is left to the
bank to seek any independent certification.
Financial Models must be fully documented and minimum standards of documentation must
be established.
Someone other than the person who wrote the software code must perform certification of
models: testers must be competent in designing and conducting tests: records of testing must be
kept,. including details of the type of tests and their results. Assumptions contained in the
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Financial Models must be documented as part of the initial certification and reviewed annually.
Unusual parameter sourcing conventions require annual approval by the risk Policy Committee.
Any mathematical model that uses theory, formulae or numerical techniques involving more
than simple arithmetic operations must be validated to ensure that the algorithm employed is
appropriate and accurate.
Persons who are acceptable to the Risk Policy committee and independent of the area
creating the models must validate models in writing. It is left to the bank to decide on who
should validate, whether internal or external, at the discretion of the Risk Policy Committee.
Models to calculate risk measures like Sensitivities to market factor either at transaction or
portfolio level and value-at-risk should be validated independently.
Unauthorised or unintended changes should not be made to the models. These standards
should also apply to models that are run on spreadsheets until development of fully automated
processors for generating valuations and risk measurements.
The models should also be subject to model assumption review on a periodic basis. The
purpose of this review is to ensure applicability of the model over time and that the model is
valid for its original intended use. The review consists of evaluating the components of the
financial model and the underlying assumptions, if any.
5) Risk Reporting
Risk report should enhance risk communication across different levels of the bank, from the
trading desk to the CEO. In order of importance, senior management reports should:
be timely
be reasonably accurate
highlight portfolio risk concentrations
include written commentary, and
be concise.
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ORGANISATIONAL SET UP
Management of market risk should be the major concern of top management of banks. The
Boards should clearly articulate market risk management policies. Procedures, prudential risk
limits, review mechanisms and reporting and auditing systems. The policies should address the
banks exposure on a consolidated basis and clearly articulate the risk measurement systems that
capture all material sources of market risk and assess the effects on the bank. The operating
prudential limits and the accountability of the line management should also be clearly defined.
The Asset-Liability Management Committee (ALCO) should function as the top operational unit
for managing the balance sheet within the performance/risk parameters laid down by the Board.
Successful implementation of any risk management process has to emanate from the top
management in the bank with the demonstration of its strong commitment to integrate basic
operation s and strategic decision making with risk management. Ideally, the organization set up
for Market Risk Management should be as under:-
The Board of Directors
The Risk Management Committee
The Asset-Liability Management Committee (ALCO)
The ALM support group/ Market Risk Group.
1) Board of Directors
Itshould have the overall responsibility for management of risks. The Board should decide the
risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange
and equity police risks.
2) Risk Management Committee
It will be a Board level Sub Committee including CEO and heads of Credit, Market and
Operational Risk Management Committees. It will decide the policy and strategy for integrated
risk management containing various risk exposures of the bank including the market risk. The
responsibilities of Risk Management Committee with regard to market risk managementaspects include:
Setting policies and guidelines for market risk measurement, management and reporting.
Ensuring that market risk management processes (including people, systems, operations,
limits and controls) satisfy banks policy.
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ORGANISATIONAL STRUCTURE FOR RISK MANAGEMENT
BOARD OF DIRECTORS
(Decide overall risk management policy and strategy)
RISK MANAGEMENT COMMITTEE
Board Sub Committee including CEO and Heads of Credit Market and
operational Risk Management Committee
(Policy and strategy for integrated risk management)
ASSET LIABILITY
COMMITTEE
(ALCO)
Headed by CEO/CMD/ED,
including Chief of investment,
credit, Resource/Fund
Ensure adherence to the limits,
monitoring and control, articulatinginterest rate view/ funding/ transfer
ricin olic etc. and submit to
CREDIT RISK
MANAGEMENT
COMMITTEE
Credit RiskManagement
Department
(CRMD)
Credit
Administration
Department (CAD)
OPERATIONAL
RISK
MANAGEMENT
COMMITTEE
ALM SUPPORT GROUP/RISK
MANAGEMENT GROUP
MIDDLE OFFICE
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The first step towards liquidity management is to put in place an effective liquidity management
policy, which, inter alia, should spell out the funding strategies, liquidity planning under
alternative scenarios, prudential, limits, liquidity reporting/ reviewing, etc. Liquidity
measurement is quite a difficult task and can be measured through stock or cash flow
approaches. The key ratios, adopted across the banking system are Loans to Total Assets, Loans
to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus)
Temporary Investments, Purchased Funds to Total Assets, Loan Losses/Net Loans etc.
While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed
financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks, which
are operating generally in an illiquid market. Experiences show that assets commonly considered
as liquid like Government securities, other money market instruments etc. have limited liquidityas the market and players are unidirectional. This analysis of liquidity involves tracking of cash
flow mismatches. For measuring and managing net funding requirements, the use of maturity
ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is
recommended as a standard tool. The format prescribed by RBI in this regard under ALM system
should be adopted for measuring cash flow mismatches at different time bands. The cash flows
should be placed in different time bands based on projected future behavior of assets, liabilities
and off-balance sheet items. In other words, Banks should have to analyze the behavioral
maturity profile of various components of on/ off-balance sheet items on the basis of
assumptions and trend analysis supported by time series analysis. Banks should also undertake
variance analysis, at least, once in six months to validate the assumptions. The assumptions
should be fine-tuned over a period which facilitate near reality predictions about future behavior
of on / off-balance sheet items. Apart from the above cash flows, banks should also track the
impact of prepayments of loans, premature closure of deposits and exercise of options built in
certain instruments which offer put/call options after specified times. Thus, cash outflows can be
ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise
an early repayment option or the earliest date contingencies could be crystallized.
The difference between cash inflows and outflows in each time period, the excess or deficit of
funds, becomes a starting point for a measure of a banks future liquidity surplus or deficit, at a
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series of points of time. The banks should also consider putting in place certain prudential
limits as detailed below to avoid liquidity crisis.
i) Cap on inter-bank borrowings, especially call borrowings
ii) Purchased funds vis--vis- liquid assets
iii) Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, statutory Liquidity Ratio
and loans
iv) Duration of liabilities and investment portfolio
v) Maximum Cumulative Outflows across all time bands
vi) Commitment Ratio- track the total commitments given to corporate/ banks and other financial
institutions to limit the off- balance sheet exposure:
vii) Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.
Banks should also evolve a system for monitoring high value deposits (other than inter-bank
deposits) say Rs.1 Crore or more to track the volatile liabilities. Further, the cash flows arising
out of contingent liabilities in normal situation and the scope for an increase in cash flows during
periods of stress should also be estimated. It is quite possible that market crisis can trigger
substantial increase in the amount of drawdowns from cash credit/overdraft accounts, contingent
liabilities like letters of credit etc.
The liquidity profile of the banks could be analyzed on a static basis, wherein the assets and
liabilities and off-balance sheet items are pegged on a particular day and the behavioral pattern
and the sensitivity of these items to changes in market interest rates and environment are duly
accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due
importance to:
1) Seasonal pattern of deposits /loans:
2) Potential liquidity needs for meeting new loan demands, unvalied credit limits, potential
deposit losses, investment obligations, statutory obligations, etc.
Contingency Funding Plan
- All banks are required to produce a Contingency Funding Plan. These plans are to be approved
by ALCO, submitted annually as part of the Liquidity and Capital plan, and reviewed quarterly.
The preparation and the implementation of the plan may be entrusted to the treasury.
- Contingency funding plans are liquidity stress tests designed to quantify the likely impact of an
event on the balance sheet and the net potential cumulative gap over a 3-month period. The plan
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Foreign Currency Liquidity Management
For banks with an international presence, the treatment of assets and liabilities in multiple
currencies adds a layer of complexity to liquidity management for two reasons. First, banks
are often less well known to liability holders in foreign currency markets. Therefore, in the
event of market concerns, especially if they relate to a banks domestic operating
environment, these liability holders may not be able to distinguish rumour from fact as well
or as quickly as domestic currency customers. Second, in the event of a disturbance, a bank
may not always be able to mobilize domestic liquidity and the necessary foreign exchange
transactions in sufficient time to meet foreign currency funding requirements. These issues
are particularly important for banks with positions in currencies for which the foreign
exchange market is not highly liquid in all conditions.
Banks should, therefore, have a measurement, monitoring and control system for liquidity
positions in the major currencies in which it is active. In addition to assessing its aggregate
foreign currency liquidity needs and the acceptable mismatch in combination with its
domestic currency commitments, a bank should also undertake separate analysis of its
strategy for each currency individually.
When dealing in foreign currencies, bank is exposed to the risk that a sudden change in
foreign exchange rates or market liquidity, or both, could sharply widen the liquidity
mismatches being run. These shifts in market sentiment might result either from domestically
generated factors or from contagion effects of developments in other countries. In either
event, a bank may find that the size of its foreign currency funding gap has increased.
Moreover, foreign currency assets may be impaired, especially where borrowers have not
hedged foreign currency risk adequately. The Asian crisis of the late 1990s demonstrated the
importance of banks closely managing their foreign currency liquidity on a day- to -day.
The particular issues to be addressed in managing foreign currency liquidity will depend on
the nature of the banks business. For some banks, the use of foreign currency deposits and
short-term credit lines to fund domestic currency assets will be the main area of vulnerability,
while for others it may be the funding of foreign currency assets with domestic currency. As
with overall liquidity risk management, foreign currency liquidity should be analysed under
various scenarios, including stressful conditions.
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adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and
relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-
statistical concept such as stop loss and gross/net positions can be used.
Banking Book
The changes in market interest rates have earnings and economic value impacts on the banks
book. Thus, given the complexity and range of balance sheet products, banks should have IRR
measurement systems that assess the effects of the rate changes on both earnings and economic
value. The variety of technique ranges from simple maturity (fixed rate) and repricing (floating
rate) gaps and duration gaps to static simulation, based on current on and off balance sheet
positions, to highly sophisticated dynamic modeling techniques that incorporate assumptions on
behavioral pattern of assets, liabilities and off balance sheet items and can easily capture the full
range of exposures against basis risk, embedded option risk, yield curve risk etc.
Rigidities and remedial measures
However, there are certain rigidities at micro level of banks and also at systematic level, which
the bank the banks have to strengthen their Management Information System(MIS) and computer
processing capabilities for accurate measurement of interest rate risk in their banking books,
which impact, in short term, their net interest income (NII) or net interest margin (NIM) or
spread and in long term, the economic value of the bank.
At the systematic level, rigidities are the following:
Most of the liabilities of banks, like deposits and borrowings are on fixed interest rate
basis while their assets like loans and advances are on floating rate basis.
There is still some regulation in place on interest rates in the system, such as savings bank
deposit, export credit, refinances, etc.
There is no definite interest rate repricing dates for floating Prime Lending Rate (PL:R)
based products like loans and advances, thereby placing them in accurate time buckets for
measurement of interest rate risk difficult.
The RBI has taken a number of measures to correct the systemic rigidities, like introduction of :
Floating rate deposits,
Fixed rate lending,
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Equity Position Risk Management
Internationally banks use VaR models for management of equity position risk. The banks should
devise specific price risk structure (like sensitivity limits, VAR, stop-loss limits) and the methods
to measure liquidity of shares to mitigate equity position risk.
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FOREIGN EXCHANGE RISK MANAGEMENT
The risk inherent in running open foreign exchange positions have been heightened in recent
years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk
profile of banks balance sheets. 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. The banks are also exposed to interest rate risk, which arises from
the maturity mismatching of foreign currency position. Even in cases where spot and forward
positions in individual currencies are balanced, the maturity pattern of forward transactions may
produce mismatches. As a result, banks may suffer losses as a result of changes in
premia/discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the counterparties or settlement risk.
While such type of risk crystallization does not cause principal loss, banks may have to
undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus,
banks may incur replacement cost, which depends upon the currency rate movements. Banks
also face another risk called time-zone risk or Herstatt risk which arises out of time lags in
settlement of one currency in one center and the settlement of another currency in other time-
zone . The forex transactions with counterparties from another country also trigger sovereign or
country risk (dealt with in details in the guidance note on credit risk.).The three important issues that need to be addressed in this regard are:
Nature and magnitude of exchange risk
The strategy to be adopted for heading or managing exchange risk
The tools of managing exchange risk.
Nature and Magnitude of Risk
The first aspect of management of foreign exchange risk is to acknowledge that such risk doesexist and that it must be managed to avoid adverse financial consequences. Many banks refrain
from active management of their foreign exchange exposure because they feel that financial
forecasting is outside their field of expertise or because they find it difficult to measure currency
exposure precisely. However not recognizing a risk would not make it go away. Nor is the
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inability to measure risk any excuse for not managing it. Having recognized this fact the nature
and magnitude of such risk must now be identified.
The basic difficulty in measuring exposure comes from the fact that available accounting
information which provides the most reliable base to calculate exposure (accounting or
translation exposure) does not capture the actual risk a bank faces, which depends on its future
cash flows and their associated risk profiles (economic exposure). Also there is the distinction
between the currency in which cash flows are denominated and the currency that determines the
size of the cash flows. For instance a borrower selling jewellery in Europe may keep its records
in Rupees, invoice in Euros, and collect Euro cash flow, only to find that its revenue stream
behaves as if it were in U.S. dollars | This occurs because Euro-prices for the exports might
adjust to reflect world market prices which could be determined in U.S. dollars.
Another dimension of exchange risk involves the element of time. In the very short run, virtually
all local currency prices for goods and services (although not necessarily for financial assets)
remain unchanged after an unexpected exchange rate change. However, over a longer period of
time, price and costs respond to price changes. It is therefore necessary to determine the time
frame within which the bank can react to ( unexpected) rate changes.
For a bank, being a financial entity, it is relatively easier to gauge the nature as well as the
measure of forex risk simply because all financial assets/liabilities are denominated in a
currency. A banks future cash streams are more predictable than those of a non-financial firm.
Its net exposure, or position, completely encapsulates the measure of its exposure to forex risk.
In order to manage forex risk some forex market relationships need to be understood well. The
first and most important of these is the covered interest parity relationship. If there is free and
unrestricted mobility of capital, the interest differential between two currencies will equal the
forward premium / discount for either of the currency. This relationship must hold under the
assumptions: otherwise arbitrage opportunities will arise to restore the relationship. However, in
the case of Rupee; since it is not totally convertible, this relationship does not hold exactly.
Although interest rate differentials are the driving factor for the Dollar premium against the
Rupee, it also is a factor of forward demand/ supply factors. This brings in typical complications
to forward hedging which must be taken in to account.
From the above it can easily be determined that a currency with a lower interest rate will be at a
premium to a currency with a higher interest rate. The other relationships in the forex market are
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hedge different risks. In particular, symmetric hedging tools like futures cannot easily hedge
contingent cash flows where risk is non-linear: options may be better suited to the latter.
Foreign exchange forward contracts are the most common means of hedging transactions in
foreign currencies. However since they require future performance, and if one party is unable to
perform on the contract, the hedge disappears, bringing in replacement risk which could be high.
This default risk also means that many banks may not have access to the forward market to
adequately hedge their exchange exposure. For such situations, futures may be more suitable,
where available, since they are exchange traded and effectively minimize default risk. However,
futures are standardised and therefore may not be as versatile in terms of quantity and tenor as
over the counter forward contracts. This in turn gives rise to assumption of basis risk.
Money market borrowing to invest in interest-bearing assets to offset a foreign currency
payment-also serves the same purpose as forward contracts. This follows from the covered
interest parity principle. Since the carrying cost of a position is the same in both, the forex or the
money market hedging can also be done in either market. For instance, let us say a bank has a
short forward Dollar position. It can of course hedge the position by buying forward Dollar.
Alternatively it can borrow Rupees now, buy Dollar with the proceeds, and place the Dollars in a
forward deposit to meet the short Dollar position on maturity. The Rupees received on the sale
on maturity are used to pay off the Rupee borrowing. The cost of this money market hedge is the
difference between the Rupee interest rate paid and the US dollar interest rate earned. According
to the interest rate parity theorem, the interest differential equals the forward exchange premium,
the percentage by which the forward rate differs from the spot exchange rate. So the cost of the
money market hedge should be the same as the forward or futures market hedge.
Currency options are another tool for managing forex risk. A foreign exchange option is a
contract for future delivery of a currency in exchange for another, where the holder of the option
has the right to buy(or sell) the currency at an agreed price, the strike or exercise price, but is not
required to do so. The right to buy is a call: the right to sell, a put. For such a right he pays a
price called the option premium. The option seller receives the premium and is obliged to make
(or take) delivery at the agreed-upon price if the buyer exercises his option. In some options, the
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BCBS PRINCIPLES FOR INTEREST RATE RISK
MANAGEMENT
Board and senior management oversight of interest rate riskPrinciple 1:
In order to carry out its responsibilities, the board of directors in a bank should approve strategies
and policies with respect to interest rate risk management and ensure that senior management
takes the steps necessary to monitor and control these risks. The board of directors should be
informed regularly of the interest rate risk exposure of the bank in order to assess the monitoring
and controlling of such risk.
Principle 2:
Senior management must ensure that the structure of the banks business and the level of interest
rate risk it assumes are effectively managed, that appropriate policies and procedures are
established to control and limit these risks, and that resources are available for evaluating and
controlling interest rate risk.
Principle 3:
Banks should clearly define the individuals and/or committees responsible for managing interest
rate risk and should ensure that there is adequate separation of duties in key elements of the risk
management process to avoid potential conflicts of interest. Banks should have risk
measurement, monitoring and control functions with clearly defined duties that are sufficiently
independent from position-taking functions of the bank and which report risk exposures directly
to senior management and the board of directors.
Adequate risk management policies and procedures
Principle 4:
It is essential that banks interest rate risk policies and procedures are clearly defined andconsistent with the nature and complexity of their activities. These policies should be applied on
a consolidated basis and, as appropriate, at the level of individual affiliates, especially when
recognizing legal distinctions and possible obstacles to cash movements among affiliates.
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Principle 5:
It is important that banks identify the risks inherent in new products and activities and ensure
these are subject to adequate procedures and controls before being introduced pr undertaken.
Risk measurement, monitoring and control functions
Principle 6:
It is essential that banks have interest rate risk measurement systems that capture all material
sources of interest rate risk and that assess the effect of interest rate changes in ways that are
consistent with the scope of their activities. The assumptions underlying the system should be
clearly understood by risk managers and bank management.
Principle 7:
Banks must establish and enforce operating limits and other practices that maintain exposures
within levels consistent with their internal policies.
Principle 8:
Banks should measure their vulnerability to loss under stressful market conditions including the
breakdown of key assumptions and consider those results when establishing and reviewing their
policies and limits for interest rate risk.
Principle 9:
Banks must have adequate information systems for measuring, monitoring, controlling andreporting interest rate exposures. Reports must be provided on a timely basis to the banks board
of directors, senior management and, where appropriate, individual business line managers.
Internal controls
Principle 10:
Banks must have an adequate system of internal controls over their interest rate risk management
process. A fundamental component of the internal control system involves regular independent
reviews and evaluations of the effectiveness of the system and, where necessary, ensuring that
appropriate revisions or enhancements to internal controls are made. The results of such reviews
should be available to the relevant supervisory authorities.
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Information for supervisory authorities
Principle 11:
Supervisory authorities should obtain from banks sufficient and timely information with which to
evaluate their level of interest rate risk. This information should take appropriate account of therange of maturities and currencies in each banks portfolio, including off-balance sheet items, as
well as other relevant factors, Such as the distinction between trading and non-trading activities.
Capital adequacy
Principle 12:
Banks must hold capital commensurate with the level of interest rate risk they undertake.
Disclosure of interest rate risk
Principle 13:
Banks should release to the public information on the level of interest rate risk and their policies
for its management.
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SOURCES, EFFECTS AND MEASUREMENT OF INTEREST
RATE RISK
Interest rate risk is the exposure of a banks financial condition to adverse movements in interest
rates. Accepting this risk is a normal part of banking and can be an important source of
profitability and shareholder value. However, excessive interest rate risk can post a significant
threat to a banks earnings and capital base. Changes in interest rates affect a banks earnings by
changing its net interest income and the level of other interest-sensitive income and operating
expenses. Changes in interest rates also affect the underlying value of the banks assets.
Liabilities and off-balance sheet instruments because the present value of future cash flows (and
in some cases, the cash flows themselves change when interest rates change.
A. Sources of Interest Rate Risk
Repricing risk:
Asfinancial intermediaries, banks encounter interest rate risk in several ways. The primary and
most often discussed form of interest rate risk arises from timing differences in the maturity (for
fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS)
positions. While such repricing mismatches are fundamental to the business of banking, they can
expose a banks income and underlying economic value to unanticipated fluctuations as interest
rates vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit
could face a decline in both the future income arising from the position and its underlying value
if interest rates increase. These declines arise because the cash flows on the loan are fixed over
its lifetime, while the interest paid on the funding is variable, and increases after the short-term
deposit matures.
Yield curve risk:
Repricing mismatches can also expose a bank to changes in the slope and shape of the yield
curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effectson a banks income or underlying economic value. For instance, the underlying economic value
of a long position in 10- year government bonds hedged by a short position in 5- year
government notes could decline sharply if the yield curve steepens, even if the position is hedged
against parallel movements in the yield curve.
Basis risk:
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Another important source of interest rate risk (commonly referred to as basis risk) arises from
imperfect correlation in the adjustment of the rates earned and paid on different instruments with
otherwise similar repricing characteristics. When interest rates change these differences can give
rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and
OBS instruments of similar maturities or repricing frequencies.
Optionality:
An additional and increasingly important source of interest rate risk arises from the options
embedded in many bank assets, liabilities and OBS portfolios. Formally, an option provides the
holder the right, but not the obligation, to buy sell, or in some manner alter the cash flow of an
instrument or financial contract. Options may be stand alone instruments such as exchange-
traded options and over-the-counter (OTC) contracts, or they may be embedded within otherwise
standard instruments. While banks use exchange-traded and OTC options in both trading and
non-trading accounts, instruments with embedded options are generally most important in non-
trading activities. They include various types of bonds and notes with call or put provisions,
loans which give borrowers the right to prepay balances, and various types of non-maturity
deposit instruments which give depositors the right to withdraw funds at any time, often without
any penalties. If not adequately managed, the asymmetrical payoff characteristics of instrument
with optionality features can pose significant risk particularly to those who sell them, since the
options held, both explicit and embedded, are generally exercised to the advantage of the holder
and the disadvantage of the seller. Moreover, an increasing array of options can involve
significant leverage that can magnify the influences (both negative and positive) of option
positions on the financial condition of the firm.
B. Effects of Interest Rate Risk
As the discussion above suggests, changes in interest rates can have adverse effects both on a
banks earnings and its economic value. This has given rise to two separate, but complementary,
perspectives for assessing a banks interest rate risk exposure.
Earnings perspective:
In the earnings perspective, the focus of analysis is the impact of changes in interest rates on
accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken
by many banks. Variation in earnings is an important focal point for interest rate risk analysis
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because reduced earnings or outright losses can threaten the financial stability of an institution by
undermining its capital adequacy and by reducing market confidence. In this regard, the
component of earnings that has traditionally received the most attention is net interest income
(i.e. the difference between total interest in come and total interest expense). This focus reflects
both the importance of net interest income in banks overall earnings and its direct and easily
understood link to changes in interest rates. However, as banks have expanded increasingly into
activities that generate fee-based and other non-interest income, a broader focus on overall net
income incorporating both interest and non-interest income and expenses-has become more
common. The non-interest income arising from many activities, such as loan servicing and
various assets securitization programs can be highly sensitive to market interest rates. For
example, some banks provide the servicing and loan administration function for mortgage loan
pools in return for a fee based on the volume of assets it administers. When interest rates fall, the
servicing bank may experience a decline in its fee income as the underlying mortgages prepay. In
addition, even traditional sources of non-interest income such as transaction processing fees are
becoming more interest rate sensitive. This increased sensitivity has led both bank management
and supervisors to take a broader view of the potential effects of changes in market interest rates
of bank earnings and to factor these broader effects in to their estimated earnings under different
interest rate environments.
Economic value perspective:
Variation in market interest rates can also affect the economic of a banks assets, liabilities and
OBS positions. Thus ,the sensitivity of a banks economic value to fluctuations in interest rates is
a particularly important consideration of shareholders, management and supervisors alike. The
economic value of an instrument represents an assessment of the present value of its expected net
cash flows, discounted to reflect market rates. By extension, the economic value of a bank can be
viewed as the present value of banks expected net cash flows, defined as the expected cash
flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on
OBS positions. In this sense, the economic value perspective reflects one view of the sensitivity
of the net worth of the bank to fluctuations in interest rates. Since the economic value
perspective considers the potential impact of interest rate changes on the present value of all
future cash flows, it provides a more comprehensive view of the potential long-term effects of
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Duration is a measure of the percent change in the economic value of a
position that will occur given a small change in the level of interest rates.
Duration may also be defined as the weighted average of the time until expected cash flows from
a security will be received, relative to the current price of the security. The weights are thepresent values of each cash flow divided by the current price. In its simplest form, duration
measures changes in economic value resulting from a percentage change of interest rates under
the simplifying assumptions that changes in value are proportional to changes in the level of
interest rates and that the timing of payments is fixed.
Modified duration is standard duration divided by 1+r, where r is the level of
market interest rates - is an elasticity, As such, it reflects the percentage change in the
economic value of the instrument for a given percentage change in 1+r. As with simple duration,
it assumes a linear relationship between percentage changes in value and percentage changes in
interest rates.
In other words, Modified Duration = Macaulays Duration/ (1+r), where
Macaulays Duration [CFt (t)/ (1+r)/ {CFt/(1+r) to the power t
CFt= Rupee value of cash flow at time t
T= Number of periods of time until the cash flow payment
R= Periodic yield to maturity of the security generating cash flow andk= the number of cash flows
Duration reflects the timing and size of cash flows that occur before the instruments contractual
maturity. Generally, the longer the maturity or next repricing date of the instrument and the
smaller the payments that occur before maturity (e.g. coupon payments), the higher the duration
(in absolute value). Higher duration implies that a given change in the level of interest rates will
have a larger impact on economic value.
Duration-based weights can be used in combination with a maturity/repricing schedule to
provide a rough approximation of the change in a banks economic value that would occur given
a particular change in the level of market interest rates. Specifically, an average duration is
assumed for the positions that fall into each time band. The average durations are then multiplied
by an assumed change in interest rates to construct a weight for each time band. In some cases,
different weights are used for different positions that fall within a time band, reflecting broad
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VALUE AT RISK (VaR)
Definition:
VaR is defined as an estimate of potential loss in a position or asset/liability or portfolio of
assets/liabilities over a given holding period at a given level of certainty.
VaR measures risk. Risk is defined as the probability of the unexpected happening- the
probability of suffering a loss. VaR is an estimate of the loss likely to suffer, not the actual loss.
The actual loss may be different from the estimate. It measures potential loss, not potential gain.
Risk management tools measure potential loss as risk has been defined as the probability of
suffering a loss. VaR measures the probability of loss for a given time period over which the
position is held. The given time period could be one day or a few days or a few weeks or a year.
VaR will change if the holding period of the position changes. The holding period for n
instrument/ position will depend on liquidity of the instrument/ market. With the help of VaR,
we can say with varying degrees of certainty that the potential loss will not exceed a certain
amount. This means that VaR will change with different levels of certainty an instrument/
position will depend on liquidity of the instrument/ market. With the help of VaR, we can say
with varying degrees of certainty that the potential loss will not exceed a certain amount. This
means that VaR will change with different levels of certainty.
The bank for international Settlements (BIS) has accepted VaR as a measurement of
market risks and provision of capital adequacy for market risks, subject to approval by
banks supervisory authorities.
VaR Methodologies
VAR can be arrived as the expected loss on a position from the adverse movement in identified
market risk parameter(s) with a specified probability over a nominated period of time.
Volatility in financial markets is usually calculated as the standard deviation of t he percentage
change in the relevant assets price over a specified asset period . The volatility for calculation
of VaR is usually specified as the standard deviation of the percentage change in the risk factor
over the relevant risk horizon.
The following table describes the three main methodologies to calculate VaR:
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for back testing has been established, banks using internal VaR models for market risk capital
requirements must backtest their models on a regular basis. Banks should generally
backtest risk models on a monthly or quarterly basis to verify accuracy in these tests, they should
observe whether trading results fall within pre-specified confidence bands as predicted by
the VaR models. If the models perform poorly, they should probe further to find the cause (e.g.,
check integrity of position and market data, model parameters, methodology). The BIS outlines
back testing best practices in its January 1996 publication Supervisory framework for the use
of back testing in conjunction with the internal models approach to market risk capital
requirements.
Stress Testing
Stress testing has been adopted as a generic term describing various techniques used by banks
to gauge their potential vulnerability to exceptional, but plausible, events. Stress testing
addresses the large moves in key market variables of that king that lie beyond day-to-day risk
monitoring but that could potentially occur. The process of stress testing, therefore, involves first
identifying these potential movements, including which market variables to stress, how much to
stress them by, and what time frame to run the stress analysis over. Once these market
movements and underlying assumptions are decided upon, shocks are applied to the portfolio.
Revaluing the portfolios allows one to see what the effect of a particular market movement has
on the value of the portfolio and the overall Profit and Loss.Stress test reports can be constructed that summarize the effects of different shocks of different
magnitudes. Normally, then there is some kind of reporting procedure and follow P with
traders and management to determine whether any action needs to be taken in response.
Stress Testing Techniques : Stress testing covers many different techniques. The four
discussed here are listed in the Table below along with the information typically referred to as
the result of that type of a stress test.
Stress Testing Techniques
Technique What is the Stress test result
Simple Sensitivity Test Change in portfolio value for one or more
shocks to a single risk factor
Scenario Analysis (hypothetical or historical) Change in portfolio value if the scenario were
to occur
Maximum loss Sum of individual trading units worth case
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different reasons. First, under Mertons model the firm defaults only atmaturity of the debt, a scenario that is at odds with reality. Second, for themodel to be used in valuing default-risky debts of a firm with more than oneclass of debt in its capital structure (complex capital structures), thepriority/seniority structures of various debts have to be specified. Also, this
framework assumes that the absolute-priority rules are actually adhered toupon default in that debts are paid off in the order of their seniority.However, empirical evidence, such as in Franks and Torous (1994), indicatesthat the absolute-priority rules are often violated. Moreover, the use of alognormal distribution in the basic Merton model (instead of a more fat taileddistribution) tends to overstate recovery rates in the event of default.
3. Second-generation structural-form models
In response to such difficulties, an alternative approach has been developedwhich still adopts the original Merton framework as far as the default processis concerned but, at the same time, removes one of the unrealistic
assumptions of the Merton model; namely, that default can occur only atmaturity of the debt when the firms assets are no longer sufficient to coverdebt obligations. Instead, it is assumed that default may occur anytimebetween the issuance and maturity of the debt and that default is triggeredwhen the value of the firms assets reaches a lower threshold level3. Thesemodels include Kim, Ramaswamy and Sundaresan (1993), Hull and White(1995), Nielsen, Sa-Requejo, and Santa Clara (1993), Longstaff andSchwartz (1995) and others.
Under these models, the RR in the event of default is exogenous and
independent from the firms asset value. It is generally defined as a fixedratio of the outstanding debt value and is therefore independent from thePD. For example, Longstaff and Schwartz (1995) argue that, by looking at thehistory of defaults and the recovery rates for various classes of debt ofcomparable firms, one can form a reliable estimate of the RR. In their model,they allow for a stochastic term structure of interest rates and for somecorrelation between defaults and interest rates. They find that thiscorrelation between default risk and
Using Moodys corporate bond yield data, they find that credit spreads arenegatively related to interest rates and that durations of risky bonds dependon the correlation with interest rates.the interest rate has a significant effect on the properties of the creditspread4. This approach simplifies the first class of models by bothexogenously specifying the cash flows to risky debt in the event ofbankruptcy and simplifying the bankruptcy process. The latter occurs when
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by the BD. These value-at-risk (VaR) models include J.P. MorgansCreditMetrics (Gupton, Finger and Bhatia [1997] now provided by the RiskMetrics Group), Credit Suisse Financial Products CreditRisk+ (1997),McKinseys CreditPortfolioView (Wilson, 1998), Moodys KMVsCreditPortfolioManager, and Kamakuras Risk Manager.
Credit VaR models can be gathered in two main categories:
1) Default Mode models (DM) and
2) Mark-to-Market (MTM) models. In the former, credit risk is identified withdefault risk and a binomial approach is adopted. Therefore, only two possibleevents are taken into account: default and survival. The latter includes allpossible changes of the borrower creditworthiness, technically called creditmigrations. In DM models, credit losses only arise when a default occurs. Onthe other hand, MTM models are multinomial, in that losses arise also when
negative credit migrations occur. The two approaches basically differ for theamount of data necessary to feed them: limited in the case of default modemodels, much wider in the case of mark-to-market ones.
The main output of a credit risk model is the probability density function(PDF) of the future losses on a credit portfolio. From the analysis of such aloss distribution, a financial institution can estimate both the expected lossand the unexpected loss on its credit portfolio. The expected loss equals the(unconditional) mean of the loss distribution; it represents the amount the
investor can expect to lose within a specific period of time (usually one year).On the other side, the unexpected loss represents the deviation fromexpected loss and measures the actual portfolio risk. This can in turn bemeasured as the standard deviation of the loss distribution. Such a measureis relevant only in the case of a normal distribution and is therefore hardlyuseful for credit risk measurement: indeed, the distribution of credit losses isusually highly asymmetrical and fat-tailed. This implies that the probability oflarge losses is higher than the one associated with a normal distribution.Financial institutions typically apply credit risk models to evaluate theeconomic capital necessary to face the risk associated with their creditportfolios. In such a framework, provisions for credit losses should cover
expected losses6, while economic capital is seen as a cushion forunexpected losses. Indeed, Basel II in its final iteration (BIS, June 2004)
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6 As discussed in Jones and Mingo (1998), reserves are used to coverexpected losses.7 For a comprehensive analysis of these models, see Crouhy, Galai and Mark(2000) and Gordy (2000).
separated these two types of losses.
Credit VaR models can largely be seen as reduced-form models, where theRR is typically taken as an exogenous constant parameter or a stochasticvariable independent from PD. Some of these models, such as CreditMetrics, treat the RR in the event of default as a stochastic variable generally modeled through a beta distribution - independent from the PD.Others, such as Credit Risk+, treat it as a constant parameter that must bespecified as an input for each single credit exposure. While a comprehensiveanalysis of these models goes beyond the aim of this review7, it is important
to highlight that all credit VaR models treat RR and PD as two independentvariables.
6. Recent contributions on the PD-RR relationshipand their impact
During the last several years, new approaches explicitly modeling andempirically investigating the relationship between PD and RR have beendeveloped. These models include Bakshi et al. (2001), Jokivuolle and Peura(2003). Frye (2000a and 2000b), Jarrow (2001), Hu and Perraudin (2002),
and Carey and Gordy (2003), Altman, Brady, Resti and Sironi (2001, 2003and 2005), and Acharya, Bharath and Srinivasan (2007).
Bakshi et al. (2001) enhance the reduced-form models presented in section 4to allow for a flexible correlation between the risk-free rate, the defaultprobability and the recovery rate. Based on some evidence published byrating agencies, they force recovery rates to be negatively associated withdefault probability. They find some strong support for this hypothesisthrough the analysis of a sample of BBB-rated corporate bonds: moreprecisely, their empirical results show that, on average, a 4% worsening in
the (risk-neutral) hazard rate is associated with a 1% decline in (risk-neutral)recovery rates.
A rather different approach is the one proposed by Jokivuolle and Peura(2003). The authors present a model for bank loans in which collateral valueis correlated with the PD. They use the option pricing framework for
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modeling risky debt: the borrowing firms total asset value triggers the eventof default. However, the firms asset value does not determine .
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LIMITATIONS OF THE STUDY
1) Sample size was small i.e. 10 Managers. Survey was conducted on selected banks
because it is usually impossible to include all the banks. Therefore it cannot give
the true picture.
2) Moreover due to some restrictions of the banks and also being engaged in annual
closing and inspection, restricted me to go in more detailed study.
3) The assignment being very challenging and of exhaustive in nature requires time.
It was impossible to accomplish ideally within prescribed time period of semester.
4) Efforts were made to distribute questionnaire in such a manner that study is either
of public banks or private bank but responses received were not in similar
proportion.
5) As the study is basically based on primary data, the probability of personal bias
cannot be overruled.
6) Main root of this research study was questionnaire & interview, which has its own
limitations, for example we cant measure the reliability, enthusiasm dissonance
etc.
7) As the analysis has been done manually, few error are bound to appear.
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Only manager of SBI said that they manage risk by reducing/eliminating risk otherwise all other
banks reduce risk by managing opportunity.
How often is the Risk Management Policy audited?
Table-2
How often is the Risk Management Policy audited? Frequency of Banks
Annually 8
Two yearly 2
Occasionally 0
Table 2 indicates that 80% banks audit their risk management policy annually. Amongst thebanks selected for survey, all banks except UCO Bank and Indusind Bank audit risk management
policy annually. UCO Bank and Indusind Bank audit risk management policy two yearly.
Guidelines of New Basel Capital Accord
All banks are following guidelines of New Basel Capital Accord. This helps them to deal with
risk more effectively. RBIs instructions to prepare accounting books strictly in conformance
with US GAAP standards helps to strengthen their Risk Management Process. Allahabad bank
does not use these instruction to strengthen their policy.
Committees are set up for measuring and managing risk in banks
COMMITTEES BANKS HAVING THE COMMITTEE
Risk Management Committee (RMC) all banks
Credit Policy Committee (CPC) all banks
Assets Liability Committee (ALCO) all banks
Investment Committee all banks except Indusind Bank &
Punjab National Bank
System & Procedure Committee all banks except Indusind Bank
Credit Risk Management Committee all banks except Indusind Bank
ALCO\Operational Risk Management Support Group all banks except Indusind Bank
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All the banks surveyed have a formal Contingency Funding Plan to meet the possibility of
liquidity disruption or crises.
At what interval the funding plan is submitted/reviewed by ALCO?
Monthly - PNB, Indusind Bank
Quarterly - UBI, BOB
Bi-annually - Allahabad Bank, Canara Bank
Annually - SBI, SBP, OBC, UCO
Table-9
At what interval the funding plan is
submitted/reviewed by ALCO?
Frequency of Banks
Monthly 2Quarterly 2
Bi-annually 2
Annually 4
40% banks review the funding plan annually.
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Clear segregation between Banking Book and Trading Book in banks
All the banks except Allahabad Bank have made clear segregation between banking books and
trading books.
How frequently does your bank use Derivatives as a tool of Market Risk Management?
Never - OBC, Allahabad Bank, UCO, Canara Bank
Sometimes - UBI, State Bank of Patiala, Indusind Bank, BOB
Always - SBI, PNB
Table-10
How frequently derivatives used as tool of Market
Risk Management?
Frequency of Banks
Never 4Sometimes 4
Always 2
Which category of Derivative enjoys relatively more importance in your bank?
Forwards contracts are used as tool market risk management in banks who use derivatives. SBI
& PNB uses options as well to manage risk.
Relative importance of task performed before accepting the investment proposal
Table-11
Task Performed Frequency of weightage assigned to
each ratio
Total
Score
0 1 2 3 4 5
Detailed appraisal & rating 3 3 4 41
Risk Evaluation 1 1 4 4 41
Study of Exposure 3 1 5 1 30
Quality Standards 3 1 3 3 24
Maturity Profile 3 4 2 1 31
Table 11 indicates that before accepting the investment proposal, banks do detailed appraisal and
rating and evaluate risk.
At what frequency the variations in portfolio quality are tracked?
Monthly - UBI, Indusind Bank
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Annually - Allahabad Bank, SBP, OBC, Canara Bank
Quarterly - SBI, BOB, UCO
Weekly - PNB
Table-12
At what frequency the variations in portfolio
quality are tracked?
Frequency of Banks
Monthly 2
Quarterly 3
Biannually 1
Annually 4
40% of banks track the variations in portfolio quality annually. 30% banks track quarterly, 20%
track monthly and only 10% banks track variations in portfolio quality biannually.
Approach used for calculating Capital Charge for Market Risk
There are mainly two approaches :
Model Based Approach andStandardized Approach
All the banks use standardized approach to calculate capital charge.
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Amongst the various types of market risk, banks mainly face interest rate risk and
equity price risk. All the banks included in survey except UBI, OBC and Allahabad
Bank, Canara Bank are having risk taking unit. It works as per Market Risk Product
Programme.
In State Bank of India and Oriental Bank of Commerce, independent unit is
responsible for managing market risk but in all other banks ALCO manages the
market risk.
Risk is monitored by top management committee is almost all banks.
50% of banks receive market risk report monthly. Many banks receive this report
weekly.
All the banks surveyed are having a system to measure or calculate the sensitivity
of daily trading transaction.
Extent to which all maturing assets and liabilities are renewed is most important
factor.
Loans/Total Assets is the most common ratio that is calculated for liquidity
measurement in banks.
Most of banks forecast forex risk more frequently.
All the banks use standardized approach to calculate capital charge. Before accepting the
investment proposal, banks do detailed appraisal and rating and evaluale risk.
Forwards contracts are used as tool market risk management in banks who use derivatives.
SBI & PNB uses options as well to manage risk. Till now derivatives are used by few banks
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BIBLIOGRAPHY
BOOKS
Kothari,C.R., Research Methodology, Wishwas Parkashan, New Delhi,
1990.
Reddy, K.Ramakrishna, Risk Management
JOURNALS
Risk Management in Banks in India, IBA Bulletin (July 2002)
Risk Management in Banks for improved Corporate Governance, The
Management Accountant, November, 2005
WEBSITES
www.ficci.com
www.rbi.org.in
www.pnbindia.com
www.sbiindia.com
www.business.com
risk-management.guide.for-you.com
www.domain-b.com
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