TO RM UNIT 3 RISK MANAGEMENT KEY

TO & RM UNIT 3 RISK MANAGEMENT KEY RISKS RISK MGMT. & CONTROL RISK PROCESS-RISK ORGANISATION (5 Lect. )

Understanding Risk Management • Objective # What is Risk # Its impact on Return & Capital # Risks in banking business #Types of Risks #Portfolio Risk # Can we control & manage the Risk in the banking business

PART - I RISK MANAGEMENT INTRODUCTION

What is Risk • Uncertainty, danger; may arise in any activity • Keeping an appointment; Reaching class in time • Uncertainty resulting in adverse outcome • Financial Risks are uncertainty resulting in adverse variation in profitability or even loss of capital/ investment • In business – risks due to a number of factors

What is Risk • Lower risk means lower variation in expected returns and higher risk means higher variation • Zero risk means no variation in the return • Higher risk means either high variation on the positive side or high variation on the negative side. • It means either higher profit or higher loss. • Comparing returns on two investment options with varying risks is not correct.

What is Risk • Key driver for managing a business is seeking enhancement in Risk Adjusted Return On Capital ( RAROC )

Risk In Banking Business • Risk taking is natural in banking • Financial Intermediation • Risk is also an event which can cause damage to institution’s income or even reputation • Risk is UNAVOIDABLE • With globalisation, chances of risks have multiplied • Concepts like identify, prevent, mitigate, measure, monitor risks are being talked about

Risk In Banking Business Variety of banking business • Corporate finance – financing, merchant banking, advisory services, mergers & amalgamation, securitisation, govt. debt, syndication, IPO, private placement, underwriting • Trading & Sales - market making, Treasury, Investments in securities, equity, repos, brokerage • Retail banking – retail lending & deposits, banking services, private banking, wealth management, card services, investment advice,

Risk In Banking Business Variety of banking business • Commercial banking – project finance, real estate, export finance, factoring, leasing, letter of guarantee, letter of credit, bill finance • Payments & Collections, clearing & settlements • Agency services - depository receipts, securities lending, custody of documents • Asset Management – pooled, segregated, retail, institutional

PART _ II KEY BANKING RISKS

CREDIT RISK • Customers default/fail to service debt, leading to total/partial loss. • Customer gets downgraded • How to estimate the credit risk of overall portfolio of loans and all the transactions? • CREDIT RISK is potential of a bank borrower or counter party to meet obligations as per agreed terms. Loans are the most obvious source of credit risk

CREDIT RISK • COUNTER-PARTY RISK : It is another variant of credit risk. It is related to non performance of the trading partners due to counterparty’s refusal and or inability to perform. • COUNTRY RISK: It is also a type of credit risk where non-performance is on account of a borrower or counter party due to a constraint imposed by a country

MARKET RISK • MARKET RISK: Risk of adverse deviations in the value of trading portfolio due to market fluctuations, during the period required to liquidate the transactions. • Variation in the price of securities, shares, commodities and currencies due to market fluctuations. • Market risk is also referred as Price Risk

MARKET RISK • FOREX RISK: It is the risk that a bank may suffer due to adverse movement in foreign exchange rates. • MARKET LIQUIDITY RISK: This risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

INTEREST RATE RISK • INTEREST RATE RISK (IRR): It is the exposure of a bank’s financial position due to adverse movement in the interest rate. • In other words, it is the impact on Net Interest Income or Net Interest Margin • It can be viewed as the impact on earnings of the bank or impact on the economic value of the bank’s assets and liabilities

INTEREST RATE RISK • IRR-MISMATCH RISK: This arises due to holding of assets & liabilities with different principal amounts and different maturity dates. • This causes exposure to unexpected changes in market interest rates. • IRR-BASIS RISK: In a rising interest rate scenario, asset interest rate may rise in different magnitude than the interest rate on corresponding liabilities.

LIQUIDITY RISK • LIQUIDITY RISK (LR): It arises from funding of long term assets from short term liabilities. • LR-FUNDING RISK: It is the inability to obtain funds to meet cash flow obligations which may arise out of unanticipated withdrawals. • LR-TIME RISK: Arises from need to compensate for non receipt of expected inflows. • LR-CALL RISK: When a bank loses chance to do a profitable business due to lack of liquidity.

OPERATIONAL RISK • OPERATIONAL RISK (OR): It is a risk that leads to losses due to failure of internal systems, policies & procedures, people, external events. • OR-TRANSACTION RISK: It may arise due to fraud, competence issues, communication issues, inability to maintain proper processes. • OR-COMPLIANCE RISK: Risk of loss that a bank may suffer for non compliance of legal and regulatory guidelines, code of conduct & professional integrity.

OTHER RISKS • STRATEGIC RISK: It arises due to lack of proper response to a business situation. This risk is a function of the compatibility of organisation’s strategy towards achievement of its goals. • REPUTATION RISK: It is the risk arising from the negative opinion of public. This risk may expose the institution to litigation, loss of customer base and financial loss.

PART-III RISK MANAGEMENT PROCESS & RISK ORGANISATION

RISK MANAGEMENT PROCESS • THE PROCESS involves: a) Risk Identification b) Risk Measurement c) Risk Pricing d) Risk Monitoring & Control e) Risk Mitigation • Approach to manage risk at transaction level & at aggregate level. Aggregated risk of the organisation is called Portfolio Risk. This may comprise of all risks in transactions as discussed.

RISK MANAGEMENT PROCESS • RISK IDENTIFICATION – Sources Of Risks: Ø Decision/Indecision Ø Business cycle/Seasonality Ø Economic/Fiscal changes Ø Market Preference Ø Political Compulsions Ø Regulations Ø Competition/Technology

RISK MANAGEMENT PROCESS • RISK INDICATORS: Lack of…… Ø Supervision of lending/investment Ø Policy for lending/treasury ; implementation Ø Code of conduct; its implementation Ø Accountability Ø Expertise in certain transactions entered

RISK MANAGEMENT PROCESS Ø RISK INDICATORS Ø Too much emphasis on profits/ no care for risk Ø High rate high risk investment Ø Defective documentation Ø Improper credit analysis Ø End use of funds not monitored Ø Improper mix in credit portfolio

RISK MANAGEMENT PROCESS • RISK MEASUREMENT: Ø Reliance on quantitative measure of risk by capturing variation in earnings, market value of the assets & liabilities, losses due to defaults, etc. Ø Quantitative measures of risks are of 3 types: * based on sensitivity * volatility based * based on downside potential

RISK MANAGEMENT PROCESS • RISK PRICING: Ø Impact on banks of banking transaction risks is in two ways – maintain necessary capital and it has a cost – is the transaction so profitable that it can provide additional capital Ø The second impact is probability is te probability of loss. Ø Risk pricing involves inclusion of these factors

RISK MANAGEMENT PROCESS • PRICING therefore takes into account: Ø Cost of deployable funds Ø Operating expenses Ø Probability of loss quantum Ø Capital charge on account of transaction

RISK MANAGEMENT PROCESS • RISK MONITORING & CONTROL: Ø To take a balanced approach on Risk & Return Ø To have an organisation structure Ø comprehensive risk measurement approach Ø Risk management policies consistent with business strategies Ø Guidelines to govern risk taking with limits Ø Strong MIS, laid out procedure & reporting Ø Periodic review & evaluation

RISK MANAGEMENT PROCESS • RISK MITIGATION: Ø Have strategy to eliminate & reduce risks Ø For mitigating credit risks, collateral security or third party guarantee is taken Ø Credit derivatives are taken to mitigate cr risk Ø For Interest Rate risk – Interest rate swaps Ø Forex risks – forex forwards, options or futures Ø Mitigation reduces downside variability

RISK MANAGEMENT PROCESS • THE RISK PROCESS - SUMMARY: Ø Identify risk by functional area Ø Categorise Risk by Risk Profile Ø Anticipate the direction of the risk Ø Monitor Risk through established systems Ø State policy and procedure to identify risks:

RISK ORGANISATION Board of Directors Chairman & CEO Chief Risk Officers at functional divisions Functional Heads like treasury, credit, technology, Audit etc. Operating Management