Risk Management in Banks Risk in banking business
Risk Management in Banks
Risk in banking business n Banking business lines are many and varied • Corporate finance - mergers and acquisition underwriting and securitization • Trading and sales • Retail banking - private banking and card services • Commercial banking
• Payment and settlement • Agency services • Asset management • Retail brokerage n The key driver in managing all the business lines are enhancing risk adjusted expected returns
n From the risk management point of view banking business lines may be grouped broadly under the following major heads • The banking book • The trading book • Off balance sheet exposure
n Banking book • Banking book includes all advances deposits which usually arise from commercial and retail banking operations • All assets and liabilities in the banking book are normally held until maturity and accrual system of accounting is applied on them • The banking book is mainly exposed to liquidity risk , interest rate risk, default or credit risk and operational risk
Trading book n n The trading book includes all the assets that are marketed i. e. they can be traded in the market They are normally not held until maturity and positions are liquidated in the market after holding it for a period.
n n Mark to market system is followed and the difference between market price and book value taken to profit and loss account. Trading book mostly comprises of fixed income securities, equities, foreign exchange holdings, commodities, derivatives etc. held by the bank on its own account.
Off Balance Sheet Exposures n n n Off Balance Sheet Exposures are contingent in nature, where banks issue guarantees, committed or back up credit lines or letters of credit etc. Off Balance Sheet Exposures may become fund based exposure based on certain contingencies. Off Balance Sheet Exposures may have liquidity risk, interest rate risk, market risk, default or credit risk and operational risk.
Liquidity risk n n Liquidity risk in banks arises from funding of long term assets by short term liabilities thereby making the liabilities subject to rollover or refinancing risk. Funding liquidity risk is the inability to obtain funds to meet cash flow obligation. For banks funding liquidity risk is crucial. The liquidity risk in banks visible in following dimensions.
• Funding risk - arises from the need to replace the net outflows due to unanticipated withdrawals / non renewal of deposits. • Time risk - arises from the need to compensate for non receipt of expected inflow of funds i. e. performing assets turning into non performing assets. • Call risk - arises due to crystallization of contingent liabilities.
Interest rate risks n n Interest rate risk is the banks financial exposure to adverse movement in interest rates. IIR (interest rate risk) refers to volatility in NII or variations NIM (net interest margin), i. e. NII divided earning assets due to changes in interest rates.
n n In other words interest rate risk arises from holding assets and liabilities with a different principal amounts, maturity dates or repricing dates that is rollover rates. Interest rate risk is broadly classified into mismatch or gap risk, basis risk, net interest position risk embedded option risk, yield curve risk, price risk and reinvestment risk
• Gap or mismatch risk n n A gap or mismatch arises from holding assets, liabilities and off balance sheet items with the different principal amounts, maturity dates or repricing dates thereby creating exposure to unexpected changes in the level of market interest rates. An example of this risk would be where an asset maturing in two years at a fixed rate of interest have been funded by a liability maturing in 6 months.
n Yield curve risk • An yield curve is a line on a graph plotting the yield of all maturities of a particular instrument. • In a floating interest rate scenario, banks may price their assets and liabilities on different bench marks that is treasury bills yields, fixed deposits rates, call money rates, MIBOR etc.
• In case the banks use 2 different instruments maturing at different time horizon for pricing their assets and liabilities any non parallel movements in yield curves would affect the NII. • The movement in yield curve are rather frequent. • An example would be when a liability raised at a rate linked to say 91 days T-bill is used to fund an asset linked to 364 days T-bill. In a rising interest rate scenario, both 91 days & 364 days T-bills may increase but not identically due to non parallel movement of yield curve creating a variation in net interest earned.
n Basis risk • The risk that the interest rate of different assets, liabilities and off balance sheet items may change in different magnitude is termed as basis risk. • An example of basis risk would be say in rising interest rate scenario asset interest rate may rise in different magnitude than the interest rate on corresponding liability, creating variation in net interest income
n Embedded option risk • Significant changes in market interest rates create the source of risk to banks profitability by encouraging pre payment of cash credit / demand loans term loans and exercise of call / put options on bonds / debentures and / or premature withdrawal of term deposits before their stated maturities
• In cases where no penalty for prepayment of loans, the borrowers have a natural tendency to pay off their loans when a decline in interest rate occurs. • In such cases the bank will receive a lower NII.
n Reinvestment risk • Uncertainty with the regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. • Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions.
n Net interest position risk • Where banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rate adjusts downwards. • Such banks will experience a reduction in NII as the market interest rates declines and increases when interest rate rises. • Its impact is on the earnings of the banks.
n Market risk • Market risk is the risk of adverse deviation of a mark to market value of the trading portfolio due to market movements during the period required to liquidate the transaction. • Market risk is the risk of adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities and currencies.
• Market risk is also referred to as price risk. Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. • The price risk is closely associated with trading book, which is created for making profits out of short term movements in interest rates.
n Default or credit risk • Credit risk is defined as the potential of a bank borrower or counter party to fail to meet its obligation in accordance with the agreed term. • For most banks, loans are the largest and most obvious source of credit risk.
• Counter party risk n This is a variant of credit risk and is related to non performance of the trading partners due to counter parties refusal and or inability to perform.
• Country risk n n This is also a type of credit risk where non performance by a borrower or a counter party arises due to constraints or restriction imposed by a country. Here reason for non performance is an external factors on which the borrower or the counter party has no control.
n Operational risk • Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. • Operational risk includes transaction risk/fraud risk, communication risk, documentation risk, competence risk, model risk, cultural risk, external events risk, legal risks, regulatory risks, compliance risk, system risk etc.
• Transaction risk - It is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and mange information • Compliance risk – It is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable loss regulations, codes of conducts and standards of good practice • It is also called integrity risk since a banks reputation is closely linked to its adherence to principles of integrity and fair dealing.
Management of risk n n n Management of risks begins with identification. It is only after risks are identified and measured banks decide to accept the risk or to accept the risk at reduced level by undertaking steps to mitigate the risk. In addition pricing of the transaction should be in accordance with the risk content of the transaction.
n Hence management of risk may be sub divided into following 5 processes. • Risk • Risk identification measurement pricing monitoring and control mitigation
n Approach to manage risk at transaction level i. e. branch level were business transactions are undertaken – and at aggregate level – i. e. sum total of all transaction undertaken at all branches – differs. n This is because of risk diversification that takes place at aggregate level. n Aggregated risk of the organization as whole is called portfolio risk.
n n n Risks in banking business would depend upon the variability of its net cash flow at the aggregate level. Therefore, managing variability in aggregate cash flow is equally important and portfolio risk also need to be managed. Therefore, risk management in banking business is directed at transaction level and as well as at aggregate level.
Risk Identification n n Nearly all transactions undertaken would have one or more of the major risk i. e. liquidity risk, interest rate risk, market risk, default or credit risk, and operational risk with their visibility in different dimensions. Although all these risks are seen at the transaction level, certain risks such as liquidity risk and interest rate risk are managed at the aggregate or portfolio level.
n n n Risks such as credit risk, operational risk and market risk arising from individual transaction are taken note at transactional level as well as portfolio level. Guidance for risk taking, therefore, at the transaction level has to emanate from the corporate level. In fact, the guidelines help in standardizing risk content in the business undertaken at the transaction level.
n n Risk identification consists of identifying various risk associated with the risk taking at the transaction level and examining its impact on the portfolio and the capital requirement. Risk content of a transaction is also instrumental in pricing the exposure as risk adjusted return is the key driving force in management of banks.
Risk measurement n n Risk management relies on quantitative measures of risk. The risk measures seek to capture variations in earnings, market value, losses due to default etc (referred to as target variables), arising out of uncertainties associated with various risk elements.
n Quantitative measures of risk can be classified into 3 categories 1. Based on sensitivity 2. Based on volatility 3. Based on downside potential n Sensitivity captures deviation of a target variable due to unit movement of a single market parameter. E. g. change in market value due to 1% change in interest rate would be a sensitivity based measure.
n n Other example of market parameters could be exchange rate and stock prices. Volatility helps to capture possible variations around the average of the target variable, both upside and downside.
n n Using historical observation on the target variable, it is possible to estimate upside and downside potential of the target variable with a reasonable accuracy. Risk materializes only when earning deviate adversely.
n n Volatility captures both upside and downside deviations. Downside potential only captures possible losses ignoring profit potential. It is the adverse deviation of the target variable.
n n Downside risk is the most comprehensive measure of risk as it integrates sensitivity and volatility with the adverse effect of uncertainty. The risk measures are essentially forward looking and they estimate possible future losses that may arise within certain confidence level based on historical data.
Risk Pricing n n Risk in banking transactions impact banks in two ways. Firstly, banks have to maintain necessary capital, at least as per regulatory requirements. The capital requires is not without costs.
n n Secondly there is a probability of loss associated with all risks. Risk pricing implies factoring risks into pricing through capital charge and loss probabilities. This would be in addition to actual cost incurred in the transaction.
n Pricing therefore should take into account the following 1. 2. 3. 4. n Cost of deployable funds Operating expenses Loss probabilities Capital charge It may be noted that pricing is transaction based. This is one of the key reasons for risk measurement at transaction level.
Risk Monitoring and Control n n The key driver in managing a business is seeking enhancement in risk adjusted return on capital (RAROC). The approach to risk management centers on facilitating implementation of risk and business policies simultaneously in a consistent manner.
n n Modern best practices consists of setting risk limits based on economic measures of risk while ensuring best risk adjusted return keeping in view the capital that has been invested in the business. In order to achieve the above objective, banks put in place the following;
• An organizational structure • Comprehensive risk measurement approach • Risk management policies adopted at the corporate level, which is consistent with the broader business strategies, capital strength, management expertise and risk appetite
• Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits, discretionary limits and risk taking functions. • Feedback received on the actual performance requires monitoring also to ensure that the divergence between the planned performance and the actual performance is kept at the level that is acceptable. This requires the following;
• Strong management information system for reporting, monitoring and controlling risk. • Well laid out procedures, effective control and comprehensive risk reporting framework. • Separate risk management framework independent of operational department with a clear delineation of responsibility for management of risk. • Periodical review and evaluation.
n n n The banks senior management or board of directors should, on a regular basis receive reports on banks risk profile and capital needs. The banks conduct periodic reviews of its risk management process to ensure its integrity, accuracy and reasonableness. Identification of large exposures and risk concentrations, accuracy and completeness of data input into the banks assessment process and stress testing and analysis of assumption and inputs are all part of control and monitoring process.
Risk mitigation n Risk arise from uncertainties associated with the risk elements, risk reduction is achieved by adopting strategies that eliminate or reduce the uncertainties associated with the risk elements. This is called risk mitigation. In banking a variety of financial instruments and number of techniques are used to mitigate risk. The techniques to mitigate different types of risk are different
• For mitigating credit risk banks have been using traditional techniques such as collateralizations by first priority claims with the cash or securities or landed property, third party guarantee • Banks may buy credit derivatives to offset various forms of credit risk
• For mitigating interest rate risk banks use interest rate swaps, forward rate agreements or financial futures • For mitigating forex risk banks use forex forward contract, forex options or futures etc
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