RISK MANAGEMENT

1. RISK MANAGEMENT PRESENTATION ON CREDIT RISK AND MARKET RISK By S.D.BARGIR, Joint Director, IIBF

2. Risk may be defined as “ exposure to uncertainty” • favourable or unfavourable outcomes • aims at mitigating the loss • managing risk rather than on eliminating it

3. Risk management is a four steps process • Identifying • Measuring ( quantifying) • Managing • controlling, monitoring and reviewing

4. Three generic categories of risk • Credit risk • Market risk • Operational risk

5. Credit Risk • credit risk means default of the borrower or deterioration of borrowers’ credit quality.

6. Market Risk arising from movement in market prices • Interest Rate Risk, • Exchange Rate Risk, • Commodities Price risk • Equity Price Risk.

7. Operational Risk loss resulting from inadequate or failed • internal processes • People • systems or • external events.

8. Credit Riskdefaults take various forms • Direct Lending:Loan amount (Principal as well as interest) will not be paid • Guarantees/ Letter of Credit etc.Funds will not be forthcoming upon crystallization of liability

9. Credit Riskdefaults take various forms • Treasury Products payment due from the counter parties either stops or not forthcoming • Securities Trading Settlement will not be effected • Cross boarder exposure: free transfer of currency is restricted or comes to an end.

10. credit risk, consists of three risks • Default risk • Exposure risk • Recovery risk

11. Default risk • is the probability of an event of default • depends upon credit standing of the counter party. • default probability cannot be measured directly. • guidance from historical statistics on large sample over long period of time. • bank faces difficulty in obtaining accurate historical data.

12. Exposure risk • uncertainty associated with future amounts • credit lines- repayment schedule- exposure risk small • other lines of credit -OD, project financing , guarantees etc- risk cannot be predicted accurately

13. Recovery risk: • recoveries in the event of default not predictable • depend upon type of default • availability of collaterals, third party guarantees • circumstances surrounding the default.

14. Expected Losses & Unexpected Losses • EL depends upon default probability(PD), Loss given default (LGD)& exposure at risk (EAD) • EL = PD x LGD x EAD • Unexpected losses (UL) is the uncertainty around EL and it is Standard deviation of EL.

15. challenges faced by banks in r/o EL • aggregation of the risk-related information to assess the PD, LGD and EAD • implementation of a risk rating system that can correctly model these parameters which is statistically valid.

16. BASEL • Basel Committee on Banking supervision (BCBS) under the auspices of Bank for International Settlements (BIS) • Established in 1975 by group of 10 countries • Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

17. Basel II-Implementation in India • with effect from March, 31, 2007 by commercial banks. • 90 commercial Banks in India • 100 countries

18. Basel II • capital requirements more risk sensitive • directly related to the credit rating of each counter-party instead of counter-party category • capital for credit and market risk but also for operational risk (OR) • where warranted for interest rate risks, credit concentration risks, liquidity risks • SME sector

19. BASEL II RESTS ON THE THREE PILLARS, • Pillar I Minimum Capital Requirements • Pillar 2 Supervisory Review Process • Pillar 3 Market Discipline each pillar is as important as the other one

20. Pillar 1 – Minimum Capital Requirements • menu of approaches for computing capital adequacy • freedom to choose the approach • minimum, the Standardized Approach for credit risk • Basic Indicator Approach for operational risk • standardised Approach or Internal Risk Measurement Models approach for market risk

21. Various Approaches

22. Pillar 2- Supervisory Review • encourage to adopt better risk management techniques • intervene to mandate a higher capital requirement • more inclusive –besides CR,MR,OR credit concentration risk Interest rate risk in banking book, Liquidity risk, Business risk, Strategic risk and Reputation risk. • Takes into account Business cycle effects too

23. Business Risk Factors Capital, Credit Risk, Market Risk, Earnings risk, Liquidity Risk, Business Strategy and Environment Risk, Operational Risk Group Risk. Control Risk Factors Internal Controls Risk, Organisation risk, Management Risk Compliance Risk. RISK BASED SUPERVISION (RBS)

24. Pillar 3- Market Discipline • disclosures to enhance market discipline • Monitoring by markets- other banks, customers, depositors, subordinated debt instrument holders, analysts & rating agencies • disclosure policy approved by Board • financial penalty, for non-compliance

25. INITIATIVES BY RBI • each bank has suitable risk management framework and the expected level of capital • introduced RBS In 23 banks on a pilot basis • encouraged all banks to operationalise CAAP • expanded the area of disclosures • encouraged some banks to migrate from SA to IRB approaches

26. Standardised ApproachDifferent categories of obligors • Corporates • Sovereign • Bank • Retail • Real Estate • Specialized Lending

27. Issues emerging out of Basel II • higher capital requirements • improved IT architectures • data issues • consolidation • capacity building • external ratings • use of national discretion • validating the concept of economic capital

28. Capital requirements for CORPORATES in Basel II

29. Capital requirements for SOVEREIGN in Basel II

30. Capital requirements for BANKS in Basel II

31. Capital requirements for BANKS in Basel II

32. Capital requirements for RETAIL in Basel II

33. Capital requirements for REAL ESTATE in Basel II

34. SPECIALISED LENDDING

35. Assessing exposure customer wise and facility wise • Probability of Default (PD) - the probability that a specific customer will default within the next 12 months. • Loss Given Default (LGD) - the percentage of each credit facility that will be lost if the customer defaults. • Exposure at Default (EAD) - the expected exposure for each credit facility in the event of a default.

36. MARKET RISK Market risk takes the form of interest rate risk, exchange rate risk, commodity price risk and equity price risk , major risk presently faced by banks in India are interest rate ,exchange rate and liquidity risk.

37. MARKET RISK-CONTINUED • Basel-I focused only on credit risk excluding the market risk • Risk brought vide amendments in 1996 • usually measured with a Value-at-Risk method and on daily basis • capital charge should be either the previous day’s VaR or three times the average of the daily VaR for the preceding 60 working days.

38. Stipulations of RBI • Assign additional risk weight of 2.5% on the entire investment portfolio • Assign risk weight of 100% on the open position limit on foreign exchange and gold • Build investment fluctuation reserve up to a minimum of 5% of the investment held in ‘Held for Trading’(HFT) and ‘available for sale’(AFS) category in their investment portfolio

39. Linking risk to capital- single metric • Risk measurement focuses on unexpected losses • Different business activities lead to various unexpected losses • These different risks must be measured individually and aggregated to a single risk metric, both by business line and across the bank as a whole

40. WINNING FORMULA Overall risk should always be lower than overall economic capital

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