Chapter 14 Asset –based Retail Financial Services

Chapter 14Asset –based Retail Financial Services

Risk & Exposure • Risk is defined as “ uncertainty in changes • Exposure is the sensitivity to such changes in prices

Classification of Risk RISK MICRO RISK MACRO RISK INTEREST RATE RISK LIQUIDITY RISK CURRENCY RISK POLITICAL RISK REPUTATION RISK CREDIT RISK EQUITY RISK COMMODITY RISK MARKET RISK LEGAL RISK OPERATIONAL RISK MODEL RISK DEFAULT RISK

Risk Perceptions • Counterparty risk / Credit risk / Settlement risk / Default risk • Market risk • Interest rate risk • Liquidity risk • Model risk • Legalrisk • Commodity risk • Price risk • Quantity risk • Cost risk (input price)

Risk Perceptions • Operational risk • Frauds • Employment practices and work place safety • Clients products and business practices • Damages to physical assets due to terrorism, vandalism, natural calamities etc. • Business disruption and system failures • Reputation risk • Currency risk • Political risk • Equity risk

Risk Management • Don’t risk more than you can afford to lose • Consider the odds • Don’t risk a lot for a little

Risk Identification • Techniques • Checklists of risks and their factors • Brainstorming of risks and their factors • Cross Functional Teams to provide multiple viewpoints so that a comprehensive list of risks and their factors is developed. • Documentation Studies of risk identification literature and previous risk management plans • Incremental Development of the risks and their factors • Interviews with stakeholders and domain experts • Iteration of the identified risks and their factors • Joint Application Development (JAD) of the risks and their factors • Parallel Development of the risks with other tasks and other teams • Reuse of previously identified risks

Measuring Risk • Traditional Financial Models • Value at Risk • Standard Deviation • Sensitivity Analysis • Scenario Analysis • Stress Testing

Risk Management Strategies • Protection cover through insurance • Hedging through forwards • Hedging through derivatives • Asset Liability Management • Collateral security

Risk Management Framework BOARD OF DIRECTORS RISK MANAGEMENT COMMITTEE (BOARD SUBCOMMITTEE INCLUDING CEO AND HEADS OF CREDIT, MARKET AND OPERATIONAL RISK MANAGEMENT COMMITTEES) CORE FUNCTION: POLICY AND STRATEGY FOR INTEGRATED RISK MANAGEMENT CREDIT RISK MANAGEMENT COMMITTEE (COMMITTEE OF TOP EXECUTIVES INCLUDING CEO, HEADS OF CREDIT & TREASURY, AND CHIEF ECONOMIST) OPERATIONAL RISK MANAGEMENT COMMITTEE ALCO/ MARKET RISK MANAGEMENT COMMITTEE CREDIT RISK MANAGEMENT DEPARTMENT (CRMD) CREDIT ADMINISTRATION DEPARTMENT (CAD) Risk Planning - Definition of procedures - Design of credit processes Risk Assessment and Monitoring - Sector review - Credit Rating - Review of Credit Proposals (new) - Asset review (existing) Risk Analytics - Credit Risk and pricing models’ design & maintenance - Portfolio analysis and reporting Credit Risk –Systems - Integration of risk Procedures with credit systems - Design and development of support systems for risk assessment & monitoring

Asset Liability Management • Asset Liability mismatching • Unbundling of balance sheet and arranging in different time buckets • Measuring mismatchings • Duration analysis • Gap analysis • Dynamic liquidity

Asset Liability Management Process • ALM Information System • Management Information System • Information availability, Accuracy, Adequacy and Expediency

ALM Organization • Asset Liability Management Committee • Composition • CEO/CMD or the ED will be the head of the Committee. • The Chiefs of Investment, • Credit, • Resources Management or Planning, • Funds Management / Treasury (forex and domestic), • International Banking and Economic Research. • Head of the Technology Division should also be an invitee • Asset Liability Management Authority • Committee of Directors • Some banks may have sub-committees and sub-groups

ALM Functions • Liquidity risk management • Management of market risks • Trading risk management • Funding and capital planning • Profit planning and growth projection

Composition of Time Buckets • 1 to 7 days • 8 t0 14 days • 15 to 28 days • 29 days and up to 3 months • Over 3 months and up to 6 months • Over 6 months and up to 1 year • Over 1 year and up to 3 years • Over 3 years and up to 5 years • Over 5 years

Asset Liability Management • Preconditions for holding securities in trading books: • The composition and volume are clearly defined; • Maximum maturity/duration of the portfolio is restricted; • The holding period not to exceed 90 days; • Cut-loss limit prescribed; • Defeasance periods (product-wise) i.e. time taken to liquidate the position on the basis of liquidity in the secondary market are prescribed; • Marking to market on a daily/weekly basis and the revaluation gain/loss charged to the profit and loss account; etc.

Asset Liability Management • Interest Rate Risk • Immediate impact of changes in interest rate is on bank’s earnings by changing the Net Interest Margin • A long-term impact will be on the Market Value of Equity or the Net Worth • The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective, respectively. • RBI introduced guidelines on Modified Duration in 2006 • the traditional Gap analysis was considered as a suitable method to measure the Interest Rate Risk in the first • Place the Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. • Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions).

Asset Liability Management • Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) • An asset or liability is considered to be rate sensitive if, • Within the time interval under consideration, there is a cash flow; • The interest rate resets/reprices contractually during the interval; • RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases where interest rates are administered ; and • It is contractually pre-payable or could be withdrawn before the stated maturities • . The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next repricing period, whichever is earlier

Asset Liability Management • Assets are priced prospectively whereas liabilities are priced retrospectively • The gaps are identified in the following time buckets: • 1-28 days • 29 days and upto 3 months • Over 3 months and upto 6 months • Over 6 months and upto 1 year • Over 1 year and upto 3 years • Over 3 years and upto 5 years • Over 5 years and up to 7 years • Over 7 years and up to 10 years • Over 10 years and up to 15 years • Over 15 years • Non-sensitive

Asset Liability Management • Gap Analysis • The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. • The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). • Gap measures the interest rate sensitivity • RBI permitted the banks having deficiency in skill and infrastructure to calculate the modified duration in the following manner: • group the assets and liabilities under the broad heads under various time buckets; and • compute bucket-wise Modified Duration of these groups of assets/ liabilities using the suggested common maturity, coupon and yield parameters • The banks were advised to build up infrastructure facilities and move to more accurate method of computation of modified gap

Computation of Modified Duration • Banks are required to calculate the modified duration in the following areas: • Investments • Assets/ Liabilities in Foreign Currencies • Derivative Instruments having forward component such as Interest Rate Swaps, Forward Rate Agreements, Interest Rate Futures • Other derivatives such as Foreign Currency- Indian Rupee options, cross currency options • Banks are required to fix prudential limits with the approval of their Boards

Computation of Modified Duration • Step-by step approach for computation 1. Identify variables such as principal amount, maturity date / re-pricing date, coupon rate, yield, frequency and basis of interest calculation for each item / category of asset / liability. 2. Generate the bucket-wise cash flows for each item / category of asset / liability/ off balance sheet item. 3. Determine the yield curve for arriving at the yields based on current market yields / current replacement cost for each item / category of asset / liability/ off-balance sheet item as proposed in the framework above. 4. The mid-point of each time bucket may be taken as a proxy for the maturity of all assets and liabilities in that time bucket. • Calculation of modified duration of equity • Modified Duration of Equity = DGAP x Leverage • Leverage = RSA / Equity (which indicates extent to which equity has been leveraged to create assets)

Computation of Modified Duration • Step-by step approach for computation 5. Calculate the Modified Duration of each category of asset / liability/ off balance sheet item using the maturity date, yield, coupon rate, frequency, yield, and basis for interest calculation for each category of asset / liability/ off balance sheet item. 6. Determine the weighted average Modified Duration of all the assets (DA) and similarly for all the liabilities (DL), including off balance sheet items. 7. The Modified Duration Gap is derived by the equation: DGAP = Modified DA – W x Modified DL where W = RSL/RSA (Rate Sensitive Liabilities / Rate Sensitive Assets). DA= Weighted average Modified Duration of assets and DL= Weighted average Modified Duration of liabilities.

Currency Risk Management • RBI has issued detailed guidelines covering the following areas • Forward contracts • Contracts Other than Forward Contracts • Hedging of Commodity Price Risk in International Commodity Markets • Facilities for Foreign Institutional Investors • Facilities for hedging Foreign Direct Investments in India

Currency Risk Management • Facilities for Authorized Dealers • Management of bank’s assets and liabilities • Hedging of gold prices • Hedging of Tier I Capital • Inter-bank foreign exchange dealings • Position and gaps • Net spot position • Net forward position • Options position

Currency Risk Management • Calculation of Overall Net Open Position • Calculate the net open position in each currency • Calculate the net open position in gold. • Convert the net position in various currencies and gold into rupees in terms of existing RBI / FEDAI Guidelines. • Arrive at the sum of all the net short positions.. • Arrive at the sum of all the net long positions • Capital requirement as prescribed by RBI from time to time • Inter-bank transactions • Foreign currency accounts

Managing Market Risk • Market risk is classified into: • Interest rate risk • Foreign exchange risk • Commodity price risk • Equity price risk • Risk management differs according to the type of risk • RBI has published extensive guidelines on managing market risk and liquidity risk

Managing Market Risk • Deal room functions • Deal room is the place where the security trading operations in the Treasury Department takes place. • Separate dealing room for forex and treasury • Integrated treasury operation envisages co-operation between treasury and forex deal rooms for effective use of funds • RBI has issued detailed guidelines on deal room operations

Managing Market Risk • RBI Guidelines on Deal room Operations • Undertaking by dealers that they would abide by the code of conduct issued by FEDAI and FIMDA • Dealers should adhere to internal limits for operations • Dealers should comply with RBI Guidelines • Dealings should be restricted to the panel of brokers approved by the risk management committee • Brokers should not be principals in any transaction • Broker notes and deal confirmations should be obtained from brokers before the close of the business of each day • Dealers should not authorize release of payments to brokers • Dealers should not accept gifts, gratifications or other favours from brokers • Dealers should not nominate a broker in transactions not done through that broker • Complaints against dealers should be promptly investigated and report should be submitted to RBI and FEDAI • Dealers should be aware of dealing hours, cut off time for overnight positions and rules governing off-site trading • Maintenance of confidentiality of the customer’s trading activities and secure maintenance of access media, keys, passwords and PINS • Rotation of dealing staff periodically and compulsory leave for 14 days per annum

Managing Market Risk • RBI Guidelines on Back Office • Back office should be separate from the dealing room • Dealers should not have access to back office • Receiving the deal confirmations, verification and reconciliation of discrepancies if any • Periodical reconciliation of Nostro/ Vostro Accounts • Independent sourcing (outside the deal room) of rates used for marking exposures • Independently maintaining the risk against limits established by the risk management committee and reporting of the usage • Dual control over the procedures and systems for payments independent of the deal room.

Managing Market Risk • Control Measures • Periodical deal room audit • Foreign Exchange inspection and deal room audit by RBI • Fixing position limits: • Day light limit • Overnight limit • Stop deal/ cut loss limit • RBI has prescribed risk weight of 2.5 per cent on the investments in government and other approved securities and 100 per cent on the forex open position and gold in tune with the Basle Committee prescriptions on capital cushion for price risks

Managing Liquidity Risk • Measurement of liquidity position and funding requirements under crisis scenarios • Liquidity risk has three dimensions • Funding risk • Replacement of funds on account of unanticipated withdrawal of deposits • Timing risk • Non-receipt of expected cash flow or performing assets turning to non-performing assets • Calling risk • Crystallization of contingent liabilities

Managing Liquidity Risk • Formulate an effective risk management policy • The risk management policy should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting/ reviewing etc. • The key ratios adopted across the banking system are Loan to Total Assets, Loan to Core Deposits, Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, Purchased Funds to Total Assets, Loan Losses/ Net Loans. • Banks also maintain prudential limits to avoid liquidity crisis

Managing Liquidity Risk • Prudential Limits • Cap on inter-bank borrowings, especially call borrowings; • Purchased funds vis-à-vis liquid assets; • Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Statutory Liquidity Ratio and Loans; • Duration of liabilities and investment portfolio; • Maximum Cumulative Outflows across all time bands; • Commitment Ratio – track the total commitments given to corporates/banks and other financial institutions to limit the off-balance sheet exposure; • Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Managing Liquidity Risk • Tracking of volatile deposits- high value deposits say deposits above Rs. 1 crore • Estimation of seasonal pattern of deposits and potential liquidity needed to meet funds requirements • Develop contingency funding plan • Estimating currency wise liquidity position

Operational Risk Management • Arises due to failure of control systems • The measures for managing operational risk includes: • Strengthening of control system • Streamlining the Operational Risk Management Policies, Processes and Procedures • Documenting and communicating to the appropriate staff • Strengthening the internal audit and vigilance system • Early detection of the instances of failure etc. • RBI has advised banks to the banks to develop operational risk management policy framework covering the following areas

Operational Risk Management • Operational Risk Management Policy Framework: • The roles and responsibilities of the independent bank-wide Operational Risk Management function and line of business management. • A definition for operational risk, including the loss event types that will be monitored. • The capture and use of internal and external operational risk loss data including data potential events (including the use of Scenario analysis). • The development and incorporation of business environment and internal control factor assessments into the operational risk framework. • A description of the internally derived analytical framework that quantifies the operational risk exposure of the institution. • A discussion of qualitative factors and risk mitigants and how they are incorporated into the operational risk framework. • A discussion of the testing and verification processes and procedures. • A discussion of other factors that affect the measurement of operational risk.

Operational Risk Management • Operational Risk Management Policy Framework: • Provisions for the review and approval of significant policy and procedural exceptions. • Regular reporting of critical risk issues facing the banks and its control/mitigations to senior management and Board. • Top-level reviews of the bank's progress towards the stated objectives. • Checking for compliance with management controls. • Provisions for review, treatment and resolution of non-compliance issues. • A system of documented approvals and authorizations to ensure accountability at an appropriate level of management. • Define the risk tolerance level for the bank, break it down to appropriate sub-limits and prescribe reporting levels and breach of limits. • Indicate the process to be adopted for immediate corrective action.

Operational Risk Management • The strategic approach • An emphasis on minimising and eventually eliminating losses and customer dissatisfaction due to failures in processes. • Focus on flaws in products and their design that can expose the institution to losses due to fraud etc. • Align business structures and incentive systems to minimize conflicts between employees and the institution. • Analyze the impact of failures in technology / systems and develop mitigants to minimize the impact. • Develop plans for external shocks that can adversely impact the continuity in the institution’s operations.

Operational Risk Management • Risk management system fails because of: • Lack of control culture • Inadequate recognition and assessment of risk of certain banking activities like the risk in respect of new products • Absence/failure of key control structures such as segregation of duties, approvals, verifications, reconciliations, reviews of operating performance etc. • Inadequate communication, and • Inadequate/ineffective auditing/monitoring programmes.

Operational Risk Management • One of the major functions in operational risk management is the identification of the events leading to operational risk • The impact of risk is assessed by measuring the potential loss on account of frequency of occurrence of the events leading to the risk • Another important aspect of operational risk management is building up a strong management information and business line identification system.

Operational Risk Management • Measures for managing the operational risk includes: • Insuring cash and valuables for protection against theft and robbery • Transit insurance for carrying cash • Property insurance against damage of properties • Marine insurance to cover export and import of goods • Group insurance to cover human resources • Credit insurance to cover default by borrowers • Capital Allocation • The approaches suggested by Basle Committee are: • Basic Indicator Approach • Standardized Approach • Advanced Measurement Approach • RBI has prescribed the Basic Indicator Approach • Banks have to hold capital for operational risk equal to a fixed percentage (alpha) of a single indicator which has currently been proposed to be “gross income”. Minimum prescribed ratio is 9 per cent

Operational Risk Management • Risk Management Tools • Natural hedge • Cross hedging • Use of derivatives • Futures • Options • Swaps • Credit derivatives

Forward Contrats • Forward contracts are over the counter. • They are different form the forward rate agreements. • Full hedge is possible in the case of forward contracts. • No upfront fee or premium. • Cancellation of contract can be costly.

Use Of Interest Rate Derivatives • Interest Rate Derivatives help to mitigate the interest rate related risk. • These can be interest rate futures, interest rate options, interest rate swaps, forward rate agreements, caps, floor and collars.

Interest Rate Futures • Interest rate futures can be bond futures, treasury bills futures etc. • Interest futures are treaded in the Wholesale Debt Market segment of NSE and BSE. • Banks and Primary Dealers can trade in interest rate derivatives. • Interest rate futures and options are not widely used in India. • Banks use interest rate swaps to hedge their risk.

Hedging With Derivatives • Derivatives are protected either by way of initial margin or by way of upfront premium so as to minimise the potential loss. • Derivatives are highly disastrous if not handled properly. • Some of the derivatives like option gives option to the buyer whether to exercise the contract on maturity or not • Perfect hedge is not possible

Credit Derivatives • Credit Derivatives are derivatives contracts structured based on an underlying credit obligation, which will become operative upon the occurrence of a credit event. • Credit Derivatives increase the breadth of the credit market because they simultaneously deepen the market for hedging and investment.

Credit Derivative Instruments • Credit Default Swaps • Total Return Swap • Credit Options • Credit Linked Notes • Structured Notes and Credit linked Notes • Credit Default Notes • Synthetic bonds • Leveraged Credit derivatives • Collaterized Debt Obligations

Credit Derivatives • RBI has permitted banks to use plain vanilla credit default swaps and issued the following guidelines • the reference entity shall be a single legal entity, which is a resident; • the reference entity shall be the obligor for underlying asset/ obligation, the reference asset/ obligation and the deliverable asset/ obligation. • the protection buyer and the protection seller shall be resident entities; • the underlying asset/ obligation, the reference asset/ obligation, the deliverable asset/ obligation shall be to a resident and denominated in Indian Rupees; • the credit derivative contract shall be denominated and settled in Indian Rupees; • the underlying asset/ obligation, the reference asset/ obligation, and the deliverable asset/ obligation shall be a tradable financial security or a fund-based credit exposure or a credit risk exposure to a reference entity assumed by a protection seller in a CDS contract. • Primary Dealers may transact in CDS where the underlying/reference/deliverable asset/ obligation is a corporate debt security; • the reference asset/ obligation shall be identical to the underlying asset / obligation with reference to (a) nature of obligation; (b) seniority (equal or junior); and (c) maturity; • The protection seller shall not transact in credit derivatives with underlying assets/ obligations or deliverable assets/ obligations which they are not permitted to undertake;

Chapter 14 Asset –based Retail Financial Services