RISK MANAGEMENT MODULE A – Asset Liability Management AND MODULE B – Risk Management

1. RISK MANAGEMENT MODULE A – Asset Liability Management AND MODULE B – Risk Management A PRESENTATION BY K ESWAR MBA XLRI, CAIIB CHIEF MANAGER, SPBT COLLEGE.

2. BANKS TYPICALLY FACE THREE KINDS OF RISK Type of Risk Example • Risk of loss due to unexpected re-pricing of assets owned by the bank, caused by either • Exchange rate fluctuation • Interest rate fluctuations • Market price of investment fluctuations • Risk of loss due to unexpected borrower default • Risk of loss due to a sudden reduction in operational margins, caused by either internal or external factors viz Process failure, systems failure, human error, frauds but does not cover reputational risk/strategic risk. “Stocks” Daily price change (%) Unexpected price volatility Market Time Default rate (%) “Loans with credit rating 3” Unexpected default Avg. default Credit Time Monthly change of revenue to cost (%) “Business unit A” Unexpected low cost utilization Operational Time

3. The Current Capital Accord • Focused on credit risk but formula based • Partially amended in 1996 to include market risk • Operational risk not addressed • Simple in its application • Produced an easily comparable and verifiable measure of bank’s soundness

4. Need for a new frame-work • Financial innovation and growing complexity of transactions • Categorised bank’s assets into one of only four categories each representing a risk class • Made no allowance for the effect portfolio diversification • Requirement of more flexible approaches as opposed to “one size fits all” Approach • Requirement of Risk sensitivity as opposed to a “broad- brush Approach” • Operational Risk not covered

5. Basle Accord I & II - Differences • Talks of Credit Risk only • Capital Charge for Credit Risk – 8% • Does not mention separate Capital charge for Market and Operational Risk • No mention about market Discipline • No effort to quantify Market and Operational Risk • Talks of Credit, Market and Operational Risks • Capital Charge dependant on Risk rating of assets • Capital Charge to include risks arising out of Credit, Market and Operational risks. Not a broad brush approach • Quantitative approach for calculation of Market and Operational risks as for Credit Risk.

6. Three pillars of the Basel II framework Minimum Capital Requirements Supervisory Review Process Market Discipline • Credit risk • Operational risk • Market risk • Bank’s own capital strategy • Supervisor’s review • Enhanced disclosure

7. Pillar I – Credit Risk Pillar 1 – Credit Risk stipulates three levels of increasing sophistication. The more sophisticated approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move up the ladder are rewarded by a reduced capital charge Advanced Internal Ratings Based Approach Increase Sophistication Foundation Internal Ratings Based Approach Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Standardized Approach Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized. Risk weights are based on assessment by external credit assessment institutions Reduce Capital requirements

8. Pillar I – Minimum Capital Requirements The new Accord maintains the current definition of total capital and the minimum 8% requirement* Total capital = Bank’s capital ratio (minimum 9%) Credit risk + Market risk + Operational risk Total capital = Tier 1 + Tier 2 Tier 1: Shareholders’ equity + disclosed reserves Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions) Total Capital Credit Risk The risk of loss arising from default by a creditor or counterparty Market Risk The risk of losses in trading positions when prices move adversely Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events * The revisions affect the denominator of the capital ratio - with more sophisticated measures for credit risk, and introducing an explicit capital charge for operational risk

9. Internal Ratings Based Approach • Exposures in five categories because of different risk characteristics • Sovereigns • Banks • Corporates • Retail • NPA

10. Pillar I – Credit Risk Pillar 1 – Credit Risk stipulates three levels of increasing sophistication. The more sophisticated approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move up the ladder are rewarded by a reduced capital charge Advanced Internal Ratings Based Approach Increase Sophistication Foundation Internal Ratings Based Approach Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Standardized Approach Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized. Risk weights are based on assessment by external credit assessment institutions Reduce Capital requirements

11. Capital Requirement – What New?

12. Framework

13. Claims on Banks is 20% subject to the fact that CRAR of borrowing Bank is 9 % and above. And it is scheduled Bank.

14. Claims on corporates Unrated exposure of Rs.50(Rs.10 crores) will attract 150% risk weight.

15. Mapping process – draft guidelines

16. Retail Portfolio - Criteria • Orientation criterion - exposure to individual person or persons or to a small business. • Product criterion - revolving credit, line of credit, personal term loan and lease small business facilities and commitments. • Granularity criterion- regulatory retail portfolio is sufficiently diversified to a degree that reduces the risk in the portfolio – no aggregate exposure to one counterpart can exceed 0.2% of the overall regulatory retail portfolio • Low value of individual exposures- the maximum aggregate retail exposure to one counterpart cannot exceed an absolute threshold of euro 1 million.( Rs. 5 Crores for our Bank) • Turnover Rs.50 Crores.(AVERAGE FOR LAST 3 YEARS)

17. Capital charge for Credit risk contd… • Past due loans • The unsecured portion of any loan that is past due for more than 90 days, net of specific provisions, to be given higher risk weight • 150% if specific provision <20% o/s • 100% if provision >or= 20% • if provision = or > 50% with supervisory discretion for 50% weight • 100% if provision > or = 15% if fully secured

18. Exclusion in Regulatory Retail. • Mortgage loans to the extent they qualify for treatment as claims secured by residential property: Margin 25% : RW upto Rs.20 lakhs :50% and Rs.20 lakh and above 75% Margin less than 25% RW 100% • Consumer credit, credit card exposure etc. RW125% • Capital market exposure and NBFCs RW125% • Commercial Real Estate : RW 150% • Staff loans: 20% if covered by superanuation funds or mortgage. • Other staff loans : 75% RW

19. Operational Risk • Explicit charge on capital • Basic Indicator approach – 15% of gross income • Gross income = net interest income plus net non interest income

20. GROSS INCOME • GROSS INCOME = NET PFORIT+ PROVISIONS+OPERATING EXPENSES-PROFIT ON SALE OF INVSTEMENT-INCOME FROM INSURANCE-EXTRA ORDINARY ITEM OF INCOME+ LOSS ON SALE OF INVESTMENT

21. Operational Risk Standardised Approach- Capital charge is calculated as a simple summation of capital charges across 8 business lines

22. CREDIT RISK MITIGATION • HAIR CUT TO EXPOSURE • HAIR CUT TO FINANCIAL COLLATETAL.

23. Q. Net Interest Margin NIM is defined as • a. Net interest income divided by total earning assets. • b. Interest income –interest expenses. • c. total interest income divided by total assets. • d. None of above. • Q..Ratio of share holders funds to total assets is called as • a. Debt equity ratio. • b. TOL/TNW ratio. • c. Economic equity ratio. • d. No ne of above.

24. Q The institution is in a position to benefit from rising interest rates when assets are ……………than liabilities. • Lower. • Greater • Equal • Half. • Q. The liquidity risk arising out of unanticipated withdrawal or non renewal of deposits is called as • a. Funding Risk. • b. Time risk. • c. Market Risk • d. Operational risk.

25. Q. The liquidity risk arising out of non receipt of expected in flow of funds due to accounts turning as NPA is known as • a. Time Risk. • b. Call Risk. • c. Operational Risk. • d. Funding risk. • Q. The liquidity risk arising out of crystallization of liabilities and conversion of non fund based limits to fund based limits is known as : • a. Call risk. • b. Time risk. • c. Operational risk. • d. Market risk.

26. Q. Stock approach of measuring and managing liquidity risk and funding requirements is based on • a. level of assets and liabilities and balance sheet exposure on a particular date. • b. based on stocks pledged to Bank in Cash Credit Account • c. Stock of Investments of bank. • d. None of above. • Q. Flow approach to measuring and managing liquidity consist of • a. Measuring and managing net funding requirements. • b. Managing market access. • c. Contingency planning. • d. All the above.

27. Q. Under gap method the net funding requirement is calculated based on • a. residual maturities of assets and liabilities. • b. Actual maturities of assets and liabilities • c. Both the above. • d. None of above. • Q. Cash inflows arise from mainly: • a. Maturing assets. • b. Maturing liabilities. • c. Maturing off balance sheet exposure. • d. Maturing time deposits.

28. q. Cash outflows arise out of mainly. • a. Maturing liabilities. • b. Maturing assets. • c. Maturing T Bills. • d. Maturing CPs. • Q. Different between the cash in flow and cash out flow will result into……….. if the cash inflows are lower than the cash outflows: • a. deficit. • c. Surplus • d. None of above. • e. No impact.

29. Q. If there is significant deficit observed say after 30 days period the option available for bank is to • a. acquire an asset maturing on that day. • b. renew or roll over a 30 day liability. • c. Acquire a liability maturing after 30 days. • d. None of above. • Q. In the year 2007 RBI has for the purpose of measurement of liquidity risk split the first time bucket of 1-14 days in its structural liquidity in • a. Four time buckets. • b. Three time buckets • c. Five time buckets. • d. None of above.

30. Q the net cumulative negative mismatch during the next day, 2-7 days, 8-14 days and 15-28 days buckets should not exceed • a.5%,10%, 15% and 20% of cumulative cash inflows in respective time bucket. • b. 20%,15%,10% and 5% of cumulative cash inflows. • c.10%,5%,25% and 30% of cumulative cash inflows. • Q. Frequency of structural liquidity position is • a. fortnightly • b. Weekly. • c. Monthly • d. Quarterly.

31. Capital , Reserves and Surplus are slotted in which time bucket in Structural Liquidity Statement: • Over 5 years. • Over 3 Years. • Over 1 Year. • Over 6 months. • Q. Saving and Current deposit may be treated as volatile portion upto • a. 10% and 15 % respectively. • b.20% and 30% respectively. • c. 30% and 40% respectively. • d. None of above

32. Q. Placement of volatile portion and core portion of Saving and current deposit may be done as under: • a. volatile portion in day 1 time bucket and core portion in 1-3 year bucket. • b. Volatile portion in 7 day time bucket and core portion in 5 year bucket. • c. Volatile portion in 2-7 days time bucket and core portion in 1 year time bucket. • d. none of above. • Q. Cash should be shown under which time bucket for inflow: • a. 1 day. • b. 2-7 days. • c. 8-14 days. • d. One year.

33. Q. Investment in shares and mutual fund (open ended) should be shown in • a. Over 5 year bucket • b. Over 1 year bucket. • c. Over 2 year Bucket. • D. None of above. • Q. Investment in subsidiaries and joint ventures to be shown • a. In over 5 year bucket. • b. In over 3 year bucket. • c. In over 1 year bucket. • d. None of above.

34. Q. Core portion of Cash credit advances may be shown undera. 1-3 year time bucket. • b. over 3 year time bucket. • c. Over 5 years time bucket. • d. None of above. • Q. Term Loans to be shown under: • a. Interest and principal of the loan under residual maturity bucket. • b. Principal under residual maturity bucket. • c. all in 5 year and above bucket. • d. None of above.

35. Q. Sub Standard loans to be shown under • a. Over one year bucket. • b. Over 2 year bucket. • c. Over 3 years bucket. • d. Over 3-5 year bucket. • Q. Fixed Assets: • a. Over 5 year bucket. • b. Over 2 year bucket. • c. Over 1 year bucket. • d. none of above.

36. Q. The net cumulative negative mismatches during the day 1, 2-7, 8-14 and 15-28 days buckets if exceed the prudential limits may be financed from market by • a. Market borrowings ( call /term) • b. Bills discounting • c. Repo • d. All above.

37. Q. Market Value of an asset is conceptually equal to • a. Present value of current and future cash flows from that asset and liability. • b. future value of current and future cash flows from that asset and liability. • c. None of above. • d. all the above. • Q. There fore rising interest rates increase the discount rates on those cash flows and thus • a. Decrease the market value of asset or liability. • b. Increase the market value of asset or liability. • c. No impact is caused. • d. None of above.

38. Q. Falling interest rate decrease the discount rates on these cash flows and thus • a. Increase the market value of an asset or liability. • c. Decrease the market value of an asset or liability. • d. No Impact. • e. None of above. • Q. What is basis risk: • a. risk that interest rate of different assets and liabilities may change in different magnitudes is called basis risk. • b. Risk relating to basis on which loan is sanctioned. • c. Risk related to yield curve. • d. None of above.

39. Q. Yield Curve Risk is known as: • a. Risk owing to altering of yields across maturities and its impact on NII • b. Risk owing to wrong drawing of yield curve by Bank staff. • c. risk of lower current yield . • d. None of above. • Q. Gap method is basically used for • a. measuring banks interest rate risk exposure. • b. measure maturity mismatch • c. Measure potential losses from off balance sheet exposure. • d. None of above.

40. Q. In a given time band a negative or liability sensitive gap occurs when • a. Rate sensitive liabilities exceed rate sensitive assets. • b. Rate sensitive assets exceed rate sensitive liabilities. • c. None of above. • d. All the above. • Q. with a negative gap , an increase in market interest rates could cause a • a. decline in net interest income. • b. Increase in net interest income. • c. None of above. • d. All above.

41. Market Value with interest at 8% SPBT COLLEGE.

42. Interest Rate • Suppose that current expectation of yield is 10%. What will be the market price? SPBT COLLEGE.

43. Interest Rate • Suppose that current expectation of yield is 6%. What will be the market price? SPBT COLLEGE.

44. Q. Higher the duration implies that a given change in the level of interest rates will have • a. larger impact on economic value. • b. smaller impact on economic value. • c. No Impact. • d. None of above. • Q. Duration will be higher ifa. longer the maturity date or smaller the payments that occur before maturity ( coupon payments) • b. shorter the maturity and higher the payments that occur before maturity ( coupon payments) • c. None of above. • d. all the above.

45. Q. One of the strategies for reducing the asset or liability sensitivity could be : • a. Increase floating rate instruments. • b. Increase fixed rate instruments. • c. None of above. • d. all the above. • Q. The Duration of Zero coupon bond would be • a. Greater than its maturity. • b. Shorter than its maturity. • c. Equal to its maturity. • d. None of above.

46. None of above. • Q. Under Put option the buyer has • a. Right to sell but not obligation to sell • b. Right to buy but not obligation to buy • c. Right to receive interest payments. • d. None of above. • Q. Under Call option the buyer has • a. Right to buy but not obligation to buy • b. right to sell but not obligation to buy • c. None of above.

47. .. • Q. American option • a. Permit the holder to exercise any time before the expiration date. • b. Does not permit to exercise any time before the expiration date. • c. None of above. • d. all above. • Q. European option means • a. Which permit holder to exercise any time before expiration date. • b. Does not permit holder to exercise any time before expiration date. • c. all above. • d. none of above.

48. Q. In India only • a. European option are allowed. • b. Only American option are allowed. • c. Both are allowed. • d. None are allowed. • Q. Futures are • a. Over the counter products. • b. Exchange traded. • c. None of above. • d. all the above.

49. Q. Which of the following is true: • a. A swap has invariably two legs of transaction. • b. A swap only one leg of transaction. • c. None of above. • d. All the above. • Q. Futures are marked to market on • a. Daily basis and margin is adjusted. • b. Weekly basis. • c. Monthly basis. • d. None of above.

50. Q. Short term dynamic liquidity statement relate to • a. monitoring liquidity on dynamic basis over a time horizon of 1-90 days. • b. monitoring liquidity on dynamic basis over a time horizon of 7-90 days. • c. monitoring liquidity on dynamic basis over a time horizon of 28-90 days. • d. None of above. • Q. In statement of interest rate sensitivity : • a. Only rupee assets and liabilities and off balance sheet positions should be reported. • b. All assets and liabilities should be reflected. • c. Only foreign currency assets and liabilities should be reflected. • d. None of above.