Risk is an integral part of banking as banks primarily trade in risk in the process of maturity transformation in terms of difference in interest rate of assets and liabilities. Also, banking business operations are many and varied. Commercial banking, corporate finance, retail banking, trading and investment banking and various financial services form the main business operations of banks. Therefore, banks cannot afford to be risk avoiders. At the same time ‘banker’s prudence’, something that is critical to safety of the depositors’ funds, has to be the underlying philosophy at all times. The risk return relationship has to be optimally balanced for welfare enhancing outcomes.
RISK MANAGEMENT IN BANKS
Paradigm Shift in Banking Operations
Business OperationsSub-GroupsFunctions
Corporate FinanceCorporate Finance, Mun- Mergers and acquisitions, undercipal/government finance, writing, Privatisations, Securitisation, Merchant banking and ad-IPO, government debt visory services
Trading and SalesSales, Market making,Fixed income,equity, foreign exchTreasury primeanges, credit, funding, lending and brokeragerepos, brokerage, debt
Retail BankingRetail BankingRetail lending and deposits, banking services, trust and sales
Private BankingPrivate Lending andDeposits, banking services, trust and Card Services estates, investment advice merchant/ commercial/cards and retail
Commercial BankingCommercial BankingProject finance, real estate, export finance, trade finance, leasing, bills of exchange
Payments and SettlementExternal clients
Payments and collection, funds transfer, clearing and settlement
Agency FunctionscustodyEscrow, depository receipts, securities lending
Asset ManagementDiscretionary and non-Pooled, segregated, retail, institutidiscretionary fund man-onal, closed, open agement
The banking business has become far more sophisticated and complex. Risk too, has increased in proportion to this sophistication and complexity. The risk taking behaviour of banks has high potential for contributing to and amplifying systemic risk and consequent contagion. This can have severe repercussions for financial and economic fragility as witnessed during and in the aftermath of the global financial crisis.
The growing awareness on risk management can be accounted to following developments in the financial sector over the last couple of decades:
The deregulation of financial markets (deregulation of saving rate and interest rate) coupled with increased volatility.
The diversification of activities of banks from the traditional function of lending and borrowing to activities including, inter alia, custodial services, securities underwriting, project financing and corporate advisory.
The emergence of complex global financial institutions coupled with the growing inter-connectedness of the financial system (Quantitative Easing in US and its impact on Indian financial market).
BASEL reforms (from BASEL I to BASEL III) also added to the process by increasingly requiring banks to maintain capital in accordance with their risks.
The increasing trading of securities and derivative products along with increasing growth of complex financial products.
As new complex products proliferated in the market place, their valuation posed challenges due to lack of depth and width of the financial market and financial illiteracy.
To manage the balance sheets, Indian Banks have been focusing on mobilisation of deposits, comply the statutory reserve requirements to avoid default and to extend credits to meet the requirements of finance for working capital with all segments of industry. Depositors are becoming more and more sensitive to the new opportunities for getting best maturity yield for the surplus funds. While depositors in the household try to shift their portfolio of savings to augment their returns, the corporate treasurers are today constantly in search to optimize their returns. The change has made banks more accountable about the quality of assets through better management of risks, both on the assets and liabilities sides. The risks include not only the traditional risk of write-off but also maturity mismatch risk, interest rate risk, liquidity risk, market risk, operational risk etc.
Commercial Banks major operation includes all advances, deposits and borrowings, which usually arise from commercial and retail banking operations. All assets and liabilities in Balance sheet of the bank includes following features:
1.They are normally held until maturity
2.Accrual system of accounting is applied
Maturity mismatch between assets and liabilities results in excess or deficit of liquidity that leads to liquidity risk. In the Indian banking scenario, the liabilities are predominately at fixed rates whereas among assets, the loan assets bear floating interest rate and the
investment assets bear fixed interest rate. Also, interest rate changes makes impact on assets and liabilities held till maturity affecting net-interest margin results in interest rate risk.
In can be summarized that financial risk can be defined as probability of variation of actual return from the expected return. The probability is governed by symmetry of information. Further the outcome is dependent on several other factors such as macroeconomic fundamentals of the country comprising of level of inflation, interest rate, level of capital formation, saving and consumption propensity of Indian consumers, international trade scenario, political stability, depth of capital market, technological up-gradation, innovative financial products, corporate governance and financial penetration in India.
For efficient risk management in banks and financial institutions one need to understand the various categories and intricacies of risk and how to manage and mitigate it.
1. Liquidity Risk
The bank is exposed to such risk due to its banking activities like – Withdrawal of deposits, repayment of purchased funds at maturity, extensions of credit and working capital needs etc.
Tool for monitoring liquidity is the maturity mismatch analysis
The assessment of bank’s liquidity during stressed conditions is conducted by various stress tests at regular intervals. The liquidity position of overseas branches are reviewed by bank’s ALCO
Dimensions of Liquidity Risk
Funding risk: unanticipated withdrawals/non-renewal of deposits (wholesale/retail)
Time risk: need to compensate for non-receipt of expected inflow performing assets turning into NPAs
Call Risk: Due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.
Liquidity Risk – Measurement-
For Liquidity Risk Measurement two methods are employed:
(1)Stock Approach - Key Ratios are: Loan to Asset Ratio, Loan to Core Deposits, Large liabilities less Temporary investments to Earning assets less Temporary investments, Purchased Funds to Total Assets, Loan losses/net loans
(2)Cashflow Approach - As per RBI guidelines, commercial banks have to allocate the cash outflows and inflows in different residual maturity period known as time buckets. Earlier banks used to divide the assets and liabilities in 8 maturity buckets (1-14 days; 15-28 days; 29-90 days; 91-180 days; 181-365 days, 1-3 years and 3-5 years and above 5 years), based on residual maturity period . Since September, 2007, the
banks have adopted a more comprehensive approach to measure liquidity risk by splitting the first time bucket of 1-14 days into three time buckets viz., next day, 2-7 days and 8-14 days. Thus, now banks have 10 time buckets.
After allocating assets and liabilities in 10 time buckets, the bank has to match different time bucket assets with the corresponding bucket of the liability. When assets of the bank are more than its liabilities in a particular time bucket, bank has surplus liquidity. In case bank’s liabilities exceed its assets in a particular time bucket the bank has liquidity crunch position and depending upon the interest rate movement, such situation may turn out to be risky for the bank. Banks monitor such mismatches and take appropriate steps to minimize their interest rate risk exposure during a specific period of time.
2. Interest Rate Risk
Banks are now operating in a free and deregulated interest rate regime and hence prone to risks arising out of adverse movement in interest rates. Apart from liquidity risk, Interest rate risk is another major risk area that banks are exposed to in the deregulated environment, since taking excess interest rate risk may erode bank’s earnings and its capital base, thus raising concern for the bank by stakeholders and regulator alike.
Asset Liability Management is concerned with risk mitigation and provides a comprehensive and dynamic framework for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be integrated with the banks’ business strategy. With the deregulation of interest rate, increase in inflation rate frequent changes in the domestic interest rates, banks have been exposed to the higher level of Interest rate risk, credit risk and market risks.
The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. To achieve these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the Interest rate risk involved in these areas. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition.
The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s net worth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates.
The Net Interest Income of the bank is an outcome of the interest rate because of the mismatch and the earning of the bank would be volatile with movement of interest rates on assets and liabilities because of the ALM mismatch.
Interest Rate Risk and Asset Liability Mismatch
Single asset or liability management is a simple task, suppose Punjab National Bank has created an asset at Basic Prime Lending Rate (BPLR) at 12% for 4 years, for 10 crore for an AAA corporate. However subsequently, because of rate on interest going up, due to higher rate of inflation, the BPLR was revised to 13%, then the value of the asset will depreciate, although as per accounting the value of the asset is 10 crore in nominal terms but real terms the value is lower than 10 crore (there is inverse relationship between interest rate and value of asset). Although for accounting purpose, the depreciation on the trading portfolio is important, for an ALM manager, the net value of the portfolio is important as both economic value as well as accounting value is of concern to the ALM
manager. For risk management, limits are prescribed for fall in value due to adverse change in interest rate so as to keep the negative impact at the minimum.
In banking industry ALM is a very complex process as it consists of millions of assets and liabilities of different time period, varying rate of interest with different re-pricing nature and also having different residual/behavioural maturity. Hence banks should be very vigilant in measuring and managing interest rate risk.
Interest Rate Risk (IRR) can be viewed from two perspectives;
1.Its impact on earnings of the bank due to holding assets and liabilities and off balance sheet items with different maturity dates or re-pricing dates.
2.Its impact on the economic value of the bank’s assets, liabilities and off balance sheet positions through GAP Analysis.
Basis Risk
A gap or mismatch risk arises from holding assets and liabilities and off balance sheet items with different maturity dates or re-pricing dates, thereby creating exposure to unexpected changes in the level of market interest rates. For example: an asset maturing in two years at a fixed rate of interest have been funded by a liability maturing in six months or a liability maturing over a period but getting re-priced periodically. The interest margin would undergo a change after six months/re-pricing period, causing variation in net interest income.
The risk that the interest of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as Basis risk.
Example : In a 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.
The degree of Basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. The Loan book in India is funded out of a composite liability portfolio and is expected to a considerable degree of basis risk
The basis risk is quite visible in volatile interest rate scenarios. When the variation in market interest rate causes the NII to contract, the basis has moved against the banks.
In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. treasury bills’ yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curve would affect the NII.
Embedded Option Risk
When a liability raised at a rate linked to say 91 days Treasury bill is used to fund an asset linked to 364 days treasury bills. In a rising Interest rate scenario both, 91 days and 364 days treasury bills may increase but not equally due to non-parallel movement of yield curve creating a variation in net interest earned.
Significant changes in market interest rates create the source of risk to banks’ profitability by encouraging prepayment of cash credit/demand loan term loan exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their
stated maturities. The embedded option risk is becoming a reality in India and is expected in volatile situations.
The higher and faster the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks’ NII. The result is reduction of projected cash flow and income for the bank.
Measurement of Interest Rate Risk: GAP ANALYSIS
The Interest rate risk can be measured and managed by assessing the position of risk sensitive assets and liabilities. Banks do Gap analysis by grouping rate sensitive liabilities, assets and off balance sheet positions into time buckets according to residual maturity or next re-pricing period, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. All investments, advances, deposits, borrowings, purchased funds etc. that mature/re-price within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the bank expects to receive it within the time horizon. This includes final principal payment and interim instalments.
Certain assets and liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are re-priced at pre-determined intervals and are rate sensitive at the time of re-pricing. While the interest rates on term deposits are fixed during their currency, the advances portfolio of the banking system is basically floating. The interest rates on advances could be re- priced any number of occasions, corresponding to the changes in Prime lending rate. To evaluate earnings exposure, interest rate sensitive liabilities in each time band are subtracted from the corresponding interest rate sensitive assets to produce a re-pricing ‘gap’ for that time bucket. This gap can be multiplied by an assumed change in interest rates to yield an approximation of the change in net interest income that would result from such an interest rate movement. The size of the interest rate movement used in the analysis can be based on variety of factors, including historical experience, simulation of potential future interest rate movements, and the judgment of bank management.
A negative or liability –sensitive gap occurs when liabilities exceed assets (including off balance sheet positions) in a given time bucket. In other words, an increase in market interest rates could cause a decline in net interest income.
A positive or asset sensitive gap occurs when assets exceed liabilities. This means that a decrease in market interest rates could cause a decline in net interest income.
GAP ti = Rate Sensitive Assets (RSA) ti - Rate Sensitive Liabilities (RSL) ti Where; ti is for ith time bucket
If RSA > RSLs of the bank as a whole, then GAP is Positive, Bank is called Asset Sensitive
If RSA < RSLs of the bank as a whole, then GAP is Negative, Bank is called Liability Sensitive
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). The Gap can, therefore, be used as a measure of interest rate sensitivity.
The Management of banks has to base their business decisions on a dynamic and integrated risk management system and process, driven by corporate strategy. To achieve
RISK MANAGEMENT IN BANKS
these objectives, it is essential that banks have to monitor, maintain and manage their assets and liabilities portfolios in a systematic manner taking into account the Interest rate risk involved in these areas.
Illustration: Interest Rate Sensitive Gap
days to 3 months 3,319.5512,036.66-8,717.11-13,969.81
3 months to 6 months 3,350.049154.08-5,804.0419,773.85 Over 6 months to 1 year18,930.11 6,576.9112,353.20-7,420.65
1 year to 3 years 14,393.728,109.836,283.89-1.136.76
3 years to 5 years 5,513.334,115.671,397.66260.90
5 years 5,773.274,211.561,561.71,822.61
The above table depicts that the bank have short term negative gap and long term positive gap. Considering the cumulative gap of one year is 7,420.65 crore. If the short term interest rate increases by 1%, the Net Interest Margin of the bank will be reduced by 74.20 crore. Bank can eliminate liability sensitive gap by extending the liability maturity or shorten the asset maturities so that refinancing risk (arising due to refinancing need for long term assets by borrowing funds at a higher rate of interest from the market) can be mitigated.
If in above case rate sensitive assets were greater than rate sensitive liabilities for a period of one year, the bank with decrease in interest rate would have gained lower net interest margin. This positive asset sensitive gap would have exposed the bank to reinvestment risk as assets at the date of maturity need to be reinvested at lower rate of interest. Hence the bank can mitigate reinvestment risk by extending the maturity of assets or shortening the liability maturities.
3.
Credit Risk
The definition in a layman’s language is essentially the risk that a loan will not be repaid or that a borrower will be unable to make payment of interest or principal in a timely manner.
The exposure of Credit Risk of banks varies depending on effectiveness of:
1.Loan Policy
2.Credit Monitoring Policy
3.Real Estate Policy
4.Credit Risk Management Policy
5.Collateral Risk Management Policy
6.Recovery Policy
7.Treasury Policy
Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to meet its obligations in accordance with agreed terms. It is the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or a counterparty to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio arising from actual or perceived deterioration in credit quality.
Credit Risk is made up of two components:
1. Risk Transaction Risk (Default Risk), which represents the risk arising from individual credit exposure
2. Portfolio Risk , which represents the risk inherent in the portfolio of credit assets (concentration of assets, correlation among portfolios, etc.)
For most banks, loans are the largest and the most obvious source of credit risk; however, credit risk is found in varieties of transactions across the banks’ portfolio including in the banking book and in the trading book, and both on and off balance sheet. Banks increasingly face credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, inter-bank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options and in guarantees and settlement of transactions.
Banks frame their credit risk policy to achieve the following key objectives:
Monitoring concentration risk in particular products, segments, geographies etc. thereby avoiding concentration risk from excessive exposures to any particular products, segments and geographies.
Assisting in building quality credit portfolio and balancing risks and returns in line with bank’s risk appetite.
Tracking credit quality migration on a regular basis.
Determining how much capital to hold against each class of the assets.
Undertaking Stress testing to evaluate the credit portfolio strength.
To develop a greater ability to recognize and avoid potential problems.
Alignment of risk mitigation strategy with business objectives in adherence to RBI’s guidelines.
The goal of credit risk management is to maximize a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio, as well as, the risk in the individual credits or transactions.
Loan Review and Risk Migration
Prior to extending a credit a bank (or any other lender) has to obtain all required information about the borrower. This is done through a proper scan of the borrower’s annual income, existing debts, ownership of house etc. A standard formula is applied to the information extracted to produce a number called the Credit score. Based on this credit score, the lending firm decides whether or not to extend credit.
162 RISK MANAGEMENT IN BANKS
After sanction of the credit limit, banks need to evaluate the performance of the borrowal accounts and assess the financial health of the credit portfolio. The loan review mechanism gives an indication of the risk migration and reliability and robustness procedure used at the time of assuming credit risk. In assessing credit risk from counterparty (the uncertainty in counterparty’s ability to meet obligations), an institution must consider 3 issues –
Default Probability – The likelihood that the counterparty will default on its obligation over the life of its obligation.
Credit exposure – The size of the outstanding obligation in the event of default.
Recovery rate – The fraction of the exposures that can be recovered through bankruptcy proceedings or other forms of settlement, in the event of default.
In the rating process to assess credit risk, the first step should be examination of the character of the applicant/promoter including integrity, honesty and values. The credit should be granted with due diligence and detailed insight into the customer’s circumstances and of specific assessments that provide a context for such credits. The credit facility should be granted based on the customer’s credit worthiness, capital base or assets to assure that the customer is able to substantiate the repayment. Due regard should be placed to the industry in which customer is operating the business specific risks and management capability and their risk appetite.
The forms of credit risks associated with large Institutions are often complicated and unique. The term Credit analysis is used to any process for assessing the credit quality of such firms. The credit analysis of a firm is done through the review of its Balance sheet, Income statement, recent trends in the industry, economic environment etc. Based on the information extracted, the credit analyst assigns the counterparty a credit rating which is used for making credit decisions. Credit Analysis is an ongoing process applicable at each transaction level. The prime objective of managing credit risk at each transaction level is development and evaluation and monitoring system that covers the entire life cycle of the exposure i.e.; opportunity for transaction, assessing credit risk, granting of credit, disbursement and subsequent monitoring, identifying the obligors (corporate, SMEs, trader and schematic loans such as home loan, personal loan, etc.) with emerging credit problems, remedial action in event of credit quality deterioration and repayment or termination of the obligation.
Many banks, insurance companies, investment managers etc. hire their own credit analyst for preparing credit ratings for their internal use. Certain agencies like Standard & Poor, Moody’s & Fitch etc are in business of developing credit ratings for use by investors, lenders and third parties. Banks should have a keen awareness of the need to identify measure, monitor and control credit risk, as well as, to determine that they hold adequate capital against these risks and they are adequately compensated for risks incurred.
