1 Risk Management and Transfer Pricing by G. V. Nageswara Rao, CEO Commercial Banking, IDBI at FICCI-IBA Conference on Global Banking: Paradigm Shift, October 5, 2005

2 Risk Management Philosophy Not just compliance  Risk Management is more than compliance - it is about building value by optimising rather than minimising risks Value creates shareholder wealth Risk creates opportunity Opportunity creates value Risk management is not about avoiding risk. It helps you be aware of the risks inherent in your business and take advantage of this knowledge to gain competitive advantage and enhance shareholder value

3 The Changing Risk Paradigm A decade of advancement  Competition  Precise measurement of risks becomes necessary to win in a highly competitive world  Evolution of Risk Products  Enables decomposition of risks. Construction of desired risk- return payoffs brings a new paradigm.  Trading in Risk Products  Enables transfer and pricing of risks. Dynamic management of risk portfolio becomes possible.  Advances in Modelling  Measurement and management goes scientific

4 Building ERM Capabilities Gaining a strategic advantage Risk Management Sophistication Maximize Earnings Potential Earnings Stability Protection Strategic Advantage Control Shareholder Value Objective Identification of risks Consistent measurement across risks Linking risk and return Measuring risk adjusted business performance Evaluating value creating business Investing capital in successful businesses

5 Funds Transfer Pricing Aids measurement of risks and returns  The way we determine where risk is located is by using transfer pricing  Key tool to understanding sources of profitability and risk; whether return justifies risk  Transfer Price – 1. For Services 2. For Funds  NII analysis by product, customer, branch, channel, market segment, business line, geography or other management unit  Measurement of profits Asset units: Interest Revenues, FTP Cost, Direct Fixed Costs, Direct Variable Costs, Credit Cost, Indirect Allocated Costs Liability units: FTP Revenues, Interest Cost, Direct Fixed Costs, Direct Variable Costs, Indirect Allocated Costs  The major units include: lending units, deposit-taking units, trading units and ALM Desk

6 Stripping of Interest Rate Risk Active ALM and measurement of P&L  Most popular FTP mechanism is on matched maturity basis  Choice of FTP curves  FTP fixed for maturity of asset or liability  Business units are insulated from maturity mismatches  ALM Unit responsible for management of gaps  ALM P&L shows results of interest rate risk in banking book  Tools in the hands of ALM Unit Gap limits Gap funding Hedging Control over FTP  Serious limitations arise in practice

7 FTP Curves No perfect solution  Market benchmarks  Treasury Curve  Swap Curve  Cost of Funds  Actual or proxy/target  ALM unit or ALCO determined

8 RAROC as a pricing guide Keeps focus on required return  RAROC = Adjusted income / Economic Capital  Adjusted income = NII + Fees – Expected Loss – Operating Costs  Economic capital = Capital required to support the risk, in line with institution’s target credit rating  Measurement of Credit Cost  Expected loss = PD x EAD x LGD  RAROC  At individual credit level  At portfolio level – branch, region, bankwide

9 Clear Articulation of Objectives Needs to drive right behaviour  FTP can easily become very complex, can result in unproductive arguments, can drive wrong behaviour  Objectives need to be well-defined  Unnecessary complexity needs to be avoided  Over-analysis and very frequent reporting does not help  Basis, utility and limitations should be made clear to business managers  Should be only one of the factors to evaluate performance

10 Thank you for your attention