1. TO & RM UNIT 3 RISK MANAGEMENT KEY RISKS RISK MGMT. & CONTROL RISK PROCESS-RISK ORGANISATION (5 Lect.)

2. Understanding Risk Management Objective # What is Risk # Its impact on Return & Capital # Risks in banking business #Types of Risks #Portfolio Risk # Can we control & manage the Risk in the banking business

3. RISK MANAGEMENT - INTRODUCTION PART - I

4. What is Risk Uncertainty, danger; may arise in any activity Keeping an appointment; Reaching class in time Uncertainty resulting in adverse outcome Financial Risks are uncertainty resulting in adverse variation in profitability or even loss of capital/ investment In business – risks due to a number of factors

5. What is Risk Lower risk means lower variation in expected returns and higher risk means higher variation Zero risk means no variation in the return Higher risk means either high variation on the positive side or high variation on the negative side. It means either higher profit or higher loss. Comparing returns on two investment options with varying risks is not correct.

6. What is Risk Key driver for managing a business is seeking enhancement in Risk Adjusted Return On Capital ( RAROC )

7. Risk In Banking Business Risk taking is natural in banking Financial Intermediation Risk is also an event which can cause damage to institution’s income or even reputation Risk is UNAVOIDABLE With globalisation, chances of risks have multiplied Concepts like identify, prevent, mitigate, measure, monitor risks are being talked about

8. Risk In Banking Business - Variety of banking business Corporate finance – financing, merchant banking, advisory services, mergers & amalgamation, securitisation, govt. debt, syndication, IPO, private placement, underwriting Trading & Sales - market making, Treasury, Investments in securities, equity, repos, brokerage Retail banking – retail lending & deposits, banking services, private banking, wealth management, card services, investment advice,

9. Risk In Banking Business - Variety of banking business Commercial banking – project finance, real estate, export finance, factoring, leasing, letter of guarantee, letter of credit, bill finance Payments & Collections, clearing & settlements Agency services - depository receipts, securities lending, custody of documents Asset Management – pooled, segregated, retail, institutional

10. KEY BANKING RISKS PART _ II

11. CREDIT RISK Customers default/fail to service debt, leading to total/partial loss. Customer gets downgraded How to estimate the credit risk of overall portfolio of loans and all the transactions? CREDIT RISK is potential of a bank borrower or counter party to meet obligations as per agreed terms. Loans are the most obvious source of credit risk

12. CREDIT RISK COUNTER-PARTY RISK : It is another variant of credit risk. It is related to non performance of the trading partners due to counterparty’s refusal and or inability to perform. COUNTRY RISK: It is also a type of credit risk where non-performance is on account of a borrower or counter party due to a constraint imposed by a country

13. MARKET RISK MARKET RISK: Risk of adverse deviations in the value of trading portfolio due to market fluctuations, during the period required to liquidate the transactions. Variation in the price of securities, shares, commodities and currencies due to market fluctuations. Market risk is also referred as Price Risk

14. MARKET RISK FOREX RISK: It is the risk that a bank may suffer due to adverse movement in foreign exchange rates. MARKET LIQUIDITY RISK: This risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

15. INTEREST RATE RISK INTEREST RATE RISK (IRR): It is the exposure of a bank’s financial position due to adverse movement in the interest rate. In other words, it is the impact on Net Interest Income or Net Interest Margin It can be viewed as the impact on earnings of the bank or impact on the economic value of the bank’s assets and liabilities

16. INTEREST RATE RISK IRR-MISMATCH RISK: This arises due to holding of assets & liabilities with different principal amounts and different maturity dates. This causes exposure to unexpected changes in market interest rates. IRR-BASIS RISK: In a rising interest rate scenario, asset interest rate may rise in different magnitude than the interest rate on corresponding liabilities.

17. LIQUIDITY RISK LIQUIDITY RISK (LR): It arises from funding of long term assets from short term liabilities. LR-FUNDING RISK: It is the inability to obtain funds to meet cash flow obligations which may arise out of unanticipated withdrawals. LR-TIME RISK: Arises from need to compensate for non receipt of expected inflows. LR-CALL RISK: When a bank loses chance to do a profitable business due to lack of liquidity.

18. OPERATIONAL RISK OPERATIONAL RISK (OR): It is a risk that leads to losses due to failure of internal systems, policies & procedures, people, external events. OR-TRANSACTION RISK: It may arise due to fraud, competence issues, communication issues, inability to maintain proper processes. OR-COMPLIANCE RISK: Risk of loss that a bank may suffer for non compliance of legal and regulatory guidelines, code of conduct & professional integrity.

19. OTHER RISKS STRATEGIC RISK: It arises due to lack of proper response to a business situation. This risk is a function of the compatibility of organisation’s strategy towards achievement of its goals. REPUTATION RISK: It is the risk arising from the negative opinion of public. This risk may expose the institution to litigation, loss of customer base and financial loss.

20. RISK MANAGEMENT PROCESS & RISK ORGANISATION PART-III

21. RISK MANAGEMENT PROCESS THE PROCESS involves: a) Risk Identification b) Risk Measurement c) Risk Pricing d) Risk Monitoring & Control e) Risk Mitigation Approach to manage risk at transaction level & at aggregate level. Aggregated risk of the organisation is called Portfolio Risk. This may comprise of all risks in transactions as discussed.

22. RISK MANAGEMENT PROCESS RISK IDENTIFICATION – Sources Of Risks:  Decision/Indecision  Business cycle/Seasonality  Economic/Fiscal changes  Market Preference  Political Compulsions  Regulations  Competition/Technology

23. RISK MANAGEMENT PROCESS RISK INDICATORS: Lack of……  Supervision of lending/investment  Policy for lending/treasury ; implementation  Code of conduct; its implementation  Accountability  Expertise in certain transactions entered

24. RISK MANAGEMENT PROCESS  RISK INDICATORS  Too much emphasis on profits/ no care for risk  High rate high risk investment  Defective documentation  Improper credit analysis  End use of funds not monitored  Improper mix in credit portfolio

25. RISK MANAGEMENT PROCESS RISK MEASUREMENT:  Reliance on quantitative measure of risk by capturing variation in earnings, market value of the assets & liabilities, losses due to defaults, etc.  Quantitative measures of risks are of 3 types: * based on sensitivity * volatility based * based on downside potential

26. RISK MANAGEMENT PROCESS RISK PRICING:  Impact on banks of banking transaction risks is in two ways – maintain necessary capital and it has a cost – is the transaction so profitable that it can provide additional capital  The second impact is probability is te probability of loss.  Risk pricing involves inclusion of these factors

27. RISK MANAGEMENT PROCESS PRICING therefore takes into account:  Cost of deployable funds  Operating expenses  Probability of loss quantum  Capital charge on account of transaction

28. RISK MANAGEMENT PROCESS RISK MONITORING & CONTROL:  To take a balanced approach on Risk & Return  To have an organisation structure  comprehensive risk measurement approach  Risk management policies consistent with business strategies  Guidelines to govern risk taking with limits  Strong MIS, laid out procedure & reporting  Periodic review & evaluation

29. RISK MANAGEMENT PROCESS RISK MITIGATION:  Have strategy to eliminate & reduce risks  For mitigating credit risks, collateral security or third party guarantee is taken  Credit derivatives are taken to mitigate cr risk  For Interest Rate risk – Interest rate swaps  For Forex risks – forex forwards, options or futures  Mitigation reduces downside variability

30. RISK MANAGEMENT PROCESS THE RISK PROCESS - SUMMARY:  Identify risk by functional area  Categorise Risk by Risk Profile  Anticipate the direction of the risk  Monitor Risk through established systems  State policy and procedure to identify risks:

31. RISK ORGANISATION Board of Directors Chairman & CEO Chief Risk Officer Risk Officers at functional divisions Functional Heads like treasury, credit, technology, Audit etc. Operating Management