Module3: Risk Management

 Syllabus

1. Types of Risk

2. Risk Management Process in Banks

3. Risk Management Framework 

4. Three lines of Defence

5. Risk Apetite Setting

For Financial Risks the risk reward ratio works. Like if we give loan to a low rated borrower we charge more rate of interest and if we invest in a stock which is highly volatile we expect more returns. But the Risk reward ratio does not work for non-financial risks. 

What is Credit Risk- Possibility of Loss due to default by a counterparty or possibility of loss due diminution in the credit quality of borrowers or counterparty. 

What is Market Risk- Possibility of loss due to change in Market Variables. Market variables are Interest Rate, Exchange rate, equity Price and commodity Price. 

OPerational Risk - Possibility of default due to inadequate/failed Internal process, people, systems, or external events. 

Other Material Risks under Basel Pillar 2

1.Liquidity Risk:

Liquidity represents the ability to maintain statutory prescriptions, meet contractual and maturing cash outflows and profitably deploy surplus cash.  Liquidity risk arises when a bank or financial institution is unable to meet both expected and unexpected cash and collateral obligations and fund increase in assets at a reasonable cost without incurring unacceptable losses. Bank liquidity has two interrelated dimensions: funding liquidity or ability to get funding from the market and market liquidity when bank is not able to sell its assets.

 

Under normal circumstances liquidity management is basically a cost benefit trade off. For funding its obligations a bank may either mobilize funds from the market at the prevailing rates or hold some liquid assets in its portfolio. However,  if it holds liquid assets there would be a cost in terms of getting lower returns.

 

In a crisis situation, specific to a bank, its ability to raise funding gets severely restricted because market participants may not be willing to provide funds even at a higher rates. But, in a systemic crisis bank may not even be able to sell its assets.

 

In a bank, liquidity or the ability to fund increase in assets and meet obligations as they fall due is critical to the ongoing viability. The solvency of a bank is closely associated with the liquidity of the bank. Effective liquidity risk management helps ensure a bank’s ability to meet its obligation as and when they fall due and reduces the probability of developing an adverse situation for the bank.

 

2.Credit Concentration Risk: 

Risk arising from an uneven distribution of counterparties in credit or from a concentration in industries which may generate losses large enough to jeopardize the Bank‘s position.

 

3.Country Risk:

Risk arising out of Political, Social and Economic factors which can impinge on a country‘s capacity, ability and willingness to honor its international off- shore obligations.

 

4.Compliance Risk:

Risk  of  legal  or  regulatory sanctions,   monetary penalty or loss of reputation, a bank may suffer as a result of its failure to abide by the regulations, laws, rules, standards and internal codes of conduct applicable to it.

 

5.Interest Rate Risk:

It refers to fluctuations in Bank‘s Net Interest Income and the value of its assets and liabilities arising from internal and external factors.

 

6.Cyber Risk:

It represents the possibilities of circumventing/ exploiting weak technologies, processes and practices.

 

7.Talent Risk:

Talent (Human Resources) Risk is the risk arising from employee attrition, absenteeism, competency gap, lack of productivity, lack of motivation or inadequate training.

 

8.Reputational Risk:

It is the risk of damage to the reputation, name or brand of the Bank arising directly from the organization or indirectly from the actions of the employees and associated parties such as joint ventures / subsidiaries, resulting in an impact on the earning.

 

9.Contagion Risk:

It is defined as the current and prospective risk to earnings or capital by which liabilities, losses or events affecting a particular legal entity (primary entity) may affect another legal entity within the Group, resulting in loss or risk of loss to that other legal entity.

 

10.Pension Obligation Risk:

Pension Obligation Risk is the risk to the Bank‘s Employee’s Pension  Scheme and  financial  condition  arising  from  an underfunded Defined Benefit Pension Plan.

 

11.Residual Risk:

Risk arising due to inappropriate valuation, deterioration in quality or unclear title to the properties accepted as collateral by the Bank. These are the risks arising from use of Credit Risk Mitigation techniques and are not fully covered under Pillar 1 Credit Risk Capital.

 

12.Model Risk:

It is the risk of error in estimated risk measures   due   to inadequacies in the models. It relates to the risk of inaccurate assessment of underlying risks arising   from inappropriate model   development or calibration.

 

13.Strategic Risk:

Strategic Risk is the risk of current or prospective impact on the Bank‘s  earnings,  capital  or  standing  arising from  the strategic  decisions, improper implementation of decisions or failure to respond to changes in the competitive environment, business cycles, customer preferences, product  innovations, execution and/ or other intrinsic risks of business impacting the ability of the Bank to meet its objectives.

 

14.Settlement Risk:

The risk that a transaction is not settled as expected through a settlement system. It comprises credit risk elements, treasury transactions etc.

 

15.Securitization Risk:

Risk arising from securitization deals in which  bank  acts  as a protection buyer or a protection seller.

 Risk Management is defined as the process by which organizations try to identify risk, measure and assess risk. Mitigate and control risk, monitory and report risk. 

For credit risk we use PD- probability of default or EAD- Exposure at default or LGD- Loss Given default to measure and asses risk. For Market Risk we use VAR Value at Risk and modified duration. For operational risk Loss data and tools such as RCSA- Risk and Control Self Assesment are used to asses and measure risk. 

Mitigation and control is achieved through setting up limits. Limits such as Exposure limit for credit risk. There could be individual exposure limits or sectoral exposure limits or even country exposure limits. For Market Risk as well there could be exposure limits such as Value at Risk limit or Stop Loss limits for trading. Hedging that is doing an equal and opposite deal is also used for mitigation of market risk. For operational risk mitigation and control can be achieved through setting up Business Continutiy Plans or BCP's through trainings or thorugh insurance. 

Under monitoring the limits that have been set are monitored. Alerts are issued by Risk Management department if the limits are breached. Reporting is done to the top management and to the regulator by the risk management department. Reporting helps in decisions making by the top amangement. 

Setting the risk apetite for the bank consists of both a qualitative statement and a quantitative limit setting. 

The qualitative Risk appetite defines the Banks Risk Taking Philosophy in terms of which businesses/ sectors the Bank will be venturing into and which businesses or sectors the Bank will avoid. So a Bank’s Risk Appetite may state that: The bank will be financing Personal Loans, Auto Loans, Home Loans and small business loans. The Bank will not go into financing of Long gestation Project Loans. The Bank will not be dealing in Complex Derivatives.

For quantitative risk apetite setting two approaches are followed: - 1. Top Down 2. Bottom up.

For the quantitative Risk appetite setting. 2 approaches are followed: Top-Down approach and Bottom-Up approach. In the Top-Down Approach, we start with the Capital available with the Bank. Bank works out the percentage of capital it is willing to put at risk, which will be the Risk Appetite for the Bank. Then this Risk Appetite is further distributed among different business verticals and segments.

Alternatively, a Bottom-up approach may be followed. In this approach Risk Appetite is decided at the lowest level, say at trader desk level and then these are added up to arrive at the risk appetite for a segment or a vertical which are then summed up to arrive at the Bank Level risk Appetite. Methodologies such as Value at Risk or VaR are very useful in setting up and allocation of Risk Appetite.