Transcript Overview of Risk Management - CAB

Overview of Risk Management
N. Gopal
Deputy General Manager & MoF
RBI, CAB , Pune
RISK
WHAT IS RISK ?
The probability of a loss or damage in the event of
an untoward or unexpected event happening.
Probability of an untoward event
Loss on account of the untoward event
Possibility of the real outcome being different from the expected
outcome
Derived from the Latin word “Rescum”- risk at sea
Also said to be from the Italian word “Riscare” to dare
Risk is in inherent in any walk of life in general and in
the financial sector in particular
RISK AND RISK MANAGEMENT
Why talk of risk and risk management now ?
 Was banking not in existence a century ago ?
 De-regulation, Globalization, integration
 The regulators decided the banks liabilities and assets
 The regulators took decisions and the banks merely
implemented them
 No scope for risk taking in a regulated environment
 Closed economy limited exposure to international
banking
 Competition: Other things being equal, a bank which
manages its risk better would be the preferred bank

Business is the art of extracting money from other’s pocket,
sans resorting to violence. But profiting in business without
exposing to risk is like trying to live without being born.
A THOUGHT
RISK IS THE ONLY CONSTANT
UNCERTAINITY IS THE ONLY
CERTAINITY
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A FEW MORE OF IT

ALL OF BANKING IS MANAGEMENT OF
RISK……..NOT ITS ELIMINATION

RISK MANAGEMENT IS A CONTINUOUS PROCESS
AND NOT A ONE TIME ACTIVITY

BANKING IS A RISKY BUSINESS BUT RISK IS THE
BUSINESS OF BANKING

CURRENT RISKS ARE TOMMORROWS POTENTIAL
LOSSES

THE OTHER NAME FOR RISK IS, “OPPORTUNITY”
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RISK AND LOSSES
 Risk
has the potential to cause both expected and
unexpected losses having an adverse impact on the
bank’s capital and earnings.
Expected losses to be borne by the borrower through risk
premium or having to pay a higher price
 Expected losses also covered through provisioning/creating
reserves
 Unexpected losses to borne by the bank by allocating higher
capital

RISK MANAGEMENT ?
 Banks
no more a mere financial intermediary but a
risk intermediary
 Risk Management system is the pro-active action in
the present for the future.
 Risk management is all about
Identifying risk
 Measuring risk
 Monitoring risk
 Managing risk
 Mitigating risk

SCALE OF MEASURE
Certainty of occurrence
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No occurrence
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Mid point
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RISKS EXIST- WHAT IS THE WAY OUT
Banking has to be done despite the risks
 Without risk there is no reward
 Risks have to be taken but managed, controlled and
mitigated
 To manage risks:- Identify the risk, measure the risk,
 To control risks: Put in place a system of checks and
balances
 To mitigate risks: Stipulate covenants- hedge, stipulate
thresholds, have alternate flows

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PRINCIPLES OF SOUND RISK MANAGEMENT
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A thorough understanding of risks
Bank specific risk management framework.
A good risk management structure.
An independent & explicit risk management function
A comprehensive risk management policy
Identification of financial & non-financial risks.
Measure, Monitor & control the overall level of risks.
Hold capital commensurate with the overall level of risks.
Segregation of risk takers and risk managers (RMD / Midoffice/ LRM)
Committee approach rather than individual perception
(collective wisdom)
PRINCIPLES OF SOUND RISK MANAGEMENT
7.
Integrated approach for risk management.
a) Capturing all material sources of risks.
b) Participation by all concerned.
c) Integration of counterparty risk.
d) Integration of the risk management function
PRE-REQUISITES OF EFFECTIVE RISK MANAGEMENT
Organizational Structure
 Policy & Strategy
 Operations / Systems
 Existence of a robust MIS, consistent in quality
 Upgradation of the skills of staff
 Continuous evaluation and monitoring

Design of risk management functions should be bank
specific, dictated by the size, complexity of functions,
the level of technical expertise and the quality of MIS
ORGANIZATION STRUCTURE
Global trend- centralizing risk management with
integrated treasury management function
 Integrated structure: The risks are not independent
but to a great extent interdependent- Macro view
 Benefits-information on aggregate exposure, natural
netting of exposures, economies of scale and easier
reporting to top management

RISK MANAGEMENT POLICIES
A policy should include risk identification,
risk measurement, reporting and risk control /
mitigation techniques.
 Risk Management Policy
 Loan Policy (Credit Risk Policy)
 Market Risk Management Policy
 Liquidity Risk Management (ALM Policy)
 Operational Risk Management Policy
Approval and periodical review by Board reviewed periodically,
updated regularly depending on the external environment
BOARD OF DIRECTORS
Responsibilities
 Primary responsibility- understanding the risks run by the
bank and ensuring that the risks are appropriately managed
 Set risk limits by assessing the bank’s risk and risk-bearing
capacity
 Review the risk exposure limits from time to time to ensure
that the limits conform to the changes in business strategies,
addition of new products and changes in market conditions.
 Approve the overall business strategies and significant
policies including policy relating to managing and taking
risks.
Ultimate responsibility for the level of risk taken
by banks rests with the Board of Directors.
RESPONSIBILITIES OF SENIOR MANAGEMENT

Implementing business strategies in a manner that
limits risks associated with the strategy and ensure
compliance both with bank’s policies and regulations.

The senior management should ensure:
Requisite personnel with knowledge, experience and
expertise consistent with their nature of duties and volume
of operations are in position to manage the risks
 Risk managers have sufficient knowledge to understand
and operate within limits
 Employees have the integrity, ethical values to conform to
management philosophy and operating style.
 Day to day activities of risk managers/risk control
officers/heads of business lines are monitored.

RISK MANAGEMENT COMMITTEE (RMC)
A Board level sub-committee including the CEO, heads
of credit, Market & Operational risk management
Committees
 Independence of this Committee to be preserved.

Functions:
A. Devise policy & strategy for integrated risk
management
B. Coordinate between CRMC, ALCO, & ORMC
C. Make recommendations to Board
RISKS IN BANKING

Four major risks faced by banks
Credit Risk
Market Risk
Liquidity Risk
Operational Risk
Credit Risk?
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“Possibility of a borrower or a counterparty
failing to meet his/its obligation in accordance
with the terms of contract/agreement”
CREDIT RISK
Possibility of a borrower or a counterparty failing to
meet his/its obligation in accordance with the terms
of contract/agreement resulting in a loss”
“
Possibility of a borrower or counter party failing
Loss caused
Inability to fulfill obligation as per the terms of
contract leading to a possible loss
Features of credit risk:
Predictable part- contained through proper strategy
Unpredictable part- faced and overcome
CREDIT RISK

Two components of credit risk
 Quantitative- the balance outstanding – Default
 Qualitative- deterioration in the credit quality (short of
default) which might lead to default- Exposure

Credit risk is a combined outcome of Default Risk and
Exposure Risk.
Default is the extreme case- it does not happen
abruptly- quality deteriorates over a period of time- if
not addressed it turns into default
Why Manage Credit Risk
IMPORTANCE OF MANAGEMENT

Banking is all about intermediation
Deals with public money
Credit is the basic premise of banking
There can be no banking without lending
Credit risk is inherent to banking business

Some Fundamental issues involved in Credit Risk
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Solvency Aspect of Credit Risk
Liquidity Aspect of Credit Risk
Credibility Aspect of Credit Risk
Reputational Aspect of Credit Risk
Factors responsible for Credit Risk and How they
arise
WHAT ARE FACTORS RESPONSIBLE FOR CREDIT
RISK
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III.
External factors:
Changes in government policies- trade policy, fiscal
policy, import-export policy
Business Cycle- slow down in economy
changes in market variables-demand trends etc
Internal factors:
Management,
Unviable business model,
Financial mis-management
Settlement Risk
Un-rest
Product, process, people failure
Willful Default
WHAT ARE FACTORS RESPONSIBLE FOR CREDIT
RISK?
IV. Portfolio risk
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Adverse distribution,
Adverse concentration, Credit Concentration
Large exposure,
Correlation between industry sectors
HOW MAJOR CREDIT PROBLEMS ARISE
a)
b)
c)
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Weakness in Credit processing and monitoring
Credit decisions not taken on credit rating basis
compromising on inadequate global financial and
economic analysis data
Subjective decision making in cases of related
party lending
Not adopting stringent credit assessment and
appraisal standards
Globalization of credit market and competition
inducing time constraint that interferes with due
diligence process
Adoption of new credit techniques and products
without validation sacrificing due diligence and
benchmark financial norms
HOW MAJOR CREDIT PROBLEMS ARISE
g.
h.
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j.
k.
Absence of credit audit and credit review process
Indulgence to highly leveraged large borrowers
Breakdown of credit control mechanism leading to
credit related fraud
Non-recognition of downslide scenario and business
cycle effects in credit processing analysis and credit
risk rating
Absence of monitoring mechanism to detect early
warning signals (deterioration of borrower’s financial
condition or collateral values)
Market Risk?
MARKET RISK
 The
possibility that the value of on and off balance
sheet positions of a bank would be adversely affected
by movement in market variables such as interest
rates, equity prices, foreign exchange rates,
commodity prices resulting in depletion in earnings
and erosion of capital
 Adverse impact on the banks investment due to
movement in interest rates in the market.
MARKET RISK ELEMENTS
Interest rate risk- caused by movement of interest rates
up or down
 Arises when there is a mismatch between interest rate
sensitive assets and liabilities
 Impact of interest rate risk
 Immediate- Earnings- Net Interest income
 Long term- Economic value
 Sources of interest rate risk
 Re-pricing risk (arises due to timing mismatch)
 Basis risk (changing or shifting of the basic relationship)
 Yield curve risk
 Embedded risk or options risk

MEASURING INTEREST RATE RISK
 Static
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measure- Gap analysis, sensitivity analysis
Re-pricing gap modelsInterest rate sensitive Ratio- ISA/ISL
Risk to net interest income- Gap x change in rate x time over
which the periodic gap is in effect= Change in NII
EaR- Earnings at Risk
EVE –Economic Value of equity
VaR- Value at Risk
 Dynamic
measures- Modeling measure (Monte Carlo
simulation), scenario analysis, stress testing etc
MARKET RISK ELEMENTS
 Price

risk or equity price risk
Adverse impact due to movement of prices of assets up or down.
 Foreign

exchange risk or currency risk
Adverse impact due to movement of one currency vis-à-vis
another currency
 Commodity
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risk
Movement prices of commodities
MARKET RISK MANAGEMENT

Liquidity Risk Management
 Measuring & monitoring liquidity position of the bank
Stock Approach: Managing liquidity risk through threshold ratios
Flow Approach: Structural liquidity Statements, monitoring gaps in
flow
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Examining funding requirements
Contingency funding plan
ORGANIZATIONAL STRUCTURE- MARKET RISK
Asset – Liability Management Committee (ALCO)
 To be headed by CMD/CEO/ED and members- heads of
Investment, Credit, Planning, Treasury & IT
 Role:
 Product pricing for deposits & advances
 Decide on maturity profile
 Articulating interest rate view of the bank and deciding on
the future business strategy
 Reviewing & articulating funding policy
 Decide on transfer pricing policy
 Reviewing economic & political impact on the balance
sheet

ORGANIZATIONAL STRUCTURE- MARKET RISK
ALM Support Group (consisting of operating staff)
 Function:
 Analyzing, monitoring & reporting risk profiles to the
ALCO
 Prepare forecasts showing effects of various possible
changes in market conditions & recommend action needed
 Mid-Office
 Function:
 Independent monitoring , measurement, analysis of
market risk & reporting to ALCO

OPERATIONAL RISK
Risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events.
This definition includes legal risk, but excludes strategic
and reputational risk……………….BCBS
 This definition is based on the underlying causes of
operational risk and not on the outcome or consequence of
the risk
 why a loss happened and at the broadest level includes the
breakdown by four causes: people, processes, systems and
external factors.

DIMENSIONS OF OPERATIONAL RISK
CAUSE
Why did event happen?
Failed people, process, systems,
external
Factors..
Event
What happened?
Fraud, trade input error, system
failure, ..
Impact
What are the consequences?
Monetary loss, Reputation damage, etc
OPERATIONAL RISK MANAGEMENT
Various contributing factors for operational risks are:
 People Risk
 Process Risk
 Systems Risk
 Reputational Risk
 Legal and Regulatory Risk
 Event Risk - Operating Environment Risk (external
factors risk) unanticipated changes in external
environment other than macro economic factors.
ORGANIZATIONAL STRUCTURE- OPERATIONAL RISK
Operational Risk Management Committee (ORMC)
 Functions:
 Review of operational risk exposures across the bank
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mitigation of operational risk within the institution by the
creation and maintenance of an explicit operational risk
management process
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to take a cross-business view and assure that a proper
understanding is reached and actions are being taken to
meet the stated goals and objectives of operational risk
management in the bank
ORGANIZATIONAL STRUCTURE- OPERATIONAL RISK
Operational Risk Management Department (ORMD)
 Functions:
 responsible for coordinating all the operational
risk activities of the Bank, working towards
achievement of the stated goals and objectives
 building an understanding of the risk profile
 implementing tools related to operational risk
management
 working towards the goals of improved controls and
lower risk
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ORGANIZATIONAL STRUCTURE- OPERATIONAL RISK

Operational Risk Managers
It is expected that each business/ functional area will
appoint a person responsible to coordinate the
management of operational risk

Risk Managers will report to their respective
departments/businesses, but work closely with ORMD
and with consistent tools and risk management
framework and policy.
ORGANIZATIONAL STRUCTURE- OPERATIONAL RISK
Support group for ORM
 Functions:
 Work with ORMD and the departments/businesses
to identify, analyse, explain and mitigate operational
issues within their respective areas of expertise
 Assist in the development and review of appropriate
risk indicators, both on a bank-wide and business
specific basis
 Assist in the timely identification and recording
of operational loss data and explanations
 Ensure that all operational risk issues are brought to
the attention of ORMD and the Department/business.
 Assist the department/business in the design and
implementation of risk mitigation strategies.

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THANK YOU
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7/16/2015
Cyber Crime Week Pune