Risk Management in Banks Risks Faced by Banks • • • • • • Liquidity Risk Credit Risk Interest Rate Risk Market Risk Operational Risk Asset-Liability Management address the risks arising due to the maturity mismatches between Asset and Liabilities N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 2 Risks because of Intermediation • • • • • • lending and deposits traditional banking "Banking Portfolio" NII or Interest Margin generally unbalanced => great degree of uncertainty –Liquidity Risk –Interest Rate Risk –Credit Risk N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 3 Risks because of Treasury Operations • • • • • • • "Market Portfolio" earnings carry, coupon, dividend capital appreciation mark-to-market Credit Risk Market Risk Equity Fixed Income [ function of interest rates ] N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 4 Risks because of Off-Balance Sheet items • • • • Credit Limits Credit Lines Guarantees Derivatives N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 5 Banks Balance Sheet • Liabilities Capital L T Debt Deposits Current Savings Fixed Floating Rate • Assets Cash/Bank/RBI Loans /bills etc Fixed Rate Floating Rate Investments Bank Book Trading Book Fixed Income Securites Equity I Bk Borrowings Others N. R. Bhusnurmath MDI Gurgaon I Bk Assets Fixed Assets / Others Risk Management in Banks 6 Liquidity Risk • Liquidity risk is inherent in the banking business • This arises because: – banks offer extreme liquidity on their liabilities (deposits are with-draw- able on demand) – Cash-Credit Facility or Revolving Credit Facility allows customers to withdraw or deposit funds whenever they want & without any prior warning or intimation – whereas assets are not liquid – Cash flows on account of Deposits & Cash-Credit Limits are not predictable N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 7 Interest Rate Risk Interest Rate Risk • Affects Banks in two ways • Affects the Net Interest Income (NII) • Affects the Market Value of the Fixed Income Securities in the Investment Portfolio of the banks • Complication : • When interest rates are marked down they have to be marked down on loans & advances priced at floating rate but existing deposits continue at the old (higher) rates • When interest rates are marked up only loans & advances priced at floating rate are marked up and price of all deposits goes up because of “pre-mature repayment option” N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 9 Asset Liability Maturity Mismatch • 100 million term deposit for 2 years used to make a loan for 3 years • Deposit @ 9% and loan @ 10% • At the end of 2 years, if deposit rates are 11%, bank stands to lose • Problem because of maturity mismatch • Can we match maturities of deposits and loans? • What about CASA and CC? • Interest rate risk • How to manage? – Gap are monitored and hedged N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 10 Interest rates go up…… • Should NBI Bank raise interest rates on loans and advances? • Should NBI Bank raise interest rates on deposits? • When does NBI Bank benefit? • What happens to existing deposits? • What happens to term loans? • Fixed and floating rates of interest. N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 11 Interest Rate Risk • Net Interest Income (NII) is affect by interest rate changes • Gaps based interest rate risk management – Rate Sensitive Liabilities (RSL) & Rate Sensitive Assets (RSA) – Assets & Liabilities @ floating rate are affect immediately – Fixed rate assets and liabilities are affected on date of maturity – Interest rate sensitivity matrix -Time buckets’ gaps – These gaps are then managed • Interest rate swaps to hedge • Or leave the gaps open in favourable interest rate movements N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 12 Interest rate risk on other assets • • • • Investments mainly fixed income Interest rate goes up market value falls! How to avoid this? Duration of the bonds N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 13 Interest Rate Sensitivity Gaps 1 m 1-3m 3-6m 6m-1y 1-5yr >5yr Non-Sen Capital Deposits Borrowings Others LIABILITIES Cash etc Investment Advances Lendings Assets FRA/Swap GAPS N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 14 Interest rate and investments • Investments portfolio of banks largely bonds • Market value of bonds inversely related to interest rates • So if interest rates rise, value of investments portfolio falls • Mark-to Market losses • How to manage this? • Banks cannot sell of the bonds because of SLR requirements • Duration of a bonds is a measure of its price sensitivity to interest rate changes • Change in price per basis point increase in interest rate • So banks should move from high duration to low duration bonds in case rates are expected to rise N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 15 Using P P P P 1* 1 + 2 * 2 + 3 * 3 + ... + n * n = duration D P P Concepts P P Duration ΔP Δi = D* (1 + i) P Δi ΔE = (-) * Dgap * A * (1 + i ) where N. R. Bhusnurmath MDI Gurgaon L D A - DL * = Dgap A Risk Management in Banks 16 Managing Credit Risk N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 17 Credit Risk • Default Risk • Borrower may not pay on time or may not pay interest or may not pay full amount or may not pay at all • Most important risk for banks as 50-65% of the assets are Loans & Advances • Can we prevent defaults? • An we lend to only those who will definitely repay? • Can we predict defaults? • Willful and non willful defaults. N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 18 Components of Credit Risk • Default Risk – Risk that a borrower or counterparty is unable to meet its commitment • Portfolio Risk – Risk which arises from the composition / concentration of bank’s exposure to various sectors • Two factors affect credit risk – Internal Factors – Bank specific – External factors – State of economy, size of fiscal deficit etc. N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 19 Basics of credit risk management • Appraisal – Borrower • Financial statements • Market intelligence • Rating .. External & Internal….Scoring models – How much - DSCR (Financial modeling), estimation of CC limits • Security – primary & secondary – Intangibles ? • Kingfisher brand • Personal guarantee • Documentation N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 20 Once the loan has been disbursed • Post sanction monitoring – Proper use of funds – Conduct of the account – Information • Formal …Stock statements • Informal – Market intelligence – Labour trouble – Maruti Suzuki – Board & Management issues – Warning signals • Delays in payments – solvency issues • deterioration of borrowers rating N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 21 If things go wrong ? • Recognition of NPA’s & provisioning • Reconstruction, rescheduling, turnaround …?? • Recovery – Costly litigation – Security …do they have any value? • Resolution – Is it better to get something atleast? • Sale of NPA’s – ARC’s – At what haircut? • Write-off N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 22 Basel Norms • Till early 1990’s regulation concentrated on the inherent liquidity risk – Cash - CRR – Liquid assets –SLR – Capital was necessary but not critical • Borrowers may default or loans may go bad… • Write off of loans - debit to P&L A/c – ie absorbed by the income of that year • If bad loans are more than the income? – Accumulated loss • • • • If loans go bad does the bank have enough capital to absorb the loss? How much capital? Minimum capital linked to the loans portfolio- risk weighted assets Subsequently market risk (investment portfolio) & off-balance sheet items included N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 23 Basel 3 • RWA = Exposure * risk weight • Who should fix the risk weights? • Basel 2 - three pillars – Internal Rating- model based on banks’ own data – Regulatory validation of the internal rating model – Market will reward or punish – disclosures • Basel 3 – response to credit crisis – Leverage ratios, minimum equity capital, capital buffer, liquidity ratios N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 24 Expected Loss - Three Components EXPEC TED LOSS Rs. N. R. Bhusnurmath MDI Gurgaon = Probabili ty of Default (PD) % What is the probability of the counterparty defaulting? Loss x Given Default (Severity )% If default occurs, how much of this do we expect to Risk Management in Banks lose? x Loan Equivalent Exposure Rs If default occurs, how much exposure do we expect to have? 25 Credit Risk Rating Framework • Use of credit rating models and credit rating analysts • Loans to individuals or small businesses, credit quality is assessed through credit scoring which is based on a standard formulae which incorporates party’s information viz. annual income, existing debts, other details such as homes (rented or owned) etc. N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 26 Recognition of asset quality • Prevalent measures to recognise quality of the risk assets are mainly found to be based on aging of the loan defaults which is mandated by the regulatory provision. Beyond this, banks are not following other measures to recognise the asset quality. They are not taking qualitative as well as other quantitative measures to check the impairment in such assets and recognise their quality prudently for the proper classification and adequate provisioning for the loss given default on such assets. N. R. Bhusnurmath MDI Gurgaon Risk Management in Banks 30