Risk Management in Banks
Risks Faced by Banks
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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
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Gurgaon
Risk Management in Banks
2
Risks because of Intermediation
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lending and deposits
traditional banking
"Banking Portfolio"
NII or Interest Margin
generally unbalanced
=> great degree of uncertainty
–Liquidity Risk
–Interest Rate Risk
–Credit Risk
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Gurgaon
Risk Management in Banks
3
Risks because of Treasury Operations
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"Market Portfolio"
earnings carry, coupon, dividend
capital appreciation mark-to-market
Credit Risk
Market Risk
Equity
Fixed Income [ function of interest rates ]
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Gurgaon
Risk Management in Banks
4
Risks because of Off-Balance Sheet items
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Credit Limits
Credit Lines
Guarantees
Derivatives
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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
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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
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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”
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Gurgaon
Risk Management in Banks
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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
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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.
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Gurgaon
Risk Management in Banks
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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
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Gurgaon
Risk Management in Banks
12
Interest rate risk on other assets
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Investments mainly fixed income
Interest rate goes up market value falls!
How to avoid this?
Duration of the bonds
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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
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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
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Gurgaon
Risk Management in Banks
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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
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Gurgaon
L
D A - DL *
= Dgap
A
Risk Management in Banks
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Managing Credit Risk
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Gurgaon
Risk Management in Banks
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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.
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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.
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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
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Gurgaon
Risk Management in Banks
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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
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Gurgaon
Risk Management in Banks
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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
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Gurgaon
Risk Management in Banks
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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
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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
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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
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Gurgaon
Risk Management in Banks
24
Expected Loss - Three Components
EXPEC
TED
LOSS
Rs.
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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?
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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.
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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