CAIIBCAIIB- RISK MANAGEMENT - RISK MANAGEMENT – MODULE B– MODULE B

G.R.Rao, Faculty, IIBFG.R.Rao, Faculty, IIBF

WHAT IS RISKWHAT IS RISK

EVERY ACTION HAS A REACTIONEVERY ACTION HAS A REACTION IF REACTION IS FOR OUR BEENFIT; NO IF REACTION IS FOR OUR BEENFIT; NO

WORRY AND NO RISKWORRY AND NO RISK IF IT IS AGAINST OUR INTEREST ONLY IF IT IS AGAINST OUR INTEREST ONLY

WE ARE WORRIED AND THAT IS RISKWE ARE WORRIED AND THAT IS RISK RISK IS THEREFORE POSSIBILITY OF A RISK IS THEREFORE POSSIBILITY OF A

NEGATIVE RESULT FOR OUR ACTIONSNEGATIVE RESULT FOR OUR ACTIONS COULD BE DUE TO US OR BEYOND USCOULD BE DUE TO US OR BEYOND US

RISK Contd…RISK Contd… RISK IS SUPPOSED TO HAVE BEEN RISK IS SUPPOSED TO HAVE BEEN

DERIVATIVE OF “RISICARE” WHICH DERIVATIVE OF “RISICARE” WHICH MEANS “TO DARE”MEANS “TO DARE”

DARING IS TO TAKE STEPS DARING IS TO TAKE STEPS RECOGNISING THE POTENTIAL FOR RECOGNISING THE POTENTIAL FOR LOSSLOSS

EXTENT OF THIS BEHAVIOUR IS EXTENT OF THIS BEHAVIOUR IS “TAKER” SPECIFIC“TAKER” SPECIFIC

MORE RISK IS TAKEN IN VIEW OF MORE RISK IS TAKEN IN VIEW OF POTENTIAL FOR HIGHER YIELDPOTENTIAL FOR HIGHER YIELD

RISK Contd…RISK Contd…

DUE TO RISK EITHER , PROFITS DUE TO RISK EITHER , PROFITS AND CAPITAL MAY GROW AND CAPITAL MAY GROW MULTIFOLD OR BUSINESS MAY BE MULTIFOLD OR BUSINESS MAY BE WIPED OUTWIPED OUT

NEVERTHLESS WE CANNOT BE RISK NEVERTHLESS WE CANNOT BE RISK FREE/AVERSE BANKER LIKE A SHIP FREE/AVERSE BANKER LIKE A SHIP IN A PORTIN A PORT

BANKING IS THEREFORE RISK BANKING IS THEREFORE RISK MANAGEMENTMANAGEMENT

RISK Contd…RISK Contd…

RETURN IS THEREFORE RELATED RETURN IS THEREFORE RELATED TO RISK TO RISK

RETURNS FROM BUSINESSES ARE RETURNS FROM BUSINESSES ARE TO BE ADJUSTED FOR RISKS FOR TO BE ADJUSTED FOR RISKS FOR COMPARABILITY-THIS IS RAROCCOMPARABILITY-THIS IS RAROC

BANKING BUSINESSBANKING BUSINESS

BUSINESS IS BROADLY DIVIDED INTO BUSINESS IS BROADLY DIVIDED INTO ON BALANCE SHEET AND OFF BALANCE ON BALANCE SHEET AND OFF BALANCE SHEET ACTIVITIES.SHEET ACTIVITIES.

ON BALANCE SHEET ACTIVITIES ARE ON BALANCE SHEET ACTIVITIES ARE BANKING BOOK (DEPOSITS & BANKING BOOK (DEPOSITS & ADVANCES) AND TRADING ADVANCES) AND TRADING BOOK(INVESTMENTS)BOOK(INVESTMENTS)

BANKING BOOK HAS NO MARKET RISKBANKING BOOK HAS NO MARKET RISK RISKS COMMON TO BOTH BOOKS ARE RISKS COMMON TO BOTH BOOKS ARE

CREDIT, OPERATIONALCREDIT, OPERATIONAL

RISKS ContdRISKS Contd.... MAJOR RISKS AREMAJOR RISKS ARE

– CREDIT RISKCREDIT RISK– MARKET RISK MARKET RISK

INTEREST RISKINTEREST RISK LIQUIDITY RISKLIQUIDITY RISK PRICE RISKPRICE RISK

– OPERATIONAL RISKOPERATIONAL RISK– STRATEGIC RISKSTRATEGIC RISK– REPUTATION RISK REPUTATION RISK

RFISK MANAGEMENTRFISK MANAGEMENT IDENTIFICATIONIDENTIFICATION MEASUREMENTMEASUREMENT

– SENSITIVITYSENSITIVITY– VOLATILITYVOLATILITY– DOWNSIDE POTENTIALDOWNSIDE POTENTIAL

PRICING COVERINGPRICING COVERING– COST OF RESORUCESCOST OF RESORUCES– COSTOF OPERATIONSCOSTOF OPERATIONS– RISK PREMIUMRISK PREMIUM– CAPITAL CHARGECAPITAL CHARGE

MONITORING AND CONTROLMONITORING AND CONTROL MITIGATIONMITIGATION

– TRANSFERINGTRANSFERING

BASEL 1 & 2BASEL 1 & 2 THREE PILLARSTHREE PILLARS TWO TYPES OF CAPITALSTWO TYPES OF CAPITALS DIFFERENT METHODS OF DIFFERENT METHODS OF

MEASUREMENT OF RWAMEASUREMENT OF RWA

MARKET RISKMARKET RISK HAS A COMPONENT OF CREDIT RISK IN HAS A COMPONENT OF CREDIT RISK IN

ADDITION TO PRICE, LIQUIDITY AND ADDITION TO PRICE, LIQUIDITY AND INTEREST RATE RISKSINTEREST RATE RISKS

LIQUIDITY RISK CAN ALSO BE DUE TO LIQUIDITY RISK CAN ALSO BE DUE TO MARKETSMARKETS

RISK IN INVESTMENTS IS MEASURED RISK IN INVESTMENTS IS MEASURED THRO’ BPV, MODIFIED DURATION, VaR THRO’ BPV, MODIFIED DURATION, VaR AND YIELD AND PRICE VOLATILITIES AND YIELD AND PRICE VOLATILITIES

MONITORING & CONTROL AND MONITORING & CONTROL AND MITIGATIONMITIGATION

MONITORINGMONITORING– POLICY GUIDELINES FOR VARIOUS POLICY GUIDELINES FOR VARIOUS

ACTIVITIESACTIVITIES– CAPS FOR TRANSACTION SIZES, STOP CAPS FOR TRANSACTION SIZES, STOP

LOSS LIMITS, GUIDLEINES ON LOSS LIMITS, GUIDLEINES ON PORTFOLIO SIZES BOTH TYPE AND PORTFOLIO SIZES BOTH TYPE AND INDUSTRY, EXPOUSRE NORMSINDUSTRY, EXPOUSRE NORMS

MITIGATION THROUGH DERIVATIVESMITIGATION THROUGH DERIVATIVES

CREDIT RISKCREDIT RISK

CREDIT SELECTION, PRUDENTIAL LIMITSCREDIT SELECTION, PRUDENTIAL LIMITS CREDIT RATINGCREDIT RATING CREDIT PRICINGCREDIT PRICING CREDIT MONITORING THROUGH RATING CREDIT MONITORING THROUGH RATING

MIGRATIONMIGRATION LOAN REVIEW MECHANISMLOAN REVIEW MECHANISM CREDIT DERIVATIVES AND SECURITIES CREDIT DERIVATIVES AND SECURITIES

AND SECURITISATIONAND SECURITISATION

OPERATIONAL RISKOPERATIONAL RISK

CAN BE CLASSIFIED BASED ON CAN BE CLASSIFIED BASED ON BOTHBOTH

SOURCE, IMPACT AND EVENTSOURCE, IMPACT AND EVENT RISK MITIGATION CAN BE RISK MITIGATION CAN BE

THORUGH AUDIT, VARIOUS THORUGH AUDIT, VARIOUS REPORTSREPORTS

OBJECTIVE QUESTIONSOBJECTIVE QUESTIONSQ. RAROC STANDS FORQ. RAROC STANDS FOR

A. RISK ADJUSTED RETURN ON CAPITALA. RISK ADJUSTED RETURN ON CAPITALB. RISK ADJUSTED RETURN ON COST.B. RISK ADJUSTED RETURN ON COST.C. RETURN ADJUSTED RISK ON CREDIT.C. RETURN ADJUSTED RISK ON CREDIT.D NONE OF ABOVE.D NONE OF ABOVE.

Q.CREDIT DEFAULT SWAPS ARE Q.CREDIT DEFAULT SWAPS ARE A. ONE OF CREDIT DERIVATIVES.A. ONE OF CREDIT DERIVATIVES.B. A KIND OF BANK GUARANTEEB. A KIND OF BANK GUARANTEEC. A KIND OF LINE OF CREDIT.C. A KIND OF LINE OF CREDIT.D. STAND BY CREDIT.D. STAND BY CREDIT.

OBJECTIVESOBJECTIVES

Q. THE BETA FACTOR FOR CALCULATING OPERATIONAL RISK Q. THE BETA FACTOR FOR CALCULATING OPERATIONAL RISK UNDER STANDARDIZED APPROACH FOR RETAIL BANKING IS UNDER STANDARDIZED APPROACH FOR RETAIL BANKING IS A. 12%A. 12%B.18%B.18%C.15%C.15%D. NONE OF ABOVE.D. NONE OF ABOVE.

Q. PROBABILITY OF OCCURRENCE =4; POTENTIAL FINANCIAL Q. PROBABILITY OF OCCURRENCE =4; POTENTIAL FINANCIAL IMPACT =4; IMPACT OF INTERNAL CONTROL =0%IMPACT =4; IMPACT OF INTERNAL CONTROL =0%

    WHAT IS ESTIMATED LEVEL OF OPERATIONAL RISK?WHAT IS ESTIMATED LEVEL OF OPERATIONAL RISK?A. 3A. 3B. 2B. 2C. 0C. 0D. 4D. 4

OBJECTIVE QUESTIONSOBJECTIVE QUESTIONS

INORDER TO DEVELOP ACTIVE CREDIT INORDER TO DEVELOP ACTIVE CREDIT RISK MANAGEMENT, BANK MUST HAVE RISK MANAGEMENT, BANK MUST HAVE 1.GOOD CREDIT RATING MODEL AND 1.GOOD CREDIT RATING MODEL AND 2. CONDUCT MIGRATION STUDIES2. CONDUCT MIGRATION STUDIES

a.a. both of the above are requiredboth of the above are requiredb.b. Only 1 is requiredOnly 1 is requiredc.c. Only 2 is requiredOnly 2 is requiredd.d. both are insufficientboth are insufficient

A transaction where financial A transaction where financial securities are issued against securities are issued against cash flows generated from a cash flows generated from a pool of assets is calledpool of assets is called

a.a. Credit default swapCredit default swapb.b. SecuritisationSecuritisationc.c. Participation certificateParticipation certificated.d. Credit linked notesCredit linked notes

A bank expects fall in price of a A bank expects fall in price of a security if it sells it in the market. security if it sells it in the market. What is the name of such risk?What is the name of such risk?

a.a. Market riskMarket riskb.b. Operational riskOperational riskc.c. Asset liquidation riskAsset liquidation riskd.d. Market liquidity riskMarket liquidity risk

Credit rating agencies fix interest Credit rating agencies fix interest rates on bonds and debentures rates on bonds and debentures issued by companiesissued by companies

a. truea. trueb. Falseb. Falsec. Cannot sayc. Cannot sayd. Only RBI can fix rate d. Only RBI can fix rate

An 8 year 8% semi annual bond has a An 8 year 8% semi annual bond has a BPV of Rs 125.The yield on the bond BPV of Rs 125.The yield on the bond has increased by 5 basis points. What has increased by 5 basis points. What is the profit or loss suffered in price is the profit or loss suffered in price due to increase in yield?due to increase in yield?

a.a. Rs 1000 profitRs 1000 profitb.b. Rs 1000 lossRs 1000 lossc.c. Rs 625 profitRs 625 profitd.d. Rs 625 loss Rs 625 loss

A decline in CRR will cause the A decline in CRR will cause the yield curve to yield curve to

a.a. Slope upwardSlope upwardb.b. Slope downwardSlope downwardc.c. Become flatterBecome flatterd.d. Remain unchanagedRemain unchanaged

Given the rating migration of 100 a Given the rating migration of 100 a rated accounts in bank during a rated accounts in bank during a year as under, please answer the year as under, please answer the number of accounts who suffered number of accounts who suffered rating migration.rating migration.

A++ A+ A B+ B C DefaultA++ A+ A B+ B C Default11 1 75 12 1 75 12 3 5 3 5 3 3a. 2 b. 23 c. 25 d. 21a. 2 b. 23 c. 25 d. 21

ABC financial corporation has lent Rs 1500 ABC financial corporation has lent Rs 1500 crores, at an average contractual rate of 14%. crores, at an average contractual rate of 14%. Past experience indicates that the probability Past experience indicates that the probability of repayment is 0.90 what would be the of repayment is 0.90 what would be the expected return rate of the corporation if the expected return rate of the corporation if the recovery rate of principal and interest is 0.95 recovery rate of principal and interest is 0.95

Expt. rate = p * r + q [ (1 + r) R -1]Expt. rate = p * r + q [ (1 + r) R -1]Where p is probability of repayment q= 1-pWhere p is probability of repayment q= 1-pr is contractual rate and R is recovery rater is contractual rate and R is recovery rate

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