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Risk means uncertainty that may result in adverse
outcome, adverse in relation to planned objectives
Risk : Known Unknown
Uncertainty : Unknown Unknown
Classification of Banking Business
The entire Banking Business can classified under three major heads
• A) Banking Book• B) Trading Book• C) Off balance Sheet Exposures
Banking Book
All assets & liabilities in ‘banking book’ have following characteristics:
a) They are normally held till maturity.
b) Accrual System of accounting is followed
Trading Book
This book Consists of all investments and securities the bank has made, which are not held till maturity.
Mark to Market System is followed
The above book is further classified in to
a)Held to Maturity (HTM)
b)Held For Trading (HFT)
c)Available for Sale (AFS)
Off-Balance-Sheet Exposure
• Off-balance sheet exposure is contingent in nature- Guarantees, LCs, Committed or back up credit lines etc.
• A contingent exposure may become a fund-based exposure in Banking book or trading book.
Banking Book
The following are the risks involved in Banking Book
a)Liquidity Risk
b)Credit Risk
c)Interest Rate Risk
d)Operational Risk
Banking Book
As the assets and liabilities in the Banking
Book are normally held till their maturities,
they do not attract any market Risk
Trading Book
This book consists of banks` proprietary positions in financial instruments such as
a)Debt Securities
b)Equities
c)Foreign Exchange
d) Commodities
e) Derivatives held for Trading
Risks in Trading Book
Market Risk
Credit Risk
Liquidity Risk
Interest Rate Risk
Currency Risk
Operational Risk
Off Balance Sheet Exposures
All risks as applicable to Banking Book &
Trading book are applicable to this book
also
Liquidity Risk
Liquidity risk arises on account of funding long
term assets by short term liabilities.
Such risk arises, when there is a mismatch
in the maturity periods or repricing periods
of the assets and liabilities .
Example for Liquidity Risk
A Rs100 crores liability is raised for one year and the same is deployed in a two year assets
Naturally, there is a mismatch in the maturity periods of the assets and liabilities.
The liability cannot be repaid at the end of first year, as the bank would receive after two years only.
Hence the bank incurs a liquidity risk
Dimensions of Liquidity Risk
Funding Risk
Need to replace net outflows on account of unexpected withdrawals and non-renewal of deposits, due to loss of reputation or systemic risk.
Time Risk
Need to compensate for nonreceipt of expected inflow of funds on account of deterioration in asset quality or standard assets turning to NPA
Call Risk
This risk arises on account of crystallization of off balance sheet exposures or Contingent liabilities
Interest Rate Risk
When Banks` financial assets/liabilities such as
Advances and Deposits are exposed to
fluctuations in market interest rates, it will have
an impact on Net Interest Margin and the
market value of their equities.
This is called Interest Rate Risks
Dimensions of Interest Rate Risk
01. Gap or mismatch Risk
This risk arises from holding assets and liabilities
with different principal amounts, maturity dates or
repricing dates, thereby creating an exposure to
unexpected changes in the level of market interest
rates
02.Basis Risk
When interest rates of different assets and liabilities change
in different magnitude, the risk that arises is called Basis
Risk.
03.Embedded Option Risk
Significant changes in interest rates create a source of risk
to banks` profitability, by encouraging pre payment of Cash
credit /demand loan and/ or premature withdrawal of term
deposits before their slated period of maturity.
04.Yield Curve Risk
When banks take two different instruments
maturing on two different time horizon, as the
basis for pricing their assets and liabilities, any
non-parallel movement in yield curve would
affect the Net Interest Margin.
Example for Yield Curve Risk
91 days Treasury Bill8%
364 days Treasury Bill12%
Prevailing Market Rates
A liability is raised with interest rates 2% above 91 days
T-bill rate.Interest Rate on deposits 10%
Amount is deployed in advances with interest rates 2% above 364 days T-bill rate-Int rate on advances :14%
Spread 4%
91 days treasury Bill rate increases
to 10%Then, deposit rate also increases to
12%
364 days treasury bill rate does not
increase. Int rate is 14%
NII declines to
2%
Market Risk
Market Risk is the risk of adverse deviations of the mark
to market value of the trading portfolio, due to market
movements, during the period of holding. This results
from adverse movement of prices of interest rate related
instruments, equities, commodities and currencies.
Market risk is also called as Price risk
01.It is the loss in the market value of Fixed Income securities due to adverse fluctuations in their prices.
02.Risk of adverse deviations in the market to market value of a trading portfolio, due to market movements, during the period of holding.
03.Loss that occurs on account of the assets are being sold before the slated period of their maturity.
04.It is that part of Interest Rate Risks ,which affects the price of interest rate related instruments like Fixed Income securities
Interest Rate Risk Change in Price Leads to change in NII
Market Risk
Market Risk is that part of Interest Rate Risks, which affects the price of interest rate related instruments like Fixed Income securities
A fixed income security is an investment that pays regular income in the form of a coupon payment, interest payment or preferred dividend.
How it works/Example:
Fixed income securities provide periodic income payments at an interest or dividend rate known in advance by the holder. The most common fixed-income securities include Treasury bonds, corporate bonds, certificates of deposit (CDs) and preferred stock.
Operational Risk
It is the risk of loss resulting from inadequate or failed
internal processes, people and systems or from
external events.
Strategic Risk and Reputation risk are not part of
operational risk
Reputation Risk –
Reputation risk is the current or prospective indirect risk to earnings and capital from adverse perception of the image of the bank on the part of customers, shareholders and regulator.
Reputation risk may originate in lack of compliance with industry service standards and regulatory standards, failure to deliver on commitments, lack of customer friendly service and fair market practices, a service style that does not harmonize with customer expectation.