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Dr NeelamDr Neelam
TandonTandon
Risk Management SystemsRisk Management Systems
in Banksin BanksGenesis, Significance andGenesis, Significance and
ImplementationImplementation
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CONTENTSCONTENTS
What is Risk?What is Risk?
Classification of RiskClassification of Risk
Objectives of Risk ManagementObjectives of Risk Management
Tools for Managing RiskTools for Managing Risk
Risk Management in PNBRisk Management in PNB
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TheThe potentialpotential lossloss anan assetasset
oror aa portfolioportfolio isis likelylikely totosuffersuffer duedue toto aa varietyvariety ofof
reasonsreasons..
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Financial risk in a banking organization isFinancial risk in a banking organization is
possibility that the outcome of an action orpossibility that the outcome of an action or
event could bring up adverse impacts.event could bring up adverse impacts. Such outcomes could either result in a directSuch outcomes could either result in a direct
loss of earnings / capital or may result inloss of earnings / capital or may result in
imposition of constraints on banks ability toimposition of constraints on banks ability to
meet its business objectives.meet its business objectives.
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Such constraints pose a risk as these couldSuch constraints pose a risk as these could
hinder a bank's ability to conduct its ongoinghinder a bank's ability to conduct its ongoing
business or to take benefit of opportunitiesbusiness or to take benefit of opportunitiesto enhance its business.to enhance its business.
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Regardless of the sophistication of theRegardless of the sophistication of the
measures, banks often distinguish betweenmeasures, banks often distinguish between
expected and unexpected losses.expected and unexpected losses. Expected losses are those that the bExpected losses are those that the bankank
knows with reasonable certainty will occurknows with reasonable certainty will occur
((e.g., the expected default ratee.g., the expected default rate ofof
corporate loan portfolio or credit cardcorporate loan portfolio or credit card
portfolio) and are typically reserved for inportfolio) and are typically reserved for in
some manner.some manner.
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Unexpected losses are those associatedUnexpected losses are those associated
with unforeseenwith unforeseenevents (e.g. lossesevents (e.g. losses
experienced by banks due to a suddenexperienced by banks due to a suddendown turn in economy or falling interestdown turn in economy or falling interest
rates). Banks rely on their capital as a bufferrates). Banks rely on their capital as a buffer
to absorb such losses.to absorb such losses.
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While the types and degree of risks anWhile the types and degree of risks an
organization may be exposed to dependorganization may be exposed to depend
upon a number of factors such
as its size,upon a number of factors such
as its size,complexity business activities, volume etc, itcomplexity business activities, volume etc, it
is believed that generally the banks faceis believed that generally the banks face
Credit, Market, Liquidity, Operational,Credit, Market, Liquidity, Operational,
Compliance / legal / regulatory andCompliance / legal / regulatory andreputation risks.reputation risks.
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Risk Management is a discipline at the coreRisk Management is a discipline at the core
of every financial institution andof every financial institution and
encompasses all the activities t
hat affect itsencompasses all t
he activities t
hat affect itsrisk profile.risk profile.
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It involves identification,It involves identification,
measurement, monitoring and controllingmeasurement, monitoring and controlling
risks to ensure thatrisks to ensure that a) The individuals who take or manage risksa) The individuals who take or manage risks
clearly understand it.clearly understand it.
b) The organizations Risk exposure isb) The organizations Risk exposure iswithin the limits established by Boardwithin the limits established by Board
of Directors.of Directors.
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c) Risk taking Decisions are in line with thec) Risk taking Decisions are in line with the
business strategy and objectives set bybusiness strategy and objectives set by
BOD.BOD.
d) The expected payoffs compensate for thed) The expected payoffs compensate for the
risks takenrisks taken
e) Risk taking decisions are explicit ande) Risk taking decisions are explicit and
clear.clear.
f) Sufficient capital as a buffer is available tof) Sufficient capital as a buffer is available to
take risktake risk
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The acceptance and management ofThe acceptance and management of
financial risk is inherent to the business offinancial risk is inherent to the business of
banking and banks roles as financialbanking and banks roles as financialintermediaries.intermediaries.
Risk management as commonly perceivedRisk management as commonly perceived
does not mean minimizing risk; rather thedoes not mean minimizing risk; rather the
goal of risk management is to optimize riskgoal of risk management is to optimize risk--
reward tradereward trade --off.off.
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Notwithstanding the fact that banks are inNotwithstanding the fact that banks are in
the business of taking risk, it should bethe business of taking risk, it should be
recognized th
at an institution need notrecognized th
at an institution need notengage in business in a manner thatengage in business in a manner that
unnecessarily imposes risk upon it: nor itunnecessarily imposes risk upon it: nor it
should absorb risk that can be transferred toshould absorb risk that can be transferred to
other participants.other participants.
Rather it should accept those risks that areRather it should accept those risks that are
uniquely part of the array of banks services.uniquely part of the array of banks services.
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Survival of the organizationSurvival of the organization
Efficiency in OperationsEfficiency in Operations
Uninterrupted OperationsUninterrupted OperationsIdentifying and achieving acceptable level ofIdentifying and achieving acceptable level of
riskrisk
Earning StabilityEarning StabilityContinued and sustained GrowthContinued and sustained Growth
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RISKSRISKS
FINANC
IAL R
ISK NON
FINANC
IAL R
ISK
CREDIT RISK MARKET RISK
TRANSACTION RISK
PORTFOLIO RISK
INTEREST RATE RISK
LIQUIDITY RISK
FOREX RISK
OPERATING RISK
SYSTEMATIC RISK
POLITICAL RISK
HUMAN RISK
TECHNOLOGY RISK
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CREDIT RISKCREDIT RISKRisk that the counterparty will fail to perform orRisk that the counterparty will fail to perform or
meet the obligation on the agreed terms .meet the obligation on the agreed terms .
TYPES OF CREDIT RISKSTYPES OF CREDIT RISKS
Transaction RiskTransaction RiskRiskRisk relatingrelating toto specificspecific tradetrade transactions,transactions,
sectorssectors oror groupsgroups..
PortfolioPortfolio RiskRisk
RiskRisk arisingarising fromfrom lendinglending toto sectorssectors nonnon relatedrelated
toto thethe corecore competenciescompetencies ofof thethe BankBank //
concentratedconcentrated creditscredits toto aa particularparticular sectorsector //
lendinglending toto aa fewfew bigbig borrowersborrowers..
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MARKET RISKMARKET RISKMarket risk is the risk to a banks financial condition thatMarket risk is the risk to a banks financial condition that
could result from adverse movements in market price.could result from adverse movements in market price.
TYPES OF MARKET RISKTYPES OF MARKET RISK
InterestInterest RateRate RiskRisk
RiskRisk felt,felt, whenwhen changeschanges inin thethe interestinterest rateratestructurestructure putput pressurepressure onon thethe netnet interestinterest marginmargin ofof
thethe BankBank..
LiquidityLiquidity RiskRiskRiskRisk arisingarising duedue toto thethe potentialpotential forfor liabilitiesliabilities totodraindrain fromfrom thethe BankBank atat aa fasterfaster raterate thanthan assetsassets..
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TYPES OF MARKET RISKTYPES OF MARKET RISK
(continued)(continued)
FOREX RISKFOREX RISKThis risk can be classified into three types.This risk can be classified into three types.
TransactionTransaction RiskRiskisis observedobserved whenwhen movementsmovements inin priceprice ofof aa
currencycurrency upwardsupwards oror downwards,downwards, resultresult inin aa lossloss onon aa particularparticulartransactiontransaction..
TranslationTranslation RiskRiskarisesarises duedue toto adverseadverse exchangeexchange raterate movementsmovementsandand changechange inin thethe levellevel ofof investmentsinvestments andand borrowingsborrowings inin foreignforeigncurrencycurrency..
CountryCountry RiskRisk.. TheThe buyersbuyers areare unableunable toto meetmeet thethe commitmentcommitment dueduetoto restrictionsrestrictions imposedimposed onon transfertransfer ofof fundsfunds byby thethe foreignforeign govtgovt.. ororregulatorsregulators..WhenWhen thethe transactionstransactions areare withwith thethe foreignforeign govtgovt.. thethe riskrisk isis calledcalled asasSovereignSovereign RiskRisk..
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NONNON--FINANCIAL RISKSFINANCIAL RISKS
OperationalOperational RiskRisk arisesarises asas aa resultresult ofof failurefailure ofofoperatingoperating systemsystem inin thethe bankbank duedue toto certaincertain reasonsreasonslikelike fraudulentfraudulent activities,activities, naturalnatural disaster,disaster, humanhumanerror,error, omissionomission oror sabotagesabotage etcetc..
SystemicSystemic RiskRisk isis seenseen whenwhen thethe failurefailure ofof oneone
financialfinancial institutioninstitution spreadsspreads asas chainc
hain reactionreaction totothreatenthreaten thethe financialfinancial stabilitystability ofof thethe financialfinancial systemsystem
asas aa wholewhole..
PoliticalPolitical RiskRisk arisesarises duedue toto introductionintroduction ofof ServiceServicetaxtax oror increaseincrease inin incomeincome tax,tax, freezingfreezing thethe assetsassets ofofthethe bankbank byby thethe legallegal authorityauthority etcetc..
HumanHuman RiskRisk LabourLabour unrest,unrest, lacklack ofof motivation,motivation,inadequateinadequate skills,skills, problemsproblems facedfaced byby thethe bankbank afterafterimplementationimplementation ofof VRSVRS leadlead toto HumanHuman RiskRisk..
TechnologyTechnology RiskRisk Obsolescence,Obsolescence, mismatches,mismatches,breakdowns,breakdowns, adoptionadoption ofof latestlatest technologytechnology byby
competitors,competitors, etc,etc, comecome underunder technologytechnology riskrisk
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MANAGEMENT OF CREDITMANAGEMENT OF CREDIT
RISKRISKMeasurementMeasurement throughthrough CreditCredit RatingRating //
scoringscoring
QuantificationQuantification throughthrough estimateestimate ofofexpectedexpected loanloan losseslosses
PricingPricing onon aa scientificscientific basisbasis
ControllingControlling throughthrough EffectiveEffective loanloan
reviewreview mechanismmechanism andand portfolioportfolio
managementmanagement
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TOOLS OF CREDIT RISKTOOLS OF CREDIT RISK
MANAGEMENTMANAGEMENTEXPOSUREEXPOSURECEILINGSCEILINGS::SettingSetting ofof prudentialprudentialnormsnorms relatedrelated toto thethe BanksBanks exposureexposure toto aa singlesingle borrowerborrower //groupgroup borrowersborrowers // sectorialsectorial borrowersborrowers
REVIEWREVIEW //RENEWALRENEWAL :: ThisThis involvesinvolves multimulti--tiertiercreditcredit approvingapproving authority,authority, constitutionconstitution wisewise delegationdelegation ofofpowers,powers, higherhigher delegateddelegated powerspowers forfor betterbetter ratedrated
borrowers,borrowers, discriminatorydiscriminatory timetime forfor creditcredit reviewreview // renewal,renewal,hurdlehurdle ratesrates // benchmarksbenchmarks forfor freshfresh exposuresexposures && periodicityperiodicityforfor renewalrenewal basedbased onon riskrisk ratingrating..
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COMPREHENSIVECOMPREHENSIVE RISKRISK RATINGRATINGMODELSMODELS
RISKRISK BASEDBASED SCIENTIFICSCIENTIFICPRICINGPRICING:: LinkingLinkingloanloan pricingpricing toto expectedexpected lossloss
PORTFOLIOPORTFOLIO MANAGEMENTMANAGEMENT :: StipulateStipulatequantitativequantitative ceilingceiling onon specificspecific ratingrating categories,categories,distributiondistribution ofof borrowersborrowers inin variousvarious industriesindustries // businessbusiness
groupsgroups ,, rapidrapid portfolioportfolio reviews,reviews, onon--goinggoing systemsystem forforidentificationidentification ofof creditcredit weaknessesweaknesses wellwell inin advance,advance, initiateinitiatestepssteps toto preservepreserve thethe desireddesired portfolioportfolio qualityquality andand integrateintegrateportfolioportfolio reviewsreviews withwith creditcredit decisiondecision makingmaking processprocess..
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TOOLS OF CREDIT RISKTOOLS OF CREDIT RISK
MANAGEMENTMANAGEMENT
LOANLOAN REVIEWREVIEW MECHANISMMECHANISM :: ThisThis
shouldshould bebe donedone independentindependent ofof creditcredit
operationsoperations && administrationadministration andand covercover allall
thethe loansloans aboveabove certaincertain cutcut--offoff limitlimit
ensuringensuring thatthat atat leastleast 3030 4040%% ofof thetheportfolioportfolio isis subjectedsubjected toto LRMLRM inin aa yearyear..
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RISKMANAGEMENTINPNBRISKMANAGEMENTINPNB
NewNew CapitalCapital AdequacyAdequacy FrameworkFramework::BankBank hashas migratedmigrated toto NewNew CapitalCapital AdequacyAdequacyFramework,Framework, popularlypopularly knownknown asas BASELBASEL IIII ww..ee..ff..fromfrom MarchMarch 20082008.. TheThe approachesapproaches prescribedprescribed bybythethe 'Regulator','Regulator', namelynamely StandardisedStandardised ApproachApproachunderunder CreditCredit RiskRisk andand BasicBasic IndicatorIndicator ApproachApproachunderunder OperationalOperational RiskRisk havehave beenbeen
implementedimplemented..TheThe BankBank hadhad adoptedadopted StandardStandardDurationDuration ApproachApproach forfor MarketMarket Risk,Risk, sincesince MarchMarch20062006..
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RISKMANAGEMENTINRISKMANAGEMENTIN
PNB(contd)
PNB(contd)
BankBank hashas alreadyalready placedplaced creditcredit riskrisk ratingrating modelsmodelsonon centralcentral serverserver basedbased systemsystem PNBPNB TRAC,TRAC,whichwhich providesprovides aa scientificscientific methodmethod forfor assessingassessing
creditcredit riskrisk ratingrating ofof aa clientclient.. TheThe BankBank hashasdevelopeddeveloped andand placedplaced onon centralcentral serverserver scorescorebasedbased ratingrating modelmodel PNBPNB SCORESCORE inin respectrespect ofofretailretail loansloans andand traderstraders upup toto totaltotal limitslimits ofof RsRs 5050lacslacs.. Accept/RejectAccept/Reject decisionsdecisions areare alsoalso basedbased ononthethe scorescore obtainedobtained.. ScoringScoring modelsmodels forfor remainingremainingsectorssectors likelike SMESME segmentssegments havehave beenbeen developeddevelopedandand areare underunder testingtesting stagestage..
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BankBank isis alsoalso developingdeveloping frameworkframework forfor
estimatingestimating LGDLGD (Loss(Loss GivenGiven Default)Default) andand EADEAD ((
ExposureExposure atat Default)Default) andand alsoalso frameworkframework forfor
identifyingidentifying concentrationconcentration riskrisk.. AA datadata warehousewarehouseisis beingbeing establishedestablished forfor effectiveeffective datadata
managementmanagement andand useuse ofof applicationapplication toolstools forfor
quantificationquantification ofof risksrisks..
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ForFor thethe MarketMarket riskrisk bankbank hashas aa MidMid--OfficeOffice withwith
separateseparate desksdesks forfor TreasuryTreasury && AssetAsset LiabilityLiability
ManagementManagement (ALM)(ALM).. AssetAsset LiabilityLiability ManagementManagement
CommitteeCommittee (ALCO)(ALCO) isis primarilyprimarily responsibleresponsible forforestablishingestablishing thethe marketmarket RiskRisk Management,Management, assetasset
liabilityliability managementmanagement ofof thethe bank,bank, implementingimplementing
thethe riskrisk managementmanagement ofof thethe bankbank.. TheThe policiespolicies forfor
hedginghedging andand mitigatingmitigating riskrisk areare discusseddiscussed inin
ALCALCOO..
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AA separateseparate independentindependent DivisionDivision knownknown asas
CreditCredit AuditAudit && ReviewReview DivisionDivision hashas beenbeenformedformed toto ensureensure LRMLRM implementationimplementation.. LRMLRM
examinesexamines compliancecompliance withwith extantextant sanctionsanction
andand postpost--sanctionsanction process/proceduresprocess/procedures laidlaiddowndown byby thethe BankBank fromfrom timetime toto timetime..
PreventivePreventive MonitoringMonitoring SystemSystem (PMS)(PMS):: ItIt isis aa
tooltool usedused byby bankbank forfor detectiondetection ofof earlyearly
warningwarning signalssignals withwith aa viewview toto
prevent/minimizeprevent/minimize thethe loanloan losseslosses..
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LiquidityLiquidity RiskRisk ofof bankbank isis assessedassessed throughthrough gapgapanalysisanalysis forfor maturitymaturity mismatchmismatch basedbased onon residualresidual
maturitymaturity inin differentdifferent timetime bucketsbuckets && managementmanagement
ofof samesame isis donedone throughthrough prudentialprudential limitslimits fixedfixed
thereonthereon..
BankBank isis alsoalso monitoringmonitoring thethe liquidityliquidity throughthrough
variousvarious stockstock optionsoptions..
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TheThe BankBank isis proactivelyproactively usingusing durationduration gapgap andand
interestinterest raterate forecastingforecasting toto minimizeminimize impactimpact ofof
interestinterest raterate changeschanges..
AdvanceAdvance techniquestechniques suchsuch asas StressStress testing,testing,
simulation,simulation, sensitivitysensitivity analysisanalysis etc,etc, areare conductedconducted
atat regularregular intervalsintervals toto drawdraw contingencycontingency fundingfunding
planplan underunder differentdifferent liquidityliquidity scenariosscenarios..
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CONCLUSIONCONCLUSION
InIn thethe BankingBanking industryindustry wherewhere riskrisk isis thethenormnorm ,, ratherrather thanthan thethe exception,exception, BanksBankshavehave toto adoptadopt manymany measuresmeasures likelike reducingreducing
exposureexposure inin highhigh riskrisk areas,areas, emphasizingemphasizingmoremore onon thethe promisingpromising industries,industries, optimizingoptimizingthethe returnreturn byby strikingstriking aa balancebalance betweenbetween thetheriskrisk andand thethe returnreturn onon thethe assetsassets.. BanksBanksmottomotto shouldshould bebe effectiveeffective managementmanagement ofofrisksrisks towardstowards ensuringensuring qualityquality creditcreditportfolioportfolio..
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