Summer Project Report

On
“Risk Management in Urban Co-operative Banks”
FOR
Reserve Bank of India, Mumbai

Submitted to
Prof. P.V.Dabli
DIRECTOR, SIMSREE

In partial fulfillment of

POST GRADUATE DIPLOMA IN BUSINESS

MANAGEMENT
(2005-2007)
Submitted by

Shashank P Pai
PGDBM 534
Finance

Sydenham Institute of Management

Studies
Research and Entrepreneurship
Education

1
 Acknowledgement

Emergence of risk management in the financial sector especially in the banks following
the aggressive push given to de-regulation and liberalization of Indian banks provides a
challenging field of knowledge involving almost every aspect of a bank. For a novice
Post Graduate student like me, this project was an incredible learning experience.

I, therefore, thank Reserve Bank of India, Mumbai for giving me the valuable opportunity
of working on this immensely interesting project.

It would have been very difficult for me to do justice and complete this project in all
respects in the limited time at my disposal, without the stimulating guidance and
invaluable suggestions I received from my project guide, Mr. Sathyan David, General
Manager, UBD. I would take this opportunity to express my earnest gratitude to Mr.
Vishwanathan Chief General Manager, UBD who not only encouraged me to put in my
best in the project but also gave me the full benefit of his vast knowledge by giving me
right directions for preparing this Report.

I also thank Mr. Vivek Mandlik, Senior Investment and Tresury manager, And Mrs. Bina
Dixit for giving me the opportunity to undertake my study at Shamrao Vitthal Bank. I
also acknowledge my debt to Mr Jagdish Pai from Risk Management Department
Saraswat Bank for sharing with me their vast repertoire of knowledge and experience in
the field of Risk Management and providing me with all the necessary guidance and help
I also wish to acknowledge the help and support provided to me by Mr Shinde and many
others of the Central office, UBD without which the completion of the project would
have not been possible.

2
July 29th 2006 Shashank Padmanabh Pai

The following Project Report titled “Risk Management in

Urban Co-operative Banks” has been prepared as a part
of the Summer Training Programme undergone at Reserve
Bank of India as well as other leading Urban Co-operative
Banks. It is an academic exercise carried out based on the
reading material provided by the institutions mentioned
above as also individual study. The views expressed and
the observations recorded in the Report are of the author
and not of the organizations where the study has been
undertaken.

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 Certificate

This is to certify that Mr Shashank Padmanabh Pai,

PGDBM 2005-07 students from Sydenham Institute of
Management Studies and Research & Enterpreneurship
Education, Mumbai has undergone summer training under
my guidance at the Department of Banking Supervision,
Reserve Bank of India, Mumbai from May 2 2, 2006 to
July 22, 2006. The title of his project is ‘Risk
Management in Urban Co-operative Banks’.

Mr. Sathyan David

GM, UBD, RBI

4
 Executive Summary

Economic reforms and liberalization gave a new dimension to the playing field in
financial markets especially banks; in fact in many ways the rules of the game, too. By
definition, they tend to reduce the arbitrage opportunities as market imperfections are
eliminated. Increased competition from both domestic and foreign players puts pressure
on the margins and reduces the cushion for absorbing the losses even as the potential for
business losses increases due to higher market volatility. Just a few years ago market set
up for banks were not as complex as it is today. Interest rates were regulated, financial
assets moved within a narrow band, foreign exchange rate was pegged, by and large roles
of all financial intermediaries were well defined and banks had a stable and well known
set of customers and counterparties to deal with.

Deregulation and Internationalization

Within a fairly short span of time, the canvas has changed drastically. The sheer
movements of major macroeconomic parameters over the past few years have been
breathtaking. This volatility in the financial sector results in not only from domestic
deregulation but is also an inevitable product of opening up of the economy. It also brings
in its own influences. In a liberalizing environment, the competitive framework also
undergoes a change. Many new players have entered market. These players enter across
different financial market segments and became more dynamic with more deregulation,
inter linkages between them begin to develop and become more pronounced. It can be
exemplified saying – forex and exchange market.

The Process of Liberalization

The Indian banking industry, till 1985, was largely under regulatory provision from the
Reserve Bank of India and the Government of India. The regulations were felt necessary

5
to direct the scarce savings uniformly for all sectors of the economy, more so towards the
neglected sector.

The regulations in the initial stage did give a thrust to expand the banking activities to
every nook and corner of the country. There were positive sides of such directed bank
lending. Along with it were negative indicators too like high level of Non-Performing
Assets, Low Profitability, Low Level of Technology and Poor Customer Service.

Simultaneously, there were significant changes in the global scenario, which had its
effect on the Indian economy too. The gradual integration in the world economy
prompted Indian economy to become a part of it. The Indian banking system being the
backbone of the economy could not remain far behind. It had to accept the world
standards of accounting, transparencies in balance sheets, and prudential norms for
classification of assets.

Throughout the world, both in developed as well as the developing countries, the banking
system had to move from deregulated environment to a more gradual liberalized
environment. In Indian, the process of liberalization was initially introduced in 1985,
more on an experimental basis and from 1991, more vigorously. It continues even today.
The focus here was to open up the banking sector to more competition, diversifying of
banking activities, freeing of interest rates, transparencies in performance, convertibility
of rupee to foreign currency etc.

Post Liberalization – an experience

The experience of Indian banks in the post liberalization era had been of mixed feelings.
Due to the importance given to capital adequacy norms, the equity of banks has
increased. However, deposit and credit growth has been slow and sluggish. The Growth
in investment had been uptrend as banks found it safe to invest in government securities
than to lend money to borrowers. The private sector banks have shown relatively better
results as compared to the public sector banks and co-operative banks.

6
In fact, in this era of fast economic growth, banks would be one of the biggest
beneficiaries, on which they can capitalize. However, what is needed is better
management of funds available and various risks to which the banks are exposed.

Banking Risk Spectrum

Banks in the process of financial intermediation are confronted with various kinds of
financial and non-financial risks as mentioned below: -

Under Financial Risks: Balance Sheet Structure, Income Statement Structure and
Profitability, Capital Adequacy, Credit Risk, Liquidity Risk, Interest Rate Risk, Market
Risk and Currency Risk.

Under Operational Risk: the business strategy risk, Internal System, Operational Risk,
Technology Risk, Mismanagement & Fraud and Reputation Risk.

Under Banking Risk: the legal risk, macro policy risk, financial infrastructure and
systemic risk.

Under Event Risk: the political risk and other exogenous risks.

Risk management is important for banks in a globalization era. In the world of advanced
technology and economic liberalization, where financial markets are connected to each
other, a good risk management system is important to stay competitive. Effective RMS
will enable to accurately assess the acceptable level of risks, prepare adequate level of
capital as a buffer against loss and appropriately incorporate risk into price setting.

By definition, “Risk” is the potential that events expected or unanticipated may have an
adverse impact on a financial institution’s capital or earnings.

7
A formalized universal approach to credit risk was from set out in the BIS Accord 1988.
Banks were required by their regulators to set aside a flat fixed percentage of their risk-
weighted assets as regulatory capital. However, this regulatory framework for measuring
capital adequacy has come under severe criticism for various reasons such as inadequate
differentiation of credit risk, ignoring diversification benefits, etc.

Banks will require regulatory capital changes for “Operational Risk” and “Market Risk”.
The Operational risk was the cause of various well-publicized financial disasters such as
collapse of Barings bank in 1995. The bank lacked adequate operational controls.

The Basle committee has proposed a revised Capital Adequacy framework in June 1999,
envisaged to remove shortcomings of the 1988 Accord and remove deficiencies in its
risk-weighting model. The new framework uses three-pillar approach consisting of (a)
minimum capital requirements, (b) supervisory review process to ensure that bank’s
capital is aligned to its actual risk profile and (c) market discipline to enhance the role of
other market participants in ensuring that appropriate capital is held by prescribing
greater disclosure. The revised framework lays more emphasis on bank’s internal risk
management systems. The three pillars are critically interdependent and the success of
the new framework hinges on ensuring the proper functioning of all three of them.

The ultimate goal of the New Capital Accord is to ensure that the regulatory capital
requirement is sufficient to address the underlying risks of banks. Hence, it is an attempt
to narrow the gap between regulatory and economic capital, driven by increasing
sophistication of risk management techniques in banks. Improving standards of risk
management will enable the banking sector to prosper in future.

The Basle Capital Accord is primarily targeted towards internationally active banks.
However, Reserve Bank of India has issued various guidelines to Indian banks in line
with the committee’s proposal for the purpose of effective Risk Management, in order to

8
sustain them in the increasingly competitive environment

INDEX

Sr. No. Topic Page no.

1 Introduction

2 The Essence of Urban Co-operative

Banks

3 Risk and risk management concepts

4 Risk Management System in Banks

(Introduction)

5 Credit Risk

6 Market Risk

7 Operational Risk

8 Case Study

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 INTRODUCTION

“The fact is that bankers are in the business of managing risk,

pure and simple, that is the business of banking.”
Walter Wriston – Chairman and CEO, CITICORP (1970-84)

Risk Management has assumed greater significance in the past decade or so for the
following key environmental factors that has changed in the financial services industry
and has required the industry to improve both its monitoring and its management of risk
exposures:

I - Industry Consolidation

I - Increased Competition

T - Technological Changes

M - Management

These factors are of course, not the only ones affecting the industry, but their combined
influence has clearly altered the management challenges.

Let us understand in brief the above 4 factors, starting with Consolidation: Twenty years
ago, America's largest bank was Citicorp, with assets of around $120 billion. Though
Citicorp had a major international banking presence, its domestic banking operation was
contained largely in the State of New York. Its major national credit card operation was
its most significant departure from traditional banking lines. In contrast, today's Citigroup
has $1 trillion in assets and is a highly diversified financial services provider operating
not only throughout the United States but also internationally. Citigroup's expanded
scope is by no means unique. Rather, it is typical of the bank and non-bank consolidation
that has taken place. Today, thirteen financial holding companies hold more than $100

10
billion in assets. However, there are more than 6,000 separate banking organizations in
United States, and the largest organizations of them now have nationwide presence and
offer a broad array of financial products.

Let's move on to competition. Despite the consolidation that has taken place, the
financial services industry remains highly competitive. Not only do banks face intra-
industry competition, but they also face competition from non-bank financial service
providers. As of all of you know, virtually every financial product offered by the banking
industry is also offered--either identically or by a close substitute--outside the regulated
financial services industry.

Let me touch on several ways that technology has changed the banking industry. First,
technological advances from the past decade have allowed real-time access to credit
information and public records. This ability to mine data allows providers of financial
products to identify target markets with minimal geographic restraint. Secondly,
technology has allowed organizations to separate the various business functions, such as
product marketing, credit review and administration, and asset funding, and to locate
each of these functions based on separate criteria, such as the availability of labor or the
tax environment. Thirdly, technology has helped institutions monitor and manage risk by
hedging exposure to credit risk and interest rate risk or by selling certain assets in
secondary markets.

The fourth environmental factor is the virtually unanimous corporate goal of maximizing
shareholder value by the management. The motivation for this goal is obvious. The
stock market has accorded a price-earnings premium to financial institutions that
consistently outperform their competitors. This premium translates into highly receptive
capital markets and enhanced compensation to employees through stock options and
provides the institution with a strong currency with which to pursue mergers or
acquisitions.

11
Thus far we have understood only the positive aspects of each of these environmental
factors, but each also has potential negatives.

The consolidation that has created these giant institutions has also created many new risk-
management challenges.

Enhanced competition has brought increased pressure on interest-rate spreads and, when
combined with the continual pressure for earnings performance, can encourage either
imprudent risk-taking or a push for aggressive accounting treatment. Sophisticated
technology can at times be its own risk as a system failure or software error can have
extremely negative consequences.

With the globalization of economies world-over, the concepts like capital adequacy, asset
classification and income recognition have pride of place in the glossaries of financial
sector. Post Barings episode, the focus of supervisory concern has shifted from Asset
Quality to Risk Management. Instead of merely addressing the credit quality issues,
financial sector in general and banks in particular are laying emphasis on overall risk
profile.

Over the past few decades, there has been increased financial volatility in the financial
markets worldwide, which was triggered by the breakdown of the fixed exchange rate
system in the 1970s and fuelled further by the introduction of new financial products, the
quantum leap in technological capabilities that blurred financial boundaries, regulatory
initiatives and the thrust on profitability. This volatility has manifested itself as increased
risk and the failure to manage this risk has seen several institutions collapse across the
globe.

12
Historically, the focus in the areas of risks and controls in Indian banking has been on the
elements of management oversight, control and monitoring i.e. the operational risks. Risk
assessment of financial nature (credit, liquidity, market) has not traditionally been a
component of the risk recognition and control systems. In part, this has been due to the
fact that only operational and credit risks were the key concerns of the banks since they
were not exposed to market risks till recently. This contextual focus is evident from the
fact that the measures generally associated with assessment and control of the financial
risks viz. ALM, limit setting etc. have been implemented in 1986 itself for the overseas
branches of Indian Banks which operate in such market driven environment, whereas
such prescriptions had not been made for the domestic operations.

In the last decade, banking in India has undergone significant transformation due to the
increased market orientation of the banks, the increased competition brought out by the
entry of new banks in the private sector, deregulation of interest rates and the higher
levels of technology absorption in the industry. The arising of new risks and the
heightened awareness of existing ones has accompanied this transformation. The business
risks faced by Indian banks today can be classified as follows:

Financial Intermediation Risk

A] Financial Risks:
Credit Risk
1. Contingency Risk
2. Market Risk
- Interest Rate Risk
- Liquidity Risk
- Foreign Exchange Risk
- Equity Prices Risk, and;
- Commodities Prices Risk
- Capital Risks
- Solvency Risk

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B] Non-Financial Risks:
1. Operational Risk
2. Systemic Risk
3. Legal Risks
4. Reputation Risk

Over a period of time, regulations have been introduced by apex bank and regulator
Reserve Bank of India, requiring banks to provide for capital against credit risk in line
with the BIS capital accord. With interest rate risks becoming a reality only in the last
couple of years following the deregulation of administered rates, banks have been
advised to set up ALM committees to manage interest rate and liquidity risks. ALM
guidelines have also been drawn up which are already been advised to banks, and which
will put in place internal reporting systems required for the management of the risks. The
focus of supervision has also shifted towards a risk-based approach.

Banks are however yet to put in place comprehensive Risk Management Systems as
indicated in the Basle Core Principles and have essentially been reacting to regulatory
and reporting requirements in their risk management efforts. In an environment where the
risk-reward tradeoff can have immediate and systemic implications, having risk
management systems in place is no longer a matter of choice. These systems must be
proactive enough to constantly scan the external environment in the search of emerging
market risks and simultaneously be reactive and firmly entrenched in systems and
procedures to be able to carry out a continuous self-assessment and trigger corrective
action. These systems must also recognize that their purpose is not to contain or remove
risk but to assist the organization in exploiting potential business opportunity in a manner
so as to enhance shareholders value without endangering the assets of the firm.

14
The broad parameters of risk management function are as under.

(i) The main components of a sound risk management focus are: competitive
risk measurement approach; a detailed structure of limits, guidelines and
other parameters used to govern risk taking; and a strong management
information system for controlling, monitoring and reporting risks.
(ii) The risk appetite of a bank is decided by its Board of Directors who
should approve all significant policies relating to the management of risks,
throughout the bank. These policies have to be consistent with the broader
business strategies, capital strength, management expertise and overall
willingness to take risk.
(iii) Senior management should be responsible for ensuring that there are
adequate policies and procedure for conducting various businesses. This
responsibility includes ensuring that there are clear delineation of lines of
responsibility for managing risk, adequate systems for measuring risk,
appropriately structured limits on risk taking, effective internal controls
and a comprehensive risk reporting framework
(iv) The risk management function should be an independent function
(v) Management should ensure that the various components of the
institution’s risk management process are regularly reviewed and
evaluated.
(vi) A sound internal control system should promote effective operations;
reliable financial and regulatory reporting; and compliance with relevant
laws, regulation and policies. Internal auditors have to evaluate the
independence and overall effectiveness of the bank’s risk management
functions.

Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework
for management of risks in India. The design of risk management functions should be
bank specific, dictated by the size, complexity of functions, the level of technical
expertise and the quality of MIS. The guidelines outlined by Reserve Bank of India in

15
October 1999, only provides broad parameters and each bank may evolve their own
systems compatible to their risk management architecture and expertise.

The Broad objective of this paper is to analyze the risk management system followed in
urban cooperative Banks vis-à-vis RBI guidelines.

16
 The Essence of Urban Co-operative Banks

Definition of co-operation

The word co-operation has been defined in different ways by economists, lawmakers and
others.

According to co-operative planning Committee appointed by the Government of India in

1945 known as Saraiya Committee the definition of co-operation is:

“Cooperation is a form of organization in which persons the bonds of moral solidarity

between them, voluntarily associate and come together on the basis of equality for the
promotion of their economic interests. Those who come together have a common
economic aim which they cannot achieve by individual isolated action because of the
weakness of economic position of a large majority of them. This element of individual
weakness can be overcome by pooling their resources by making self help effective
through mutual aid and by strengthening”.

What is an Urban Co-operative Bank?

The urban co-operative banks were first started in Germany in 1888 and in Italy in 1898.
Thus urban co-operative banks are more than 100 years old.

In India first urban co-operative bank was started by Mr Vitthal Laxman Kavthekar in
1889. The guiding principles of voluntary and open membership, equal economic
participation and concern for the community were the basis.

17
Co-operative Banks in India have come a long way since the enactment of the
agricultural Credit Co-operative Societies Act 1904. The century old co-operative
banking structure is viewed as an important instrument of banking access to the rural
masses and thus a vehicle for democratization of Indian financial System. Co-operative
Banks mobilize deposits and purvey agricultural and rural credit with a wider outreach.
They have also been an important instrument for various development schemes,
particularly subsidy based programmes for the poor.

The co-operative banking structure in India comprises urban co-operative banks and rural
co-operative credit institutions. Urban co-operative banks consist of single tier viz.
primary co-operative, commonly referred to as urban co-operative banks (UCBs). The
rural co-operative credit structure has traditionally been bifurcated into two parallel
wings viz. short term and long term. Short term co-operative and credit institutions have a
federal three tier structure consisting of a large number of primary agricultural credit
societies (PACS) at the grassroot level, central co-operative banks (CCBs) at the district
level and State co-operative banks (StCBs) at the state/apex level. The smaller States and
union territories have a two tier structure with the StCBs directly meeting the credit
requirements of PACS. The long term rural co-operative structure has two tiers, viz. State
co-operative agriculture and rural development banks (SCARDBs) at the state level and
primary co-operative and rural development banks (PCARDBs) at the taluka/tehsil level.
However some states have a unitary structure with the State level banks operating
through their own branches: three States have a mixed structure incorporating both
unitary and federal systems.

Till end of March 2005 the number of UCBs was 1872 and till end of March 2004 the
count of rural co-operative credit institutions was 1,06,919 with short term having a
majority share of 1,06,131 institutions and long term having 788.Out of short term StCBs
had 31 CCBs had 365 and PACS had 1,05,735 institutions respectively. In long term
SCARDBs had 20 and PCARDBs had 768 institutions respectively.

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How do Urban Cooperative Banks differ from others?

Unlike commercial banks which are promoted by institutions or the government and are
in the nature of a joint stock company, co-operative banks are promoted by a group of
individuals to fulfill their needs.

The co-operative banks are owned by the customers or the users. Thus to borrow funds
from a cooperative bank one has to be a shareholder of the bank. The shareholders in turn
elect a managing committee which runs the bank. Various state governments have placed
limitations on maximum share holding by an individual to ensure that no single
individual or group obtains control of the bank.

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Objectives of the co-operative banks

The co-operative system world over has emerged with a distinct objective namely to
safeguard the interests of its members and to provide financial assistance to those who are
unable to get financial help from other institutions. Still a large number of people in the
urban, semiurban and villages are unable to receive the benefits. They have not benefited
from the new developments to a desired extent. The co-operatives can play a very
significant role in the traditional areas like small borrowers; retail and petty traders
transport operators and other weaker sections of the society.

Primary urban co-operative banks play an important role in meeting the growing credit
needs of urban and semi-urban areas. UCBs mobilize savings from the middle and lower
income groups and purvey credit to small sections of the society.

The basic idea of establishing the co-operative bank is still relevant but they have to
change their working style and adopt modern means of ICT. Hence it would be useful to
discuss in brief the basic philosophy behind establishing the cooperative institutions.
Today there are over 2000 primary urban cooperative banks with a deposit of over Rs
60000 crores.

Early history of cooperative movement through out the world shows that cooperative
organizations began with consumers cooperatives. The first Co-operative society known
as Rochdale Pioneer was formed by 28 flannel weavers in England in 1843 to protect
themselves against the organized sector. The movement later spread on to the other fields
of economic activities. But the ultimate aim of co-operatives was the protection of poor
sections of the society by pooling the available sources with them to help their members
by providing financial assistance to face the competition from the organized sector.

Risk and Risk Management

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Risk analysis and management is just as common to our everyday existence as the very
concept of self-preservation. It is very much a part of human psyche, yet so eluding.
Interestingly, organizations are no exception to these paradoxes. Many in the
organizations still view risk as a scientific or engineering tool but not as an essential
metric. It is not hard to understand the reasons behind it.

Firstly, 'risk' raises many questions viz., are all risks bad, is risk a natural metric, can risk
be measured directly, in what units is risk measured, can risk be added and subtracted;
than answers about its nature. Secondly, to anyone trying to understand risk there appears
to be no frame of reference within which it could be understood. Thirdly, we cannot
attach a probe to a device and measure risk. Fourthly, risk is an abstract parameter,
requiring a degree of intellect that may, perhaps, be unique to human beings, to quantify
it. Any of them could be the reasons why risk-related discussions even today sound
theoretical if not philosophical and for most of the part, irrelevant to many in
organizations.

Definition of Risk

The word 'risk' is derived from an Italian word "risicare" which means 'to dare'. It means
risk is more 'a choice' than 'a fate'. An extension of this analogy further reveals that risk is
not something to be faced but a set of opportunities open to choice.

There is however, no one precise definition of risk that captures its entire spectra but a
plethora of opinions:

 Possibility of loss or injury; Peril

 A dangerous element or factor.
 A chance of loss and the degree of probability of such loss.
 The possibility of suffering harm or loss; danger; hazard.
 A factor, element or course involving uncertain danger.
 The danger or probability of loss.

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  Risk is just the chance of losing money.
 Risk is a chance of gaining less money than normally expected.

In statistical terms, risk is defined as the degree of variability of possible outcomes for a
particular event. In financial parlance, risk is always associated with loss that is expected
to be incurred or less profit to be incurred due to the happening or non-happening of
certain events or activities. It arises as a deviation between what happens and what was
expected to happen. Therefore, how people view hazards will greatly influence their
perception of associated risk. In a way this is a good thing for, if everyone valued every
risk in precisely the same way, many risk opportunities would be passed by.

Risks can be dealt in any one or the combination of following ways:

1. Risk Avoidance – Avoiding taking risks.

2. Risk Reduction – Risk reduction through safety measures.
3. Risk Retention – One can retain the risks on to their own books.
4. Risk Transfer – By way of Insurance or Hedging.

Survey on Corporate risk management published by the Economist makes the following
observations:

 Risk Management must be regarded as a core skill by every firm.

 Risk Management is not an ivory tower for arcane specialists.

 Increased disclosure of risk assessments and responses is the best course of

action, not increased regulation or aversion of employing financial instruments
that can reduce risk if used properly.

 Risk Management must be senior management strategic responsibility, not solely

assigned to finance department.

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The primary message of this survey is that the firms need to understand all the main risks
to which their future cash flows are exposed, not just the narrowly defined financial ones.
Over focus on one type of risk or another simply perpetuates the outmoded fragmented
approach to the management of risk.

The aforesaid clearly brings out the need to have proper understanding of framework for
risk management including the concept, generating of risk profile and the process.

Risk Management Concept

Risk Management is the continuous process of identifying and capitalizing on appropriate

opportunities while avoiding inappropriate exposures in such a way to maximize the
value of the enterprise. Exposures in the aggregate result from diverse activities, executed
from many locations by numerous people. Identifying exposure - its worthiness or
otherwise, is the greatest challenge in the risk management. Ultimately how exposures
and risks are managed depends upon the organizational culture, goals and risk tolerance.
Risk Management is the primary duty of line managers. It is based on separation of
responsibilities principle. It is fundamentally a managerial process, reflective of
organizations risk characteristics.

There is a mistaken belief that risk management is window dressing for regulators. Risk
Management is neither an added layer of bureaucracy nor an impediment to quick
execution and superior customer service. Risk Management is critical to the conduct of
safe and sound banking activities. New technologies, new products and size and speed of
financial transactions have added impetus to the risk management issues. Along with
financial performance of an institution equal importance is given to risk management
practices.

The Risk Management procedures need to address the following issues:

23
  Ability to manage risk inherent in lending, trading and other transactions.

 Soundness of implicit and explicit assumptions - both qualitative and quantitative

in the risk management system.

 Consistency of policies/guidelines with lending/trading activities, managements

experience level and overall financial strength.

 Appropriateness of MIS and communication network vis-à-vis level of business

activity, and;

 Managerial capacity to identify and accommodate new risks.

A fully integrated risk management system that effectively identifies and controls all
major types of risks including those from new products and changing environment would
facilitate long-term growth and stability.

Risk is a multidimensional concept and risk management is a continuous activity. As

such, practically everyone throughout the organization is concerned with identifying and
managing risk. What is required is anticipating and preventing risk at the source and the
continuous monitoring of risk controls and ineffective processes which are the primary
source of risk. Hence, risk management needs to address to the process issue. Risk
Management encompasses three activities viz., Risk Identification, Risk Measurement
and Risk Control. Risk Identification, as a starting point consists of naming and defining
each risk associated with a type of transaction or a product or a service. When the
transactions are many and the chain of communication is long a formal risk identification
system is necessary. The second component is risk measurement. It is the estimation of
size, probability and timing of potential loss under various scenarios. This is a difficult
component due to variety of available methods, degree of sophistication and costs
involved. For example, asset/liability analysis is considered as a measure for estimating
impact of changes in interest rates on portfolio value. Various interest rate scenarios

24
could be developed for appreciation of risk involved.

Risk control has two sub-categories. The first relates to policy administrative control,
while the second is risk-mitigating activity. Having proper policies/procedures, helps to
define each person's role, limit to which he can take risk, reporting mechanism and the
like. The goal of each such policy is to keep the outcome within risk tolerance ranges.
Uniformity of language is useful while defining each risk precisely from department to
department. The other aspect of risk control is risk-mitigating activity. The available
options could be risk transfer (insurance or hedging), elimination or avoidance (staying
out of risky business), reduction (specification and adherence to limit) and risk retention.

Prerequisites of Effective Risk Management Systems in Banks

Establishment of a sound risk management system presupposes specification of and

adherence to certain qualitative and quantitative criteria. The quantitative requirements
provide a level of consistency necessary for a capital standard, while the qualitative
requirements include aspects, which may take the shape of

a) Having risk control unit independent of the operating unit

b) Implementing a regular program for validation

c) Laying down procedures for periodic stress testing to evaluate the impact of
unusual transactions

d) Adopting internal policies/procedures/controls which are documented, and;

e) Conducting independent review of risk management process by internal auditors.

For a sound risk management system to meet these quantitative and qualitative criteria,
each organization has to address to certain pre-requisites. They are:

25
 1. Active Board and Senior Management Oversight
2. Adequate Risk Management Policies and Limits
3. Appropriate Risk Measurement and Reporting Systems, and;
4. Comprehensive Internal Control System

Active Board and Senior Management Oversight

Boards of Directors have the ultimate responsibility to determine the level of risks
undertaken by the organization. Board needs to approve overall business strategies/
policies including managing and undertaking risks.

Ensuring capability of senior management to conduct the risk management task is also
the board’s responsibility. Board therefore needs to have a clear understanding of the
types of risks, the institution is exposed to. They should receive in meaningful terms
reports identifying the size and significance of risks. It may be useful to have briefing
from outside experts so that the board is capable to guide its institution on the level of
acceptable risk. This would also facilitate that the senior management implements the
procedures and controls necessary to comply with adopted policies.

Senior Management is responsible for implementing strategies that limit risks associated
with each strategy and ensures compliance with laws and regulations. Adopting policies,
devising control mechanisms and risk monitoring systems, delineating accountability and
lines of authority creating and communicating awareness of internal controls as also
ethical standards are all tasks of senior management.

Adequate Risk Management Policies and Limits

26
There can be nothing like proto-type policies or procedures for risk management. The
size of operations, sophistication, level of technology, managerial capacity and ability to
undertake risks are some of the determinants while documenting policies and procedures.
The policies and procedures are tailored according to the types of risks that arise from the
activities of the organization. They provide detailed guidelines on implementation and
prescribe limits designed to protect the organization from excessive and imprudent risks.
The core of these policies is to address to the material areas of risk and their necessary
modification to respond to significant changes to bank activities or business environment.
These policies and procedures provide risk management framework based on
management experience level, goals, objectives and overall financial strength of the
banking organization. Delineating accountability and lines of authority across the
organizational activities and review of activities new to the bank are also facilitated
through such policies.

Monitoring and Management Information Systems

Risk management related activity i.e., identification, measurement, and monitoring/

control need to be supported by a proper Management Information System (MIS). Such
MIS provides reports on financial condition, operational performance and risk exposures.
Line Managers can expect to obtain more detailed feedback on day-to-day operating
activities. Complexity and diversity of institutions financial transactions would dictate
sophistication of MIS. MIS for example will include daily financials including profit/loss
details, a watch list of troubled loans, etc. Whenever trading activities are on a larger
scale, more detailed activity reports across the whole organization may be necessary. The
purpose is to ultimately ensure that policies and procedures address to material risks areas
and that they are modifies to respond to the changes in activities, business conditions and
environment.

Comprehensive Internal Control System

27
Internal control structure is critical for safety and soundness of any organization. As the
instances of Daiwa/ Barings have proved, failure to implement/ maintain separation of
duties can result in serious financial and reputation losses. A properly placed internal
control system aims at:

• Promoting effective operations and reliable reporting

• Safeguarding assets, and;
• Ensuring regulatory/ policy compliance

Effective internal controls need to be looked into by internal auditors, who would report
directly to the top management. The internal controls primarily check the
policies/procedures in terms of their adequacy and effectiveness. The prescription for
proper policies and procedures do equally hold good for internal controls.

RISK MANAGEMENT SYSTEMS IN BANKS

28
Introduction

Banks in the process of financial intermediation are confronted with various kinds of
financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity,
equity price, commodity price, legal, regulatory, reputation, operational, etc. These risks
are highly interdependent and events that affect one area of risk can have ramifications
for a range of other risk categories. Thus, top management of banks should attach
considerable importance to improve the ability to identify measure, monitor and control
the overall level of risks undertaken.

The broad parameters of risk management function should encompass:

i) Organizational structure;
ii) Comprehensive risk measurement approach;
iii) Risk management policies approved by the Board which should be consistent with
the broader business strategies, capital strength, management expertise and overall
willingness to assume risk;
iv) Guidelines and other parameters used to govern risk taking including detailed
structure of prudential limits;
v) Strong MIS for reporting, monitoring and controlling risks;
vi) Well laid out procedures, effective control and comprehensive risk reporting
framework;
vii) Separate risk management framework independent of operational Departments and
with clear delineation of levels of responsibility for management of risk; and
viii) Periodical review and evaluation.

Risk Management Structure

29
A major issue in establishing an appropriate risk management organization structure is
choosing between a centralized and decentralized structure. The global trend is towards
centralizing risk management with integrated treasury management function to benefit
from information on aggregate exposure, natural netting of exposures, economies of scale
and easier reporting to top management. The primary responsibility of understanding the
risks run by the bank and ensuring that the risks are appropriately managed should clearly
be vested with the Board of Directors. The Board should set risk limits by assessing the
bank’s risk and risk-bearing capacity. At organizational level, overall risk management
should be assigned to an independent Risk Management Committee or Executive
Committee of the top Executives that reports directly to the Board of Directors. The
purpose of this top level committee is to empower one group with full responsibility of
evaluating overall risks faced by the bank and determining the level of risks which will
be in the best interest of the bank. At the same time, the Committee should hold the line
management more accountable for the risks under their control, and the performance of
the bank in that area. The functions of Risk Management Committee should essentially
be to identify, monitor and measure the risk profile of the bank. The Committee should
also develop policies and procedures, verify the models that are used for pricing complex
products, review the risk models as development takes place in the markets and also
identify new risks. The risk policies should clearly spell out the quantitative prudential
limits on various segments of banks’ operations. Internationally, the trend is towards
assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and
Earnings at Risk and Value at Risk (market risk). The Committee should design stress
scenarios to measure the impact of unusual market conditions and monitor variance
between the actual volatility of portfolio value and that predicted by the risk measures.
The Committee should also monitor compliance of various risk parameters by operating
Departments.

A prerequisite for establishment of an effective risk management system is the existence

of a robust MIS, consistent in quality. The existing MIS, however, requires substantial

30
up gradation and strengthening of the data collection machinery to ensure the integrity
and reliability of data.

The risk management is a complex function and it requires specialized skills and
expertise. Banks have been moving towards the use of sophisticated models for
measuring and managing risks. Large banks and those operating in international markets
should develop internal risk management models to be able to compete effectively with
their competitors. As the domestic market integrates with the international markets, the
banks should have necessary expertise and skill in managing various types of risks in a
scientific manner. At a more sophisticated level, the core staff at Head Offices should be
trained in risk modeling and analytical tools. It should, therefore, be the endeavor of all
banks to upgrade the skills of staff.

Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework
for management of risks in India. The design of risk management functions should be
bank specific, dictated by the size, complexity of functions, the level of technical
expertise and the quality of MIS. The proposed guidelines only provide broad parameters
and each bank may evolve their own systems compatible to their risk management
architecture and expertise.

Internationally, a committee approach to risk management is being adopted. While the

Asset - Liability Management Committee (ALCO) deal with different types of market
risk, the Credit Policy Committee (CPC) oversees the credit /counterparty risk and
country risk. Thus, market and credit risks are managed in a parallel two-track approach
in banks. Banks could also set-up a single Committee for integrated management of
credit and market risks. Generally, the policies and procedures for market risk are
articulated in the ALM policies and credit risk is addressed in Loan Policies and
Procedures.

31
Currently, while market variables are held constant for quantifying credit risk, credit
variables are held constant in estimating market risk. The economic crises in some of the
countries have revealed a strong correlation between unhedged market risk and credit
risk. Forex exposures, assumed by corporates who have no natural hedges, will increase
the credit risk which banks run vis-à-vis their counterparties. The volatility in the prices
of collateral also significantly affects the quality of the loan book. Thus, there is a need
for integration of the activities of both the ALCO and the CPC and consultation process
should be established to evaluate the impact of market and credit risks on the financial
strength of banks. Banks may also consider integrating market risk elements into their
credit risk assessment process.

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 Credit Risk

General

Lending involves a number of risks. In addition to the risks related to creditworthiness of

the counterparty, the banks are also exposed to interest rate, forex and country risks.

Credit risk or default risk involves inability or unwillingness of a customer or

counterparty to meet commitments in relation to lending, trading, hedging, settlement and
other financial transactions. The Credit Risk is generally made up of transaction risk or
default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and
concentration risk. The credit risk of a bank’s portfolio depends on both external and
internal factors. The external factors are the state of the economy, wide swings in
commodity/equity prices, foreign exchange rates and interest rates, trade restrictions,
economic sanctions, Government policies, etc. The internal factors are deficiencies in
loan policies/administration, absence of prudential credit concentration limits,
inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in
appraisal of borrowers’ financial position, excessive dependence on collaterals and
inadequate risk pricing, absence of loan review mechanism and post sanction
surveillance, etc.

Another variant of credit risk is counterparty risk. The counterparty risk arises from non-
performance of the trading partners. The non-performance may arise from counterparty’s
refusal/inability to perform due to adverse price movements or from external constraints
that were not anticipated by the principal. The counterparty risk is generally viewed as a
transient financial risk associated with trading rather than standard credit risk.

The management of credit risk should receive the top management’s attention and the
process should encompass:

33
a) Measurement of risk through credit rating/scoring;
b) Quantifying the risk through estimating expected loan losses i.e. the amount of loan
losses that bank would experience over a chosen time horizon (through tracking portfolio
behavior over 5 or more years) and unexpected loan losses i.e. the amount by which
actual losses exceed the expected loss (through standard deviation of losses or the
difference between expected loan losses and some selected target credit loss quantity);
c) Risk pricing on a scientific basis; and
d) Controlling the risk through effective Loan Review Mechanism and portfolio
management.

The credit risk management process should be articulated in the bank’s Loan Policy,
duly approved by the Board. Each bank should constitute a high level Credit Policy
Committee, also called Credit Risk Management Committee or Credit Control
Committee etc. to deal with issues relating to credit policy and procedures and to analyze,
manage and control credit risk on a bank wide basis. The Committee should be headed by
the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury,
Credit Risk Management Department (CRMD) and the Chief Economist. The Committee
should, inter alia, formulate clear policies on standards for presentation of credit
proposals, financial covenants, rating standards and benchmarks, delegation of credit
approving powers, prudential limits on large credit exposures, asset concentrations,
standards for loan collateral, portfolio management, loan review mechanism, risk
concentrations, risk monitoring and evaluation, pricing of loans, provisioning,
regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk
Management Department (CRMD), independent of the Credit Administration
Department. The CRMD should enforce and monitor compliance of the risk parameters
and prudential limits set by the CPC. The CRMD should also lay down risk assessment
systems, monitor quality of loan portfolio, identify problems and correct deficiencies,
develop MIS and undertake loan review/audit. Large banks may consider separate set up
for loan review/audit. The CRMD should also be made accountable for protecting the
quality of the entire loan portfolio. The Department should undertake portfolio

34
evaluations and conduct comprehensive studies on the environment to test the resilience
of the loan portfolio.

Instruments of Credit Risk Management

Credit Risk Management encompasses a host of management techniques, which help the
banks in mitigating the adverse impacts of credit risk.

Credit Approving Authority

Each bank should have a carefully formulated scheme of delegation of powers. The
banks should also evolve multi-tier credit approving system where the loan proposals are
approved by an ‘Approval Grid’ or a ‘Committee’. The credit facilities above a specified
limit may be approved by the ‘Grid’ or ‘Committee’, comprising at least 3 or 4 officers
and invariably one officer should represent the CRMD, who has no volume and profit
targets. Banks can also consider credit approving committees at various operating levels
i.e. large branches (where considered necessary), Regional Offices, Zonal Offices, Head
Offices, etc. Banks could consider delegating powers for sanction of higher limits to the
‘Approval Grid’ or the ‘Committee’ for better rated / quality customers. The spirit of the
credit approving system may be that no credit proposals should be approved or
recommended to higher authorities, if majority members of the ‘Approval Grid’ or
‘Committee’ do not agree on the creditworthiness of the borrower. In case of
disagreement, the specific views of the dissenting member/s should be recorded.

The banks should also evolve suitable framework for reporting and evaluating the quality
of credit decisions taken by various functional groups. The quality of credit decisions
should be evaluated within a reasonable time, say 3 – 6 months, through a well-defined
Loan Review Mechanism.

35
Prudential Limits

In order to limit the magnitude of credit risk, prudential limits should be laid down on
various aspects of credit:
a) Stipulate benchmark current/debt equity and profitability ratios, debt service coverage
ratio or other ratios, with flexibility for deviations. The conditions subject to which
deviations are permitted and the authority therefore should also be clearly spelt out in the
Loan Policy;
b) Single /group borrower limits, which may be lower than the limits prescribed by
Reserve Bank to provide a filtering mechanism;
c) Substantial exposure limit i.e. sum total of exposures assumed in respect of those
single borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15%
of capital funds. The substantial exposure limit may be fixed at 600% or 800% of
capital funds, depending upon the degree of concentration risk the bank is exposed;
d) Maximum exposure limits to industry, sector, etc. should be set up. There must also
be systems in place to evaluate the exposures at reasonable intervals and the limits should
be adjusted especially when a particular sector or industry faces slowdown or other
sector/industry specific problems. The exposure limits to sensitive sectors, such as,
advances against equity shares, real estate, etc., which are subject to a high degree of
asset price volatility and to specific industries, which are subject to frequent business
cycles, may necessarily be restricted. Similarly, high-risk industries, as perceived by the
bank, should also be placed under lower portfolio limit. Any excess exposure should be
fully backed by adequate collaterals or strategic considerations; and
e) Banks may consider maturity profile of the loan book, keeping in view the market risks
inherent in the balance sheet, risk evaluation capability, liquidity, etc.

Risk Rating

Banks should have a comprehensive risk scoring / rating system that serves as a single
point indicator of diverse risk factors of counterparty and for taking credit decisions in a
consistent manner. To facilitate this, a substantial degree of standardization is required in

36
ratings across borrowers. The risk rating system should be designed to reveal the overall
risk of lending, critical input for setting pricing and non-price terms of loans as also
present meaningful information for review and management of loan portfolio. The risk
rating, in short, should reflect the underlying credit risk of the loan book. The rating
exercise should also facilitate the credit granting authorities some comfort in its
knowledge of loan quality at any moment of time.

The risk rating system should be drawn up in a structured manner, incorporating, inter
alia, financial analysis, projections and sensitivity, industrial and management risks. The
banks may use any number of financial ratios and operational parameters and collaterals
as also qualitative aspects of management and industry characteristics that have bearings
on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the
years to which they represent for giving importance to near term developments. Within
the rating framework, banks can also prescribe certain level of standards or critical
parameters, beyond which no proposals should be entertained. Banks may also consider
separate rating framework for large corporate / small borrowers, traders, etc. that exhibit
varying nature and degree of risk. Forex exposures assumed by corporates who have no
natural hedges have significantly altered the risk profile of banks. Banks should,
therefore, factor the unhedged market risk exposures of borrowers also in the rating
framework. The overall score for risk is to be placed on a numerical scale ranging
between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a
quantitative definition of the borrower, the loan’s underlying quality, and an analytic
representation of the underlying financials of the borrower should be presented. Further,
as a prudent risk management policy, each bank should prescribe the minimum rating
below which no exposures would be undertaken. Any flexibility in the minimum
standards and conditions for relaxation and authority therefore should be clearly
articulated in the Loan Policy.

The credit risk assessment exercise should be repeated biannually (or even at shorter
intervals for low quality customers) and should be delinked invariably from the regular
renewal exercise. The updating of the credit ratings should be undertaken normally at

37
quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the
portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate
changes in credit quality and expected loan losses from the credit portfolio. Thus, if the
rating system is to be meaningful, the credit quality reports should signal changes in
expected loan losses. In order to ensure the consistency and accuracy of internal ratings,
the responsibility for setting or confirming such ratings should vest with the Loan Review
function and examined by an independent Loan Review Group. The banks should
undertake comprehensive study on migration (upward – lower to higher and downward –
higher to lower) of borrowers in the ratings to add accuracy in expected loan loss
calculations.

Risk Pricing

Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting,

borrowers with weak financial position and hence placed in high credit risk category
should be priced high. Thus, banks should evolve scientific systems to price the credit
risk, which should have a bearing on the expected probability of default. The pricing of
loans normally should be linked to risk rating or credit quality. The probability of default
could be derived from the past behavior of the loan portfolio, which is the function of
loan loss provision/charge offs for the last five years or so. Banks should build historical
database on the portfolio quality and provisioning / charge off to equip themselves to
price the risk. But value of collateral, market forces, perceived value of accounts, future
business potential, portfolio/industry exposure and strategic reasons may also play
important role in pricing. Flexibility should also be made for revising the price (risk
premia) due to changes in rating / value of collaterals over time. Large sized banks
across the world have already put in place Risk Adjusted Return on Capital (RAROC)
framework for pricing of loans, which calls for data on portfolio behavior and allocation
of capital commensurate with credit risk inherent in loan proposals. Under RAROC
framework, lender begins by charging an interest mark-up to cover the expected loss –
expected default rate of the rating category of the borrower. The lender then allocates
enough capital to the prospective loan to cover some amount of unexpected loss-

38
variability of default rates. Generally, international banks allocate enough capital so that
the expected loan loss reserve or provision plus allocated capital cover 99% of the loan
loss outcomes.

There is, however, a need for comparing the prices quoted by competitors for borrowers
perched on the same rating /quality. Thus, any attempt at price-cutting for market share
would result in mispricing of risk and ‘Adverse Selection’.

Portfolio Management

The existing framework of tracking the Non Performing Loans around the balance sheet
date does not signal the quality of the entire Loan Book. Banks should evolve proper
systems for identification of credit weaknesses well in advance. Most of international
banks have adopted various portfolio management techniques for gauging asset quality.
The CRMD, set up at Head Office should be assigned the responsibility of periodic
monitoring of the portfolio. The portfolio quality could be evaluated by tracking the
migration (upward or downward) of borrowers from one rating scale to another. This
process would be meaningful only if the borrower-wise ratings are updated at quarterly /
half-yearly intervals. Data on movements within grading categories provide a useful
insight into the nature and composition of loan book.

The banks could also consider the following measures to maintain the portfolio quality:
1) Stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e.
certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2
to 4 or 4 to 5, etc.;
2) Evaluate the rating-wise distribution of borrowers in various industry, business
segments, etc;
3) Exposure to one industry/sector should be evaluated on the basis of overall rating
distribution of borrowers in the sector/group. In this context, banks should weigh the pros
and cons of specialization and concentration by industry group. In cases where portfolio

39
exposure to a single industry is badly performing, the banks may increase the quality
standards for that specific industry;
4) Target rating-wise volume of loans, probable defaults and provisioning requirements
as a prudent planning exercise. For any deviation/s from the expected parameters, an
exercise for restructuring of the portfolio should immediately be undertaken and if
necessary, the entry-level criteria could be enhanced to insulate the portfolio from further
deterioration;
5) Undertake rapid portfolio reviews, stress tests and scenario analysis when external
environment undergoes rapid changes (e.g. volatility in the forex market, economic
sanctions, changes in the fiscal/monetary policies, general slowdown of the economy,
market risk events, extreme liquidity conditions, etc.). The stress tests would reveal
undetected areas of potential credit risk exposure and linkages between different
categories of risk. In adverse circumstances, there may be substantial correlation of
various risks, especially credit and market risks. Stress testing can range from relatively
simple alterations in assumptions about one or more financial, structural or economic
variables to the use of highly sophisticated models. The output of such portfolio-wide
stress tests should be reviewed by the Board and suitable changes may be made in
prudential risk limits for protecting the quality. Stress tests could also include
contingency plans, detailing management responses to stressful situations.
6) Introduce discriminatory time schedules for renewal of borrower limits. Lower rated
borrowers whose financials show signs of problems should be subjected to renewal
control twice/thrice a year.

Banks should evolve suitable framework for monitoring the market risks especially forex
risk exposure of corporates who have no natural hedges on a regular basis. Banks should
also appoint Portfolio Managers to watch the loan portfolio’s degree of concentrations
and exposure to counterparties. For comprehensive evaluation of customer exposure,
banks may consider appointing Relationship Managers to ensure that overall exposure to
a single borrower is monitored, captured and controlled. The Relationship Managers
have to work in coordination with the Treasury and Forex Departments. The Relationship
Managers may service mainly high value loans so that a substantial share of the loan

40
portfolio, which can alter the risk profile, would be under constant surveillance. Further,
transactions with affiliated companies/groups need to be aggregated and maintained close
to real time. The banks should also put in place formalized systems for identification of
accounts showing pronounced credit weaknesses well in advance and also prepare
internal guidelines for such an exercise and set time frame for deciding courses of action.

Many of the international banks have adopted credit risk models for evaluation of credit
portfolio. The credit risk models offer banks framework for examining credit risk
exposures, across geographical locations and product lines in a timely manner,
centralizing data and analyzing marginal and absolute contributions to risk. The models
also provide estimates of credit risk (unexpected loss) which reflect individual portfolio
composition. The Altman’s Z score forecasts the probability of a company entering
bankruptcy within a 12-month period. The model combines five financial ratios using
reported accounting information and equity values to produce an objective measure of
borrower’s financial health. J. P. Morgan has developed a portfolio model
‘CreditMetrics’ for evaluating credit risk. The model basically focuses on estimating the
volatility in the value of assets caused by variations in the quality of assets. The volatility
is computed by tracking the probability that the borrower might migrate from one rating
category to another (downgrade or upgrade). Thus, the value of loans can change over
time, reflecting migration of the borrowers to a different risk-rating grade. The model
can be used for promoting transparency in credit risk, establishing benchmark for credit
risk measurement and estimating economic capital for credit risk under RAROC
framework. Credit Suisse developed a statistical method for measuring and accounting
for credit risk which is known as CreditRisk+. The model is based on actuarial
calculation of expected default rates and unexpected losses from default.

The banks may evaluate the utility of these models with suitable modifications to Indian
environment for fine-tuning the credit risk management. The success of credit risk
models impinges on time series data on historical loan loss rates and other model
variables, spanning multiple credit cycles. Banks may, therefore, endeavor building

41
adequate database for switching over to credit risk modeling after a specified period of
time.

Loan Review Mechanism (LRM)

LRM is an effective tool for constantly evaluating the quality of loan book and to bring
about qualitative improvements in credit administration. Banks should, therefore, put in
place proper Loan Review Mechanism for large value accounts with responsibilities
assigned in various areas such as, evaluating the effectiveness of loan administration,
maintaining the integrity of credit grading process, assessing the loan loss provision,
portfolio quality, etc. The complexity and scope of LRM normally vary based on banks’
size, type of operations and management practices. It may be independent of the CRMD
or even separate Department in large banks.

The main objectives of LRM could be:

• to identify promptly loans which develop credit weaknesses and initiate timely
corrective action;
• to evaluate portfolio quality and isolate potential problem areas;
• to provide information for determining adequacy of loan loss provision
• to assess the adequacy of and adherence to, loan policies and procedures, and to
monitor compliance with relevant laws and regulations; and
• to provide top management with information on credit administration, including
credit sanction process, risk evaluation and post-sanction follow-up.

Accurate and timely credit grading is one of the basic components of an effective LRM.
Credit grading involves assessment of credit quality, identification of problem loans, and
assignment of risk ratings. A proper Credit Grading System should support evaluating
the portfolio quality and establishing loan loss provisions. Given the importance and
subjective nature of credit rating, the credit ratings awarded by Credit Administration
Department should be subjected to review by Loan Review Officers who are independent
of loan administration.

42
3.2.7 Banks should formulate Loan Review Policy and it should be reviewed annually by
the Board. The Policy should, inter alia, address:

• Qualification and Independence

The Loan Review Officers should have sound knowledge in credit appraisal, lending
practices and loan policies of the bank. They should also be well versed in the relevant
laws/regulations that affect lending activities. The independence of Loan Review
Officers should be ensured and the findings of the reviews should also be reported
directly to the Board or Committee of the Board.

• Frequency and Scope of Reviews

The Loan Reviews are designed to provide feedback on effectiveness of credit sanction
and to identityncipient deterioration in portfolio quality. Reviews of high value loans
should be undertaken usually within three months of sanction/renewal or more frequently
when factors indicate a potential for deterioration in the credit quality. The scope of the
review should cover all loans above a cut-off limit. In addition, banks should also target
other accounts that present elevated risk characteristics. At least 30-40% of the portfolio
should be subjected to LRM in a year to provide reasonable assurance that all the major
credit risks embedded in the balance sheet have been tracked.

• Depth of Reviews

The loan reviews should focus on:

• Approval process;
• Accuracy and timeliness of credit ratings assigned by loan officers;
• Adherence to internal policies and procedures, and applicable laws / regulations;
Compliance with loan covenants;
• Post-sanction follow-up;

43
 • Sufficiency of loan documentation;
• Portfolio quality; and
• Recommendations for improving portfolio quality

The findings of Reviews should be discussed with line Managers and the corrective
actions should be elicited for all deficiencies. Deficiencies that remain unresolved should
be reported to top management.

The Risk Management Group of the Basle Committee on Banking Supervision has
released a consultative paper on Principles for the Management of Credit Risk. The
Paper deals with various aspects relating to credit risk management. The Paper is
enclosed for information of banks.

Credit Risk and Investment Banking

Significant magnitude of credit risk, in addition to market risk, is inherent in investment

banking. The proposals for investments should also be subjected to the same degree of
credit risk analysis, as any loan proposals. The proposals should be subjected to detail
appraisal and rating framework that factors in financial and non-financial parameters of
issuers, sensitivity to external developments, etc. The maximum exposure to a customer
should be bank-wide and include all exposures assumed by the Credit and Treasury
Departments. The coupon on non-sovereign papers should be commensurate with their
risk profile. The banks should exercise due caution, particularly in investment proposals,
which are not rated and should ensure comprehensive risk evaluation. There should be
greater interaction between Credit and Treasury Departments and the portfolio analysis
should also cover the total exposures, including investments. The rating migration of the
issuers and the consequent diminution in the portfolio quality should also be tracked at
periodic intervals.

44
As a matter of prudence, banks should stipulate entry level minimum ratings/quality
standards, industry, maturity, duration, issuer-wise, etc. limits in investment proposals as
well to mitigate the adverse impacts of concentration and the risk of illiquidity.

Credit Risk in Off-balance Sheet Exposure

Banks should evolve adequate framework for managing their exposure in off-balance
sheet products like forex forward contracts, swaps, options, etc. as a part of overall credit
to individual customer relationship and subject to the same credit appraisal, limits and
monitoring procedures. Banks should classify their off-balance sheet exposures into
three broad categories - full risk (credit substitutes) - standby letters of credit, money
guarantees, etc, medium risk (not direct credit substitutes, which do not support existing
financial obligations) - bid bonds, letters of credit, indemnities and warranties and low
risk - reverse repos, currency swaps, options, futures, etc.
The trading credit exposure to counterparties can be measured on static (constant
percentage of the notional principal over the life of the transaction) and on a dynamic
basis. The total exposures to the counterparties on a dynamic basis should be the sum
total of:
1) The current replacement cost (unrealized loss to the counterparty); and
2) The potential increase in replacement cost (estimated with the help of VaR or other
methods to capture future volatilities in the value of the outstanding contracts/
obligations).

The current and potential credit exposures may be measured on a daily basis to evaluate
the impact of potential changes in market conditions on the value of counterparty
positions. The potential exposures also may be quantified by subjecting the position to
market movements involving normal and abnormal movements in interest rates, foreign
exchange rates, equity prices, liquidity conditions, etc.

45
Inter-bank Exposure and Country Risk

A suitable framework should be evolved to provide a centralized overview on the

aggregate exposure on other banks. Bank-wise exposure limits could be set on the basis
of assessment of financial performance, operating efficiency, management quality, past
experience, etc. Like corporate clients, banks should also be rated and placed in range of
1-5, 1-8, as the case may be, on the basis of their credit quality. The limits so arrived at
should be allocated to various operating centres and followed up and half-yearly/annual
reviews undertaken at a single point. Regarding exposure on overseas banks, banks can
use the country ratings of international rating agencies and classify the countries into low
risk, moderate risk and high risk. Banks should endeavor for developing an internal
matrix that reckons the counterparty and country risks. The maximum exposure should be
subjected to adherence of country and bank exposure limits already in place. While the
exposure should at least be monitored on a weekly basis till the banks are equipped to
monitor exposures on a real time basis, all exposures to problem countries should be
evaluated on a real time basis.

46
 Market Risk

Traditionally, credit risk management was the primary challenge for banks. With
progressive deregulation, market risk arising from adverse changes in market variables,
such as interest rate, foreign exchange rate, equity price and commodity price has become
relatively more important. Even a small change in market variables causes substantial
changes in income and economic value of banks. Market risk takes the form of:
1) Liquidity Risk
2) Interest Rate Risk
3) Foreign Exchange Rate (Forex) Risk
4) Commodity Price Risk and
5) Equity Price Risk

Market Risk Management

Management of market risk should be the major concern of top management of banks.
The Boards should clearly articulate market risk management policies, procedures,
prudential risk limits, review mechanisms and reporting and auditing systems. The
policies should address the bank’s exposure on a consolidated basis and clearly articulate
the risk measurement systems that capture all material sources of market risk and assess
the effects on the bank. The operating prudential limits and the accountability of the line
management should also be clearly defined. The Asset-Liability Management
Committee (ALCO) should function as the top operational unit for managing the balance
sheet within the performance/risk parameters laid down by the Board. The banks should
also set up an independent Middle Office to track the magnitude of market risk on a real
time basis. The Middle Office should comprise of experts in market risk management,
economists, statisticians and general bankers and may be functionally placed directly
under the ALCO. The Middle Office should also be separated from Treasury Department
and should not be involved in the day to day management of Treasury. The Middle Office
should apprise the top management / ALCO / Treasury about adherence to prudential /

47
risk parameters and also aggregate the total market risk exposures assumed by the bank at
any point of time.

Liquidity Risk
Liquidity Planning is an important facet of risk management framework in banks.
Liquidity is the ability to efficiently accommodate deposit and other liability decreases,
as well as, fund loan portfolio growth and the possible funding of off-balance sheet
claims. A bank has adequate liquidity when sufficient funds can be raised, either by
increasing liabilities or converting assets, promptly and at a reasonable cost. It
encompasses the potential sale of liquid assets and borrowings from money, capital and
forex markets. Thus, liquidity should be considered as a defense mechanism from losses
on fire sale of assets.

The liquidity risk of banks arises from funding of long-term assets by short-term
liabilities, thereby making the liabilities subject to rollover or refinancing risk.

The liquidity risk in banks manifest in different dimensions:

i) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-

renewal of deposits (wholesale and retail);
ii) Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e.
performing assets turning into non-performing assets; and
iii) Call Risk - due to crystallization of contingent liabilities and unable to undertake
profitable business opportunities when desirable.

The first step towards liquidity management is to put in place an effective liquidity
management policy, which, inter alia, should spell out the funding strategies, liquidity
planning under alternative scenarios, prudential limits, liquidity reporting / reviewing,
etc.

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Liquidity measurement is quite a difficult task and can be measured through stock or cash
flow approaches. The key ratios, adopted across the banking system are:
i) Loans to Total Assets
ii) Loans to Core Deposits
iii) Large Liabilities (minus) Temporary Investments to Earning Assets (minus)
Temporary Investments, where large liabilities represent wholesale deposits which are
market sensitive and temporary Investments are those maturing within one year and those
investments which are held in the trading book and are readily sold in the market;
iv) Purchased Funds to Total Assets, where purchased funds include the entire inter-
bank and other money market borrowings, including Certificate of Deposits and
institutional deposits; and
v) Loan Losses/Net Loans.

While the liquidity ratios are the ideal indicator of liquidity of banks operating in
developed financial markets, the ratios do not reveal the intrinsic liquidity profile of
Indian banks which are operating generally in an illiquid market. Experiences show that
assets commonly considered as liquid like Government securities, other money market
instruments, etc. have limited liquidity as the market and players are unidirectional.
Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring
and managing net funding requirements, the use of maturity ladder and calculation of
cumulative surplus or deficit of funds at selected maturity dates is recommended as a
standard tool. The format prescribed by RBI in this regard under ALM System should be
adopted for measuring cash flow mismatches at different time bands. The cash flows
should be placed in different time bands based on future behavior of assets, liabilities and
off-balance sheet items. In other words, banks should have to analyze the behavioral
maturity profile of various components of on / off-balance sheet items on the basis of
assumptions and trend analysis supported by time series analysis. Banks should also
undertake variance analysis, at least, once in six months to validate the assumptions. The
assumptions should be fine-tuned over a period which facilitate near reality predictions
about future behavior of on / off-balance sheet items. Apart from the above cash flows,
banks should also track the impact of prepayments of loans, premature closure of deposits

49
and exercise of options built in certain instruments which offer put/call options after
specified times. Thus, cash outflows can be ranked by the date on which liabilities fall
due, the earliest date

A liability holder could exercise an early repayment option or the earliest date
contingencies could be crystallized.

The difference between cash inflows and outflows in each time period, the excess or
deficit of funds becomes a starting point for a measure of a bank’s future liquidity surplus
or deficit, at a series of points of time. The banks should also consider putting in place
certain prudential limits to avoid liquidity crisis:

1. on inter-bank borrowings, especially call borrowings;

2. Purchased funds vis-à-vis liquid assets;
3. Core deposits vis-à-vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve
Ratio and Loans;
4. Duration of liabilities and investment portfolio;
5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches
across all time bands;
6. Commitment Ratio – track the total commitments given to corporates/banks and
other financial institutions to limit the off-balance sheet exposure;
7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency
sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-
bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash
flows arising out of contingent liabilities in normal situation and the scope for an increase
in cash flows during periods of stress should also be estimated. It is quite possible that
market crisis can trigger substantial increase in the amount of draw downs from cash
credit/overdraft accounts, contingent liabilities like letters of credit, etc.

50
The liquidity profile of the banks could be analyzed on a static basis, wherein the assets
and liabilities and off-balance sheet items are pegged on a particular day and the
behavioral pattern and the sensitivity of these items to changes in market interest rates
and environment are duly accounted for. The banks can also estimate the liquidity profile
on a dynamic way by giving due importance to:

1) Seasonal pattern of deposits/loans;

2) Potential liquidity needs for meeting new loan demands, unavailed credit limits,
loan policy, potential deposit losses, investment obligations, statutory obligations, etc.

Alternative Scenarios

The liquidity profile of banks depends on the market conditions, which influence the cash
flow behavior. Thus, banks should evaluate liquidity profile under different conditions,
viz. normal situation, bank specific crisis and market crisis scenario. The banks should
establish benchmark for normal situation; cash flow profile of on / off balance sheet
items and manages net funding requirements.

Estimating liquidity under bank specific crisis should provide a worst-case benchmark.
It should be assumed that the purchased funds could not be easily rolled over; some of the
core deposits could be prematurely closed; a substantial share of assets have turned into
non-performing and thus become totally illiquid. These developments would lead to
rating down grades and high cost of liquidity. The banks should evolve contingency plans
to overcome such situations.

The market crisis scenario analyses cases of extreme tightening of liquidity conditions
arising out of monetary policy stance of Reserve Bank, general perception about risk
profile of the banking system, severe market disruptions, failure of one or more of major
players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of
high value customer deposits and purchased funds could extremely be difficult besides

51
flight of volatile deposits / liabilities. The banks could also sell their investment with
huge discounts, entailing severe capital loss.

Contingency Plan

Banks should prepare Contingency Plans to measure their ability to withstand bank-
specific or market crisis scenario. The blue-print for asset sales, market access, capacity
to restructure the maturity and composition of assets and liabilities should be clearly
documented and alternative options of funding in the event of bank’s failure to raise
liquidity from existing source/s could be clearly articulated. Liquidity from the

Reserve Bank, arising out of its refinance window and interim liquidity adjustment
facility or as lender of last resort should not be reckoned for contingency plans.
Availability of back-up liquidity support in the form of committed lines of credit,
reciprocal arrangements, liquidity support from other external sources, liquidity of assets,
etc. should also be clearly established.

Interest Rate Risk (IRR)

The management of Interest Rate Risk should be one of the critical components of market
risk management in banks. The regulatory restrictions in the past had greatly reduced
many of the risks in the banking system. Deregulation of interest rates has, however,
exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII)
or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates.
Any mismatches in the cash flows (fixed assets or liabilities) or repricing dates (floating
assets or liabilities), expose banks’ NII or NIM to variations. The earning of assets and
the cost of liabilities are now closely related to market interest rate volatility.

Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of
Equity (MVE), caused by unexpected changes in market interest rates. Interest Rate Risk
can take different forms:

52
Types of Interest Rate Risk

Gap or Mismatch Risk:

A gap or mismatch risk arises from holding assets and liabilities and off-balance sheet
items with different principal amounts, maturity dates or repricing dates, thereby creating
exposure to unexpected changes in the level of market interest rates.

Basis Risk

Market interest rates of various instruments seldom change by the same degree during a
given period of time. The risk that the interest rate of different assets, liabilities and

off-balance sheet items may change in different magnitude is termed as basis risk. The
degree of basis risk is fairly high in respect of banks that create composite assets out of
composite liabilities. The Loan book in India is funded out of a composite liability
portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite
visible in volatile interest rate scenarios. When the variation in market interest rate
causes the NII to expand, the banks have experienced favorable basis shifts and if the
interest rate movement causes the NII to contract, the basis has moved against the banks.

Embedded Option Risk

Significant changes in market interest rates create another source of risk to banks’
profitability by encouraging prepayment of cash credit/demand loans/term loans and
exercise of call/put options on bonds/debentures and/or premature withdrawal of term
deposits before their stated maturities. The embedded option risk is becoming a reality in
India and is experienced in volatile situations. The faster and higher the magnitude of
changes in interest rate, the greater will be the embedded option risk to the banks’ NII.

53
Thus, banks should evolve scientific techniques to estimate the probable embedded
options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to
realistically estimate the risk profiles in their balance sheet. Banks should also endeavour
for stipulating appropriate penalties based on opportunity costs to stem the exercise of
options, which is always to the disadvantage of banks.

Yield Curve Risk

In a floating interest rate scenario, banks may price their assets and liabilities based on
different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc.
In case the banks use two different instruments maturing at different time horizon for
pricing their assets and liabilities, any non-parallel movements in yield curves would
affect the NII. The movements in yield curve are rather frequent when the economy
moves through business cycles. Thus, banks should evaluate the movement in yield
curves and the impact of that on the portfolio values and income.

Price Risk

Price risk occurs when assets are sold before their stated maturities. In the financial
market, bond prices and yields are inversely related. The price risk is closely associated
with the trading book, which is created for making profit out of short-term movements in
interest rates. Banks which have an active trading book should, therefore, formulate
policies to limit the portfolio size, holding period, duration, defeasance period, stop loss
limits, marking to market, etc.

Reinvestment Risk

Uncertainty with regard to interest rate at which the future cash flows could be reinvested
is called reinvestment risk. Any mismatches in cash flows would expose the banks to
variations in NII as the market interest rates move in different directions.

54
Net Interest Position Risk

The size of nonpaying liabilities is one of the significant factors contributing towards
profitability of banks. When banks have more earning assets than paying liabilities,
interest rate risk arises when the market interest rates adjust downwards. Thus, banks
with positive net interest positions will experience a reduction in NII as the market
interest rate declines and increases when interest rate rises. Thus, large float is a natural
hedge against the variations in interest rates.

Measuring Interest Rate Risk

Before interest rate risk could be managed, they should be identified and quantified.
Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to
measure the degree of risks to which banks are exposed. It is also equally impossible to
develop effective risk management strategies/hedging techniques without being able to
understand the correct risk position of banks. The IRR measurement system should
address all material sources of interest rate risk including gap or mismatch, basis,
embedded option, yield curve, price, reinvestment and net interest position risks
exposures. The IRR measurement system should also take into account the specific
characteristics of each individual interest rate sensitive position and should capture in
detail the full range of potential movements in interest rates.

There are different techniques for measurement of interest rate risk, ranging from the
traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings),
Duration (to measure interest rate sensitivity of capital), Simulation and Value at Risk.
While these methods highlight different facets of interest rate risk, many banks use them
in combination, or use hybrid methods that combine features of all the techniques.

Generally, the approach towards measurement and hedging of IRR varies with the
segmentation of the balance sheet. In a well functioning risk management system, banks

55
broadly position their balance sheet into Trading and Investment or Banking Books.
While the assets in the trading book are held primarily for generating profit on short-term
differences in prices/yields, the banking book comprises assets and liabilities, which are
contracted basically on account of relationship or for steady income and statutory
obligations and are generally held till maturity. Thus, while the price risk is the prime
concern of banks in trading book, the earnings or economic value changes are the main
focus of banking book.

Trading Book

The top management of banks should lay down policies with regard to volume,
maximum maturity, holding period, duration, stop loss, defeasance period, rating
standards, etc. for classifying securities in the trading book. While the securities held in
the trading book should ideally be marked to market on a daily basis, the potential price
risk to changes in market risk factors should be estimated through internally developed
Value at Risk (VaR) models. The VaR method is employed to assess potential loss that
could crystallize on trading position or portfolio due to variations in market interest rates
and prices, using a given confidence level, usually 95% to 99%, within a defined period
of time. The VaR method should incorporate the market factors against which the market
value of the trading position is exposed. The top management should put in place bank-
wide VaR exposure limits to the trading portfolio (including forex and gold positions,
derivative products, etc.) which is then disaggregated across different desks and
departments. The loss making tolerance level should also be stipulated to ensure that
potential impact on earnings is managed within acceptable limits. The potential loss in
Present Value Basis Points should be matched by the Middle Office on a daily basis vis-
à-vis the prudential limits set by the Board. The advantage of using VaR is that it is
comparable across products, desks and Departments and it can be validated through ‘back
testing’. However, VaR models require the use of extensive historical data to estimate
future volatility. VaR model also may not give good results in extreme volatile conditions
or outlier events and stress test has to be employed to complement VaR. The stress tests
provide management a view on the potential impact of large size market movements and

56
also attempt to estimate the size of potential losses due to stress events, which occur in
the ’tails’ of the loss distribution. Banks may also undertake scenario analysis with
specific possible stress situations (recently experienced in some countries) by linking
hypothetical, simultaneous and related changes in multiple risk factors present in the
trading portfolio to determine the impact of moves on the rest of the portfolio. VaR
models could also be modified to reflect liquidity risk differences observed across assets
over time. International banks are now estimating Liquidity adjusted Value at Risk
(LaVaR) by assuming variable time horizons based on position size and relative turnover.
In an environment where VaR is difficult to estimate for lack of data, non-statistical
concepts such as stop loss and gross/net positions can be used.

Banking Book

The changes in market interest rates have earnings and economic value impacts on the
banks’ banking book. Thus, given the complexity and range of balance sheet products,
banks should have IRR measurement systems that assess the effects of the rate changes
on both earnings and economic value. The variety of techniques ranges from simple
maturity (fixed rate) and repricing (floating rate) to static simulation, based on current on-
and-off-balance sheet positions, to highly sophisticated dynamic modelling techniques
that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance
sheet items and can easily capture the full range of exposures against basis risk,
embedded option risk, yield curve risk, etc.

Maturity Gap Analysis

The simplest analytical techniques for calculation of IRR exposure begins with maturity
Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet
positions into a certain number of pre-defined time-bands according to their maturity
(fixed rate) or time remaining for their next repricing (floating rate). Those assets and
liabilities lacking definite repricing intervals (savings bank, cash credit, overdraft, loans,
export finance, refinance from RBI etc.) or actual maturities vary from contractual

57
maturities (embedded option in bonds with put/call options, loans, cash credit/overdraft,
time deposits, etc.) are assigned time-bands according to the judgment, empirical studies
and past experiences of banks.

A number of time bands can be used while constructing a gap report. Generally, most of
the banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly
or one year. It is very difficult to take a view on interest rate movements beyond a year.
Banks with large exposures in the short-term should test the sensitivity of their assets and
liabilities even at shorter intervals like overnight, 1-7 days, 8-14 days, etc.

In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each
time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a
repricing ‘Gap’ for that time band. The positive Gap indicates that banks have more
RSAs than RSLs. A positive or asset sensitive Gap means that an increase in market
interest rates could cause an increase in NII. Conversely, a negative or liability sensitive
Gap implies that the banks’ NII could decline as a result of increase in market interest
rates. The negative gap indicates that banks have more RSLs than RSAs. The Gap is used
as a measure of interest rate sensitivity. The Positive or Negative Gap is multiplied by the
assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method
facilitates to estimate how much the earnings might be impacted by an adverse movement
in interest rates. The changes in interest rate could be estimated on the basis of past
trends, forecasting of interest rates, etc. The banks should fix EaR which could be based
on last/current year’s income and a trigger point at which the line management should
adopt on-or off-balance sheet hedging strategies may be clearly defined.

The Gap calculations can be augmented by information on the average coupon on assets
and liabilities in each time band and the same could be used to calculate estimates of the
level of NII from positions maturing or due for repricing within a given time-band, which
would then provide a scale to assess the changes in income implied by the gap analysis.

58
The periodic gap analysis indicates the interest rate risk exposure of banks over distinct
maturities and suggests magnitude of portfolio changes necessary to alter the risk profile.
However, the Gap report quantifies only the time difference between repricing dates of
assets and liabilities but fails to measure the impact of basis and embedded option risks.
The Gap report also fails to measure the entire impact of a change in interest rate (Gap
report assumes that all assets and liabilities are matured or repriced simultaneously)
within a given time-band and effect of changes in interest rates on the economic or
market value of assets, liabilities and off-balance sheet position. It also does not take into
account any differences in the timing of payments that might occur as a result of changes
in interest rate environment. Further, the assumption of parallel shift in yield curves
seldom happen in the financial market. The Gap report also fails to capture variability in
non-interest revenue and expenses, a potentially important source of risk to current
income.

In case banks could realistically estimate the magnitude of changes in market interest
rates of various assets and liabilities (basis risk) and their past behavioral pattern
(embedded option risk), they could standardize the gap by multiplying the individual
assets and liabilities by how much they will change for a given change in interest rate.
Thus, one or several assumptions of standardized gap seem more consistent with real
world than the simple gap method. With the Adjusted Gap, banks could realistically
estimate the EaR.

Duration Gap Analysis

Matching the duration of assets and liabilities, instead of matching the maturity or
repricing dates is the most effective way to protect the economic values of banks from
exposure to IRR than the simple gap model. Duration gap model focuses on managing
economic value of banks by recognising the change in the market value of assets,
liabilities and off-balance sheet (OBS) items. When weighted assets and liabilities and
OBS duration are matched, market interest rate movements would have almost same

59
impact on assets, liabilities and OBS, thereby protecting the bank’s total equity or net
worth. Duration is a measure of the percentage change in the economic value of a
position that will occur given a small change in the level of interest rates.

Measuring the duration gap is more complex than the simple gap model. For
approximation of duration of assets and liabilities, the simple gap schedule can be used
by applying weights to each time-band. The weights are based on estimates of the
duration of assets and liabilities and OBS that fall into each time band. The weighted
duration of assets and liabilities and OBS provide a rough estimation of the changes in
banks’ economic value to a given change in market interest rates. It is also possible to
give different weights and interest rates to assets, liabilities and OBS in different time
buckets to capture differences in coupons and maturities and volatilities in interest rates
along the yield curve.

In a more scientific way, banks can precisely estimate the economic value changes to
market interest rates by calculating the duration of each asset, liability and OBS position
and weigh each of them to arrive at the weighted duration of assets, liabilities and OBS.
Once the weighted duration of assets and liabilities are estimated, the duration gap can be
worked out with the help of standard mathematical formulae. The Duration Gap measure
can be used to estimate the expected change in Market Value of Equity (MVE) for a
given change in market interest rate.

The difference between duration of assets (DA) and liabilities (DL) is bank’s net
duration. If the net duration is positive (DA>DL), a decrease in market interest rates will
increase the market value of equity of the bank. When the duration gap is negative (DL>
DA), the MVE increases when the interest rate increases but decreases when the rate
declines. Thus, the Duration Gap shows the impact of the movements in market interest
rates on the MVE through influencing the market value of assets, liabilities and OBS.

60
The attraction of duration analysis is that it provides a comprehensive measure of IRR for
the total portfolio. The duration analysis also recognizes the time value of money.
Duration measure is additive so that banks can match total assets and liabilities rather
than matching individual accounts. However, Duration Gap analysis assumes parallel
shifts in yield curve. For this reason, it fails to recognize basis risk.

Simulation

Many of the international banks are now using balance sheet simulation models to gauge
the effect of market interest rate variations on reported earnings/economic values over
different time zones. Simulation technique attempts to overcome the limitations of Gap
and Duration approaches by computer modeling the bank’s interest rate sensitivity. Such
modeling involves making assumptions about future path of interest rates, shape of yield
curve, changes in business activity, pricing and hedging strategies, etc. The simulation
involves detailed assessment of the potential effects of changes in interest rate on
earnings and economic value. The simulation techniques involve detailed analysis of
various components of on-and off-balance sheet positions. Simulations can also
incorporate more varied and refined changes in the interest rate environment, ranging
from changes in the slope and shape of the yield curve and interest rate scenario derived
from Monte Carlo simulations.

The output of simulation can take a variety of forms, depending on users’ need.
Simulation can provide current and expected periodic gaps, duration gaps, balance sheet
and income statements, performance measures, budget and financial reports.

The simulation model provides an effective tool for understanding the risk exposure
under variety of interest rate/balance sheet scenarios. This technique also plays an
integral-planning role in evaluating the effect of alternative business strategies on risk
exposures.

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 The simulation can be carried out under static and dynamic environment. While the
current on and off-balance sheet positions are evaluated under static environment, the
dynamic simulation builds in more detailed assumptions about the future course of
interest rates and the unexpected changes in bank’s business activity.

The usefulness of the simulation technique depends on the structure of the model, validity
of assumption, technology support and technical expertise of banks.

The application of various techniques depends to a large extent on the quality of data and
the degree of automated system of operations. Thus, banks may start with the gap or
duration gap or simulation techniques on the basis of availability of data, information
technology and technical expertise. In any case, as suggested by RBI in the guidelines on
ALM System, banks should start estimating the interest rate risk exposure with the help
of Maturity Gap approach. Once banks are comfortable with the Gap model, they can
progressively graduate into the sophisticated approaches.

Funds Transfer Pricing

The Transfer Pricing mechanism being followed by many banks does not support good
ALM Systems. Many international banks which have different products and operate in
various geographic markets have been using internal Funds Transfer Pricing (FTP). FTP
is an internal measurement designed to assess the financial impact of uses and sources of
funds and can be used to evaluate the profitability. It can also be used to isolate returns
for various risks assumed in the intermediation process. FTP also helps correctly identify
the cost of opportunity value of funds. Although banks have adopted various FTP
frameworks and techniques, Matched Funds Pricing (MFP) is the most efficient
technique. Most of the international banks use MFP. The FTP envisages assignment of
specific assets and liabilities to various functional units (profit centers) – lending,
investment, deposit taking and funds management. Each unit attracts sources and uses of
funds. The lending, investment and deposit taking profit centers sell their liabilities to
and buys funds for financing their assets from the funds management profit centre at

62
appropriate transfer prices. The transfer prices are fixed on the basis of a single curve
(MIBOR or derived cash curve, etc) so that asset-liability transactions of identical
attributes are assigned identical transfer prices. Transfer prices could, however, vary
according to maturity, purpose, terms and other attributes.

The FTP provides for allocation of margin (franchise and credit spreads) to profit centers
on original transfer rates and any residual spread (mismatch spread) is credited to the
funds management profit centre. This spread is the result of accumulated mismatches.
The margins of various profit centers are:

• Deposit profit centre:

Transfer Price (TP) on deposits - cost of deposits – deposit insurance- overheads.

• Lending profit centre:

Loan yields + TP on deposits – TP on loan financing – cost of deposits –

deposit insurance - overheads – loan loss provisions.

• Investment profit centre:

Security yields + TP on deposits – TP on security financing – cost of deposits – deposit

insurance - overheads – provisions for depreciation in investments and loan loss.

• Funds Management profit centre:

TP on funds lent – TP on funds borrowed – Statutory Reserves cost – overheads.

For illustration, let us assume that a bank’s Deposit profit centre has raised a 3 month
deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and
one year @ 8% and 10.5% p.a., respectively. Let us also assume that the bank’s Loan

63
profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and
mismatch spreads of bank is as under:
Profit Centres Total
-------------------------------------- -----------
Deposit Funds Loan
Interest Income 8.0 10.5 13.5 13.5
Interest Expenditure 6.5 8.0 10.5 6.5
Margin 1.5 2.5 3.0 7.0
Loan Loss Provision (expected) - - 1.0 1.0
Deposit Insurance 0.1 - - 0.1
Reserve Cost (CRR/ SLR) - 1.0 - 1.0
Overheads 0.6 0.5 0.6 1.7
NII 0.8 1.0 1.4 3.2

Under the FTP mechanism, the profit centers (other than funds management) are
precluded from assuming any funding mismatches and thereby exposing them to market
risk. The credit or counterparty and price risks are, however, managed by these profit
centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the
funds management profit centre.

The FTP allows lending and deposit raising profit centers determine their expenses and
price their products competitively. Lending profit centre which knows the carrying cost
of the loans needs to focus on to price only the spread necessary to compensate the
perceived credit risk and operating expenses. Thus, FTP system could effectively be
used as a way to centralize the bank’s overall market risk at one place and would support
an effective ALM modeling system. FTP also could be used to enhance corporate
communication; greater line management control and solid base for rewarding line
management.

Foreign Exchange (Forex) Risk

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The risk inherent in running open foreign exchange positions have been heightened in
recent years by the pronounced volatility in forex rates, thereby adding a new dimension
to the risk profile of banks’ balance sheets.

Forex risk is the risk that a bank may suffer losses as a result of adverse exchange rate
movements during a period in which it has an open position, either spot or forward, or a
combination of the two, in an individual foreign currency. The banks are also exposed to
interest rate risk, which arises from the maturity mismatching of foreign currency
positions. Even in cases where spot and forward positions in individual currencies are
balanced, the maturity pattern of forward transactions may produce mismatches. As a
result, banks may suffer losses as a result of changes in premia/discounts of the
currencies concerned.

In the forex business, banks also face the risk of default of the counterparties or
settlement risk. While such type of risk crystallization does not cause principal loss,
banks may have to undertake fresh transactions in the cash/spot market for replacing the
failed transactions. Thus, banks may incur replacement cost, which depends upon the
currency rate movements. Banks also face another risk called time-zone risk or Herstatt
risk which arises out of time-lags in settlement of one currency in one centre and the
settlement of another currency in another time-zone. The forex transactions with
counterparties from another country also trigger sovereign or country risk.

Forex Risk Management Measures

1. Set appropriate limits – open positions and gaps.

2. Clear-cut and well-defined division of responsibility between front, middle and
back offices.

The top management should also adopt the VaR approach to measure the risk associated
with exposures. Reserve Bank of India has recently introduced two statements viz.

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Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of
forex risk exposures. Banks should use these statements for periodical monitoring of
forex risk exposures.

Capital for Market Risk

The Basle Committee on Banking Supervision (BCBS) had issued comprehensive

guidelines to provide an explicit capital cushion for the price risks to which banks are
exposed, particularly those arising from their trading activities. The banks have been
given flexibility to use in-house models based on VaR for measuring market risk as an
alternative to a standardized measurement framework suggested by Basle Committee.
The internal models should, however, comply with quantitative and qualitative criteria
prescribed by Basle Committee.

Reserve Bank of India has accepted the general framework suggested by the Basle
Committee. RBI has also initiated various steps in moving towards prescribing capital for
market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments
in Government and other approved securities, besides a risk weight each of 100% on the
open position limits in forex and gold. RBI has also prescribed detailed operating
guidelines for Asset-Liability Management System in banks. As the ability of banks to
identify and measure market risk improves, it would be necessary to assign explicit
capital charge for market risk. In the meanwhile, banks are advised to study the Basle
Committee’s paper on ‘Overview of the Amendment to the Capital Accord to Incorporate
Market Risks’ – January 1996 (copy enclosed). While the small banks operating
predominantly in India could adopt the standardized methodology, large banks and those
banks operating in international markets should develop expertise in evolving internal
models for measurement of market risk.

The Basle Committee on Banking Supervision proposes to develop capital charge for
interest rate risk in the banking book as well for banks where the interest rate risks are
significantly above average (‘outliers’). The Committee is now exploring various

66
methodologies for identifying ‘outliers’ and how best to apply and calibrate a capital
charge for interest rate risk for banks. Once the Committee finalizes the modalities, it
may be necessary, at least for banks operating in the international markets to comply with
the explicit capital charge requirements for interest rate risk in the banking book.

Operational Risk

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Managing operational risk is becoming an important feature of sound risk management
practices in modern financial markets in the wake of phenomenal increase in the volume
of transactions, high degree of structural changes and complex support systems. The
most important type of operational risk involves breakdowns in internal controls and
corporate governance. Such breakdowns can lead to financial loss through error, fraud, or
failure to perform in a timely manner or cause the interest of the bank to be
compromised.

Generally, operational risk is defined as any risk, which is not categoried as market or
credit risk, or the risk of loss arising from various types of human or technical error. It is
also synonymous with settlement or payments risk and business interruption,
administrative and legal risks. Operational risk has some form of link between credit and
market risks. An operational problem with a business transaction could trigger a credit or
market risk.

Measurement

There is no uniformity of approach in measurement of operational risk in the banking

system. Besides, the existing methods are relatively simple and experimental, although
some of the international banks have made considerable progress in developing more
advanced techniques for allocating capital with regard to operational risk.

Measuring operational risk requires both estimating the probability of an operational loss
event and the potential size of the loss. It relies on risk factor that provides some
indication of the likelihood of an operational loss event occurring. The process of
operational risk assessment needs to address the likelihood (or frequency) of a particular
operational risk occurring, the magnitude (or severity) of the effect of the operational risk
on business objectives and the options available to manage and initiate actions to reduce/
mitigate operational risk. The set of risk factors that measure risk in each business unit
such as audit ratings, operational data such as volume, turnover and complexity and data
on quality of operations such as error rate or measure of business risks such as revenue

68
volatility, could be related to historical loss experience. Banks can also use different
analytical or judgmental techniques to arrive at an overall operational risk level. Some of
the international banks have already developed operational risk rating matrix, similar to
bond credit rating. The operational risk assessment should be bank-wide basis and it
should be reviewed at regular intervals. Banks, over a period, should develop internal
systems to evaluate the risk profile and assign economic capital within the RAROC
framework.

Indian banks have so far not evolved any scientific methods for quantifying operational
risk. In the absence any sophisticated models, banks could evolve simple benchmark
based on an aggregate measure of business activity such as gross revenue, fee income,
operating costs, managed assets or total assets adjusted for off-balance sheet exposures or
a combination of these variables.

Risk Monitoring

The operational risk monitoring system focuses, inter alia, on operational performance
measures such as volume, turnover, settlement facts, delays and errors. It could also be
incumbent to monitor operational loss directly with an analysis of each occurrence and
description of the nature and causes of the loss.

Control of Operational Risk

Internal controls and the internal audit are used as the primary means to mitigate
operational risk. Banks could also explore setting up operational risk limits, based on the
measures of operational risk. The contingent processing capabilities could also be used
as a means to limit the adverse impacts of operational risk. Insurance is also an important
mitigator of some forms of operational risk. Risk education for familiarizing the complex
operations at all levels of staff can also reduce operational risk.

Policies and Procedures

69
Banks should have well defined policies on operational risk management. The policies
and procedures should be based on common elements across business lines or risks. The
policy should address product review process, involving business, risk management and
internal control functions.

Internal Control

One of the major tools for managing operational risk is the well-established internal
control system, which includes segregation of duties, clear management reporting lines
and adequate operating procedures. Most of the operational risk events are associated
with weak links in internal control systems or laxity in complying with the existing
internal control procedures.

The ideal method of identifying problem spots is the technique of self-assessment of

internal control environment. The self-assessment could be used to evaluate operational
risk along with internal/external audit reports/ratings or RBI inspection findings. Banks
should endeavor for detection of operational problem spots rather than their being pointed
out by supervisors/internal or external auditors.

Along with activating internal audit systems, the Audit Committees should play greater
role to ensure independent financial and internal control functions.

The Basle Committee on Banking Supervision proposes to develop an explicit capital

charge for operational risk.

Risk Aggregation and Capital Allocation

Most of internally active banks have developed internal processes and techniques to
assess and evaluate their own capital needs in the light of their risk profiles and business

70
plans. Such banks take into account both qualitative and quantitative factors to assess
economic capital. The Basle Committee now recognizes that capital adequacy in relation
to economic risk is a necessary condition for the long-term soundness of banks. Thus, in
addition to complying with the established minimum regulatory capital requirements,
banks should critically assess their internal capital adequacy and future capital needs on
the basis of risks assumed by individual lines of business, product, etc. As a part of the
process for evaluating internal capital adequacy, a bank should be able to identify and
evaluate its risks across all its activities to determine whether its capital levels are
appropriate.

Thus, at the bank’s Head Office level, aggregate risk exposure should receive increased
scrutiny. To do so, however, it requires the summation of the different types of risks.
Banks, across the world, use different ways to estimate the aggregate risk exposures. The
most commonly used approach is the Risk Adjusted Return on Capital (RAROC). The
RAROC is designed to allow all the business streams of a financial institution to be
evaluated on an equal footing. Each type of risks is measured to determine both the
expected and unexpected losses using VaR or worst-case type analytical model. Key to
RAROC is the matching of revenues, costs and risks on transaction or portfolio basis
over a defined time period. This begins with a clear differentiation between expected and
unexpected losses. Expected losses are covered by reserves and provisions and
unexpected losses require capital allocation which is determined on the principles of
confidence levels, time horizon, diversification and correlation. In this approach, risk is
measured in terms of variability of income. Under this framework, the frequency
distribution of return, wherever possible is estimated and the Standard Deviation (SD) of
this distribution is also estimated. Capital is thereafter allocated to activities as a function
of this risk or volatility measure. Then, the risky position is required to carry an expected
rate of return on allocated capital, which compensates the bank for the associated
incremental risk. By dimensioning all risks in terms of loss distribution and allocating
capital by the volatility of the new activity, risk is aggregated and priced.

71
The second approach is similar to the RAROC, but depends less on capital allocation and
more on cash flows or variability in earnings. This is referred to as EaR, when employed
to analyze interest rate risk. Under this analytical framework also frequency distribution
of returns for any one type of risk can be estimated from historical data. Extreme
outcome can be estimated from the tail of the distribution. Either a worst case scenario
could be used or Standard Deviation 1/2/2.69 could also be considered. Accordingly,
each bank can restrict the maximum potential loss to certain percentage of past/current
income or market value. Thereafter, rather than moving from volatility of value through
capital, this approach goes directly to current earnings implications from a risky position.
This approach, however, is based on cash flows and ignores the value changes in assets
and liabilities due to changes in market interest rates. It also depends upon a subjectively
specified range of the risky environments to drive the worst case scenario.

Given the level of extant risk management practices, most of Indian banks may not be in
a position to adopt RAROC framework and allocate capital to various businesses units on
the basis of risk. However, at least, banks operating in international markets should
develop suitable methodologies for estimating economic capital.

Risk Management in Saraswat Bank

72
The mission of the bank has been “To emerge as one of the premier and most
preferred banks in the country by adopting highest standard of professionalism and
excellence in all areas of working”. We therefore strive sincerely to adopt best
practices, offer a wide spectrum of products, maintain the highest service levels and
comply with all of the regulatory requirements.

According to Mr Pai of the Risk Management department, risk management is

identifying, measuring, managing and mitigating risks emanating from different business
activities. Risk management of the Bank has remained active in its efforts to contain
various types of risks namely credit risk, market risk and operational risk.

Procedure Of risk Management in the Bank

Ownership

• Head of risk management department shall be responsible for implementing the

policy in the bank
• The owner shall co-ordinate the tasks with the Business Head and treasury head
for implementing the policy in a cohesive manner.

Some Definitions

• Risk means probability of loss pecuniary or otherwise which may damage the
reputation of the bank or otherwise affect its fundamentals.
• Credit risk means the ability or willful default on the part of customer/counter
party to honor due commitments in relation to trading, lending, hedging,
settlement and other financial transactions.
• Market risks means risks which may cause loss to the bank due to the market
forces

73
 • Mismatch means the difference in the interest sensitive assets and liabilities in the
given time bucket and or in the cash inflow and cash outflow in the given time
bucket.

Credit Risk

• Owner shall manage credit risk inherent in the loan as well as investment
portfolio of the bank
• Owner shall evolve mechanism to measure the credit risk in quantifiable terms
using appropriate internal rating model and or any other techniques
• Owner shall continuously review and monitor the credit as well as investment
portfolio to ensure that the measured risk is mitgated

Market Risk

• Treasury Head shall manage market risk associated with investment portfolio in
particular and all other portfolios in general
• He shall ensure that the investments are consistent with the bank’s investment
policy
• In it’s endeavor to mange market risk bank shall manage associated risks such as
interest rate risk, liquidity risk, foreign exchange rate risk.
• In managing these risks bank shall use tools such as gap analysis/mismatch as
suggested RBI

Asset liability Statement

• Owner shall draw the statement of structural liquidity, interest sensitivity and
dynamic liquidity on a monthly basis
• Owner shall analyze the mismatches vis-à-vis past trend and suggest ways and
means of managing it for safeguarding bank’s interest.

74
 • Owner shall ensure that the norms/limits suggested by RBI in regard to
mismatches are adhered to
• Owner shall calculate mismatch in interest sensitive assets and liabilities and
suggest steps to be taken by the bank to maintain Net interest income

Operational Risk

• Vigilance officer of the bank as well Audit department shall ensure that KYC
policy as well as the deposit policy is adhered o while managing the deposit
portfolio of the bank
• Owner shall ensure that IT related policies are complied by the banks IT
Subsidiary Saraswat Infotech Limited while delivering core banking solutions and
other systems in banks.
• Vigilance officer shall be guided in minimizing the frauds being committed by the
officials of the bank.
• The respective heads shall ensure compliance to statutory requirements as
prescribed by the Law and or RBI, Central Registrar and or any other governing
body.

Review

• Owner shall review the policy at periodic intervals depending on the exigencies
and not later than once in a year

The guidelines followed by the bank in respect of the asset-liability management are
on the basis of those given by the Reserve Bank of India which is as follows

75
 Asset Liability Management

Introduction to ALM

Considering their structure, balance sheet profile and skill levels of personnel of UCBs,
RBI found it necessary to provide technical support for putting in place an effective ALM
framework. These Guidelines lay down broad framework for measuring liquidity, interest
rates and forex risks. The initial focus of the ALM function would be to enforce the risk
management discipline viz. managing business after assessing the risks involved. The
objective of good bank management is to provide strategic tools for effective risk
management systems.

UCBs need to address the market risk in a systematic manner by adopting necessary
sector–specific ALM practices than has been done hitherto. ALM, among other
functions, also provides a dynamic framework for measuring, monitoring and managing
liquidity, interest rate and foreign exchange (forex) risks. It involves assessment of
various types of risks and altering balance sheet (assets and liabilities) items in a dynamic
manner to manage risks.

The ALM process rests on three pillars:

• ALM Information Systems
⇒ Management Information Systems (MIS)
⇒ Information availability, accuracy, adequacy and expediency
• ALM Organization
⇒ Structure and responsibilities
⇒ Level of top management involvement
• ALM Process
⇒ Risk parameters
⇒ Risk identification

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 ⇒ Risk measurement
⇒ Risk management
⇒ Risk policies and procedures, prudential limits and auditing,
reporting and review.

ALM Information Systems

ALM has to be supported by a management philosophy which clearly specifies the

risk policies and procedures and prudential limits. This framework needs to be built
on sound methodology with necessary information system as back up. Thus,
Information is the key to the ALM process. It is, however, recognized that varied
business and customer profiles of UCBs do not make the adoption of a uniform
ALM System for all banks feasible. There are various methods prevalent world-wide
for measuring risks. These range from easy-to-comprehend and simple ‘Gap analysis’ to
extremely sophisticated and data intensive `Simulation’ methods. However, the central
element for the entire ALM exercise is the availability of timely, adequate and
accurate information. The existing systems in many UCBs do not generate
information in the manner required for ALM. Collecting accurate data in a timely
manner will be the biggest challenge before the UCBs taking full scale
computerization. However, the introduction of the essential information system for ALM
has to be addressed urgently. As commercial banks have already been prescribed with
ALM system and are in the process of adopting capital adequacy for market risk, it is
imminent for UCBs to put in an efficient information system for initiating ALM
process.

Considering the customer profile and inadequate support system for collecting
information required for ALM which analyses various components of assets and
liabilities on the basis of residual maturity (remaining term to maturity) and behavioral
pattern, it will take some time for UCBs some time to get the requisite information. The
problem of ALM data needs to be addressed by following an ABC approach i.e.

77
analyzing the behavior of asset and liability products in the sample branches accounting
for significant business (at least 60-70% of the total business) and then making rational
assumptions about the way in which assets and liabilities would behave in other branches.
Unlike in the case of commercial banks that have large network of branches, UCBs are
better placed in view of their compact area of operation and two-tier hierarchical
structure to have greater access to the data. Further, in respect of foreign exchange [at
present there are only 2 Authorized Dealers (ADs)], investment portfolio and money
market operations, in view of the centralized nature of functions, it would be much easier
to collect reliable data. The data and assumptions can then be refined over time as UCBs
gain experience of conducting business within an ALM environment. The spread of
computerization will also help UCBs in accessing data at a faster pace.

ALM Organization

Successful implementation of the risk management process would require strong

commitment on the part of their boards and senior management. The board should have
overall responsibility for management of risks and should decide the risk management
policy and procedures, set prudential limits, auditing, reporting and review mechanism in
respect of liquidity, interest rate and forex risks.

The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the policies and limits
set by the Board as well as for deciding the business strategy (on the assets and
liabilities sides) in line with the bank’s business and risk management objectives.

The ALM Support Groups consisting of operating staff should be responsible for
analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also
prepare forecasts (simulations) showing the effects of various possible changes in market
conditions related to the balance sheet and recommend the action needed to adhere to
bank’s internal limits.

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The ALCO is a decision making unit responsible for balance sheet planning from risk-
return perspective including the strategic management of liquidity, interest rate and forex
risks. The business and risk management strategy of the bank should ensure that the bank
operates within the limits / parameters set by the Board. The business issues that an
ALCO considers, inter alia, includes pricing of both deposits and advances, desired
maturity profile and mix of the incremental assets and liabilities, etc. In addition to
monitoring the risk levels of the bank, the ALCO should review the results of and
progress in implementation of the decisions made in the previous meetings. The ALCOs
future business strategy decisions should be based on the banks views on current interest
rates. In respect of the funding policy, for instance, its responsibility would be to decide
on source and mix of liabilities or sale of assets. Towards this end, it will have to develop
a view on future direction of interest rate movements and decide on funding mixes
between fixed vs. floating rate funds, wholesale vs. retail deposits, short term vs. long
term deposits etc. Individual UCBs will have to decide the frequency for holding their
ALCO meetings.

Composition of ALCO

The size (number of members) of ALCO would depend on the size of each UCB, level of
business and organizational structure. To ensure commitment of the Top Management
and timely response to market dynamics, the CEO or the Secretary should head the
Committee. The Chiefs of Investment/ Treasury including forex, Credit, Planning, etc can
be members of the Committee. In addition, the Head of the Information Technology
Division, if a separate division exists should also be an invitee for building up of
Management Information System (MIS) and related IT network. UCBs may at their
discretion even have Sub-committees and Support Groups.

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ALM Process

The scope of ALM function can be described as follows:

•Liquidity risk management
•Interest rate risk management
•Trading (Price) risk management
•Funding and capital planning
•Profit planning and business projection

Liquidity Risk Management

Measuring and managing liquidity needs are vital for effective operation of UCBs. By
assuring an UCBs ability to meet its liabilities as they become due, liquidity
management can reduce the probability of an adverse situation developing. The
importance of liquidity problem of an UCB need not necessarily confine to itself but its
impact may be felt on other UCBs/banks as well. UCBs should measure not only the
liquidity positions on an ongoing basis but also examine how liquidity requirements are
likely to evolve under different assumptions/scenarios. Liquidity measurement is quite a
difficult task and can be measured through stock or cash flow approaches. The stock
approach uses certain liquidity ratios viz. credit deposit ratio, loans to total assets, loans
to core deposits, etc. While the liquidity ratios are the ideal indicators of liquidity of
banks operating in developed financial markets, the ratios do not reveal the real liquidity
profile of Indian banks including UCBs, which are operating generally in an illiquid
market. Experience shows that assets commonly considered as liquid like Government
securities, other money market instruments, etc. have limited liquidity when the market
and players move in one direction. Thus, analysis of liquidity involves tracking of cash
flow mismatches (flow approach). The maturity ladder is generally used as a standard
tool for measuring the liquidity profile under the flow approach, at selected maturity
bands. The format of the Statement of Structural Liquidity under static scenario without
reckoning future business growth is given in Annexure I.

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The Maturity Profile as given in Appendix I could be used for measuring the future
cash flows of UCBs in different time bands. The time bands, given the Statutory
Reserve cycle of 14 days may be distributed as under:

i) 1 to 14 days
ii) 15 to 28 days
iii) 29 days and upto 3 months
iv) Over 3 months and upto 6 months
v) Over 6 months and upto 1 year
vi) Over 1 year and upto 3 years
vii) Over 3 years and upto 5 years
viii) Over 5 years

The investments in SLR securities and other investments are generally assumed as
illiquid due to lack of depth in the secondary market and are therefore required to be
shown under respective residual maturity bands, corresponding to the residual maturity.
However, some of the UCBs may be maintaining few securities in the trading book,
which are kept distinct from other investments made for complying with the Statutory
Reserve requirements and for retaining relationship with customers. Securities held in the
trading book are subject to certain preconditions such as:

i)The composition and volume are clearly defined;

ii)Maximum maturity/duration of the portfolio is restricted;
iii)The holding period not exceeding 90 days;
iv)Cut-loss limit prescribed; (The level up to which loss could be ascribed
by liquidating an asset. Illustrating, if a security bought at Rs. 100 is
quoted in the market on a given day at Rs. 98 and the board of
management fixed the maximum loss which may be incurred on this
particular transaction at not more than Rs.2.00, the cut loss limit is placed

81
 at Rs.2.00 for this particular security. The cut loss limit varies from
security to security based on bank’s loss / risk bearing capacity).
Defeasance periods (product-wise) i.e. time taken to liquidate the position
on the basis of liquidity in the secondary market is prescribed. The
defeasance period is dynamic and in volatile environments, such period
also undergoes changes on account of product-specific or general market
conditions;
v)Marking to market on a weekly basis and the revaluation gain/loss
absorbed in the profit and loss account; etc.

UCBs which maintain such trading books and complying with the above
requirements are permitted to show the trading securities under 1-14 days, 15-28
days and 29-90 days time bands on the basis of the defeasance periods. The ALCO
of the UCBs should approve the volume, composition, holding/defeasance period,
cut loss, etc. of the trading book.

Within each time band there could be mismatches depending on cash inflows and
outflows. While the mismatches up to one year would be relevant since these provide
early warning signals of impending liquidity problems, the main focus should be on the
short-term mismatches viz., 1-14 and 15-28 days time bands. UCBs, however, are
expected to monitor their cumulative mismatches (running total) across all time bands by
establishing internal prudential limits with the approval of the Board. The mismatches
(negative gap between cash inflows and outflows) during 1-14 and 15-28 days time
bands in normal course should not exceed 20% of the cash outflows in each time band.
If an UCB in view of its current asset-liability profile and the consequential
structural mismatches needs higher tolerance level, it could operate with higher
limit sanctioned by RBI for a limited period.

The Statement of Structural Liquidity (Annexure I) may be prepared by placing all cash
inflows and outflows in the maturity ladder according to the expected timing of cash
flows. A maturing liability will be a cash outflow while a maturing asset will be a cash

82
inflow. It would also be necessary for UCBs with AD licenses to take into account the
rupee inflows and outflows on account of their forex operations. While determining the
probable cash inflows / outflows, UCBs have to make a number of assumptions
according to their asset - liability profiles. While determining the tolerance levels, the
UCBs may take into account all relevant factors based on their asset-liability base, nature
of business, future strategy, etc.

In order to enable the banks to monitor their short-term liquidity on a dynamic basis over
a time horizon spanning from 1-90 days, UCBs may estimate their short-term liquidity
profiles on the basis of business projections and other commitments for planning
purposes. An indicative format (Annexure III) for estimating Short-term Dynamic
Liquidity is enclosed.

Currency Risk

Floating exchange rate arrangement has brought in its wake pronounced volatility adding
a new dimension to the risk profile of banks’ balance sheets. The increased capital flows
across free economies following deregulation have contributed to increase in the volume
of transactions. Large cross border flows together with the volatility has rendered the
banks’ balance sheets vulnerable to exchange rate movements. Although UCBs
predominantly confined to domestic operations, in view of few UCBs being ADs in
foreign exchange, it is necessary to address forex risk also.

Managing currency risk is one more dimension of ALM. Mismatched currency

position besides exposing the balance sheet to movements in exchange rate also
exposes it to country risk and settlement risk. Ever since the RBI (Exchange
Control Department) introduced the concept of end of the day near square position
in 1978, ADs have been setting up overnight limits and selectively undertaking
active day time trading. Following the introduction of “Guidelines for Internal
Control over Foreign Exchange Business” in 1981, maturity mismatches (gaps) are
also subject to control. Following the recommendations of Expert Group on Foreign

83
Exchange Markets in India (Sodhani Committee), the calculation of exchange
position has been redefined and banks have been given the discretion to set up
overnight limits linked to maintenance of capital to Risk-Weighted Assets Ratio of
9% of open position limit.

Presently, the ADs are also free to set gap limits with RBI’s approval but are required to
adopt Value at Risk (VaR) approach to measure the risk associated with forward
exposures. Thus the open position limits together with the gap limits form the risk
management approach to forex operations. For monitoring such risks banks should
follow the instructions contained in Circular A.D (M. A. Series) No.52 dated
December 27, 1997 issued by the Exchange Control Department.

Interest Rate Risk (IRR)

The phased deregulation of interest rates and the operational flexibility given to banks in
pricing most of the assets and liabilities imply the need for the banking system to hedge
the Interest Rate Risk. Interest rate risk is the risk where changes in market interest rates
might adversely affect a bank’s financial condition. The changes in interest rates affect
banks in a larger way. The immediate impact of changes in interest rates is on bank’s
profits by changing its spread [Net Interest Income (NII)]. A long-term impact of
changing interest rates is on bank’s Market Value of Equity (MVE) or Net Worth as the
marked to market value of bank’s assets, liabilities and off-balance sheet positions get
affected due to variation in market rates. The interest rate risk when viewed from these
two perspectives is known as ‘earnings perspective’ and ‘economic value’ perspective,
respectively. The risk from the earnings perspective can be measured as changes in the
NII or Net Interest Margin (NIM). There are many analytical tools for measurement and
management of Interest Rate Risk. In the context of poor MIS, slow pace of
computerization and the absence of total deregulation, the traditional `Gap Analysis’ is
considered as a suitable method to measure the Interest Rate Risk in the first place.

84
The Gap or Mismatch risk can be measured by calculating Gaps over different time
intervals as at a given date. Gap analysis measures mismatches between rate sensitive
liabilities and rate sensitive assets (including off-balance sheet positions). An asset or
liability is normally classified as rate sensitive if:

i) within the time interval under consideration, there is a cash flow ; for instance,
repayment of installments of term loans etc
ii) The interest rate resets/reprices contractually during the interval. For instance,
charges made in the interest on CC accounts, term loan accounts before maturity.
iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, Minimum
Lending Rate(MLR), DRI advances, Refinance, CRR balance, etc.) in cases where
interest rates are administered; and

The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-
balance sheet positions into time bands according to residual maturity or next repricing
period, whichever is earlier. The difficult task in Gap analysis is determining rate
sensitivity. All investments, advances, deposits, borrowings, etc. that mature/reprice
within a specified timeframe are interest rate sensitive. Similarly, any repayment of loan
installment is also rate sensitive if the bank expects to receive it within the time horizon.
This includes final principal payment and periodical installments. Certain assets and
liabilities receive/pay rates that vary with a reference rate. These assets and liabilities are
repriced at pre-determined intervals and are rate sensitive at the time of repricing. While
the interest rates on term deposits are fixed during their currency, the advance portfolio of
the banking system is basically floating. The interest rates on advances could be repriced
any number of occasions.

The Gaps may be identified in the following time bands:

i) Upto 3 months
ii) Over 3 months and upto 6 months
iii) Over 6 months and upto 1 year
iv) Over 1 year and upto 3 years

85
 v) Over 3 years and upto 5 years
vi) Over 5 years
vii) Non-sensitive
The various items of rate sensitive assets and liabilities and off-balance sheet items may
be classified as explained in Appendix - II and the Reporting Format for interest rate
sensitive assets and liabilities is given in Annexure II.

The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time band. The positive Gap indicates that it has more RSAs
than RSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports
indicate whether the institution is in a position to benefit from rising interest rates by
having a positive Gap (RSA > RSL) or whether it is in a position to benefit from
declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used
as a measure of interest rate sensitivity.

Each bank should set prudential limits on individual Gaps with the approval of the
Board. The prudential limits should have a bearing on the Total Assets, Earning Assets
or Equity. The banks may also work out Earnings at Risk (EaR) i.e. 20–30% of the last
years NII or Net Interest Margin (NIM) based on their views on interest rate movements.

When the UCBs gain sufficient experience in operating ALM system, RBI may
introduce capital adequacy for market risk in due course.

Behavioral Patterns

The classification of various components of assets and liabilities into different time bands
for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in
Appendices I & II is the benchmark. Banks which are better equipped to reasonably
estimate the behavioral pattern of various components of assets and liabilities on the basis
of past data / empirical studies could classify them in the appropriate time bands, subject
to approval from the ALCO.

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 Strategic Analysis

SWOT analysis

In order to better understand the cooperative banks and the environment in which they
function (taking into consideration Fund management, Risk management, Asset and
Liability management), a SWOT analysis has been undertaken.

STRENGTHS:

• Cooperative banks have less number of branches and that to in a small area.
Thus it is easier for them to control and regulate their overall operation.
• These banks have limited and known customer base, which give them more
potential to control credit risk
• These banks are free from market risk arising due to fluctuations in the market
• These banks are free from risk arising out of Para-banking activities.
• As these banks are localized they are able to maintain a personal touch with
depositors and borrowers.
• These banks can avail of cheaper labor and thus can maintain low costs.

WEAKNESS:

• These banks suffer from dual accountability to both the regulators (RBI) ant
the state government.
• These banks suffer from lack of corporate governance. The BOD as well as
the staff members lacks professional banking knowledge and expertise.
• These banks have very limited avenues for expanding and diversifying loan as
well as investment portfolios.

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 • These banks are unable to raise additional capital by making public issue of
capital.
• Reluctance of state government to give up control over cooperative banks and
political involvement in the management of banks further worsens the state of
these banks.
• Lack of internal control systems makes these banks vulnerable to fraud and
scams.
• The cooperative spirit no more exists in these banks. The distance between the
members and the cooperatives has widened.
• Smaller size and lesser profit make it difficult for the banks to adopt latest
MIS systems and other technologies.

OPPORTUNITIES

• These banks have the opportunity to tap local resources fir mobilizing
deposits and granting advances.
• They can provide better customized services thus leading to longer
relationships and customer satisfaction.
• As these banks are area specific, it will be easier for them to consolidate
information necessary for putting in place ALM systems.

THREATS

• These banks face serious threats form then private banks and foreign banks,
which use advanced techniques and technologies for risks and fund
management. As public sector banks have also joined the competition,
cooperative banks face threats form these banks too.
• Cooperative banks suffer from threats of frauds, scams and misinterpretations
as well as from lack of professionalism.

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 Recommendations and Suggestions

The comparison of practices of different commercial banks, and the survey results of
UCBs as well as a detailed theoretical study of UCBs, brings out the high need for
introducing Funds Management, Risk management and Assets liability management in
UCBs.

• Many a time, the populist policies of the Government such as loan waivers have
done a great harm to the cooperative agricultural credit and banking institutions.
The Government has provided a big budgetary support to commercial banks and
RRBs to cleanse their balance sheet. But in case of cooperative banking
institutions, the Government has not provided such support. Since cooperative
credit and banking institutions constitute a very important segment of financial
sector particularly in the context of effective flow of credit to the agriculture and
priority sectors, the Government should also provide such support to them.

• An important contributory factor for this positive feature is the fact that these
banks have maintained close proximity with their borrowers. An indiscriminate
branch expansion would perhaps erode this vital strength. UCBs would, therefore,
do well to keep this in mind while planning their expansion in terms of branches.

• One of the problem areas in the supervision of UCBs is the duality in control by
the State Government and the Reserve Bank. Since UCBs are primarily credit
institutions meant to be run on commercial lines, the responsibility for their
supervision devolves on the Reserve Bank. Therefore, while the banking
operations pertaining to branch licensing, expansion of areas of operations,
interest fixation on deposits and advances, audit and investments are under the
jurisdiction of the RBI, the managerial aspects of these banks relating to
registration, constitution of management, administration and recruitment, are
controlled by the State Governments under the provisions of the respective State
Cooperative Societies Act. This duality of control needs to be done away with and

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 RBI needs to be given the full control. This will require amendment of the Multi-
State Cooperative Societies Act, 1984; State Cooperative Societies Act, and the
Banking Regulation Act.

• One issue of serious concern regarding UCBs is the delay/ non-submission of

returns within the stipulated time frame. In particular, PCBs are required to
submit two types of returns (statutory returns and control returns) to the Reserve
Bank with a view to exercise adequate supervision over them. Unfortunately,
there is often a serious delay in the submission of these returns by individual
banks. Non-availability of adequate and timely data would no doubt have serious
effect on timely policy action. In this context, PCBs have to improve their
statistical reporting system and bridge the wide gap in data availability as
compared to that of commercial banks.

• There are serious doubts over the accuracy and credibility of the data sent by the
UCBs to RBI. It is only when an on-site inspection is carried out that exact
financial position of a particular UCB can be determined. However, the on-site
inspections are carried out at a very low frequency, sometimes even 2 to 3 years
for a bank. There is a dire need to increase the frequency of on-site inspections to
at least 6 months.

• Training for bank executives is very necessary for any system to run smoothly.
Banks should be asked to send their employees for regular training in Risk
management, Funds management and Assets and liability management to training
centers and colleges. RBI can distribute a detailed list of institutes where such
training is given to all UCBs. In house training can also prove to be useful.

• Banks should be asked to employ professional MBAs, CAs, or CFAs- well versed
in prudent financial practices. Banks can also go for professional executives

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 having experience in Commercial Banking Sector. Attempts should be made to
make such norms compulsory.

• Sharing of defaulters’ list amongst the UCBs would help them to contain risk to
some extent.

• In order to increase transparency in operations, the banks should be asked to give

more information through their published balance sheets, Cash flow statements,
NPA and provision disclosures, Maturity profiles of assets and liabilities, etc. are
some of the items that the banks can be made to disclosed annually.

• RBI should undertake ratings of cooperative banks or should appoint an agency to

do so and make their ratings public. This would support competition in the
cooperative sector and motivate banks to increase their profitability and improve
their functioning.

• Strict penalties should be levied for inaccurate reporting or misreporting by UCBs

to RBI.

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 Personal Learning’s

• The most significant value-addition was a good exposure to the banking sector. It
was interesting to look at the banking world from two different angles, a central
bank perspective which is supposed to exercise control, and co-operative banks,
which are demanding more autonomy.

• It was an enriching experience to work with highly knowledgeable people with

excellent people skills and banking experience running in decades.

• The project helped me apply theoretical inputs to practical situations. This has
greatly enhanced my understanding of the basic principles of banking.

• I interacted with many people during tenure of my project. This helped me to

improve my soft skills.

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 Bibliography

A. Magazines
• Banking Finance
• Professional Banker
• Analyst
• Vision

B. RBI Publications
• Master Circulars
• Trend and Progress Reports
• Notifications
• Draft Vision document on UCBs

C. Books
• Value at Risk – Phillipe Jorion
• Managing Indian Banks – The Challenges Ahead, Vasant and Vinay Joshi
•

D. Internet
• www.rbi.org.in
• www.indiainfoline.com
• www.banknetindia.com
• www.bankersindia.com
• www.google.com
• www.erisk.com

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