RISK MANAGEMENT IN BANKS
BBA-II
.
BANKS TYPICALLY FACE THREE
Type of Risk
KINDS OF RISK Example
“Stocks”
• Risk of loss due to Daily price
change (%)
unexpected re-pricing of
assets owned by the bank,
caused by either
Unexpected
Market
Market – Exchange rate price volatility
fluctuation Time
– Interest rate Default
rate (%)
“Loans with credit rating 3”
fluctuations
– Market price of Unexpected
default
investment fluctuations Avg. default
• Risk of loss due to
Credit
unexpected borrower default Time
Monthly change “Business unit A”
of revenue to cost
• Risk of loss due to a sudden (%)
reduction in operational
margins, caused by either Unexpected
low cost
internal or external factors utilization
Operational viz Process failure, systems
Time
failure, human error, frauds
but does not cover
reputational risk/strategic
risk.
The Current Capital Accord
• Focused on credit risk but formula based
• Partially amended in 1996 to include
market risk
• Operational risk not addressed
• Simple in its application
• Produced an easily comparable and
verifiable measure of bank’s soundness
Need for a new frame-work
• Financial innovation and growing complexity of
transactions
• Categorised bank’s assets into one of only four
categories each representing a risk class
• Made no allowance for the effect portfolio diversification
• Requirement of more flexible approaches as opposed to
“one size fits all” Approach
• Requirement of Risk sensitivity as opposed to a “broad-
brush Approach”
• Operational Risk not covered
Basle Accord I & II -
Differences
Talks of Credit, Market
Talks of Credit Risk only and Operational Risks
Capital Charge
Capital Charge for Credit dependant on Risk rating
Risk – 8% of assets
Does not mention Capital Charge to include
separate Capital charge risks arising out of Credit,
for Market and Market and Operational
Operational Risk risks. Not a broad brush
No mention about market approach
Discipline Quantitative approach for
No effort to quantify calculation of Market and
Market and Operational Operational risks as for
Risk Credit Risk.
Three pillars of the Basel II framework
Minimum Capital Supervisory
Market Discipline
Requirements Review Process
– Credit risk – Bank’s own capital – Enhanced disclosure
strategy
– Operational risk
– Supervisor’s review
– Market risk
Pillar I – Credit Risk
Pillar 1 – Credit Risk stipulates three levels of increasing sophistication. The more
sophisticated approaches allow a bank to use its internal models to calculate its
regulatory capital. Banks who move up the ladder are rewarded by a reduced capital
charge
at ion Advanced Internal
i s ti c Ratings Based
Soph Approach
as e
re
Inc
Foundation Internal Banks use internal estimations of
PD, loss given default (LGD) and
Ratings exposure at default (EAD) to
Based Approach calculate risk weights for exposure
classes
Banks use internal estimations of
Standardized probability of default (PD) to calculate risk
Approach weights for exposure classes. Other risk
components are standardized.
Risk weights are based on
assessment by external credit
assessment institutions
Reduce Capital requirements
Pillar I – Minimum Capital
Requirements
The new Accord maintains the current definition of total capital and the minimum 8%
requirement*
Total capital
= Bank’s capital ratio
Credit risk + Market risk + Operational risk (minimum 8%)
Total capital = Tier 1 + Tier 2
Total Capital Tier 1: Shareholders’ equity + disclosed reserves
Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions)
Credit Risk The risk of loss arising from default by a creditor or counterparty
Market Risk The risk of losses in trading positions when prices move adversely
Operational Risk The risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events
* The revisions affect the denominator of the capital ratio - with more sophisticated measures for credit risk, and introducing an explicit capital charge for
operational risk
Internal Ratings Based Approach
• Exposures in five categories because of
different risk characteristics
– Sovereigns
– Banks
– Corporates
– Retail
– NPA
Pillar I – Credit Risk
Pillar 1 – Credit Risk stipulates three levels of increasing sophistication. The more
sophisticated approaches allow a bank to use its internal models to calculate its
regulatory capital. Banks who move up the ladder are rewarded by a reduced capital
charge
at ion Advanced Internal
i s ti c Ratings Based
Soph Approach
as e
re
Inc
Foundation Internal Banks use internal estimations of
PD, loss given default (LGD) and
Ratings exposure at default (EAD) to
Based Approach calculate risk weights for exposure
classes
Banks use internal estimations of
Standardized probability of default (PD) to calculate risk
Approach weights for exposure classes. Other risk
components are standardized.
Risk weights are based on
assessment by external credit
assessment institutions
Reduce Capital requirements
Capital Requirement – What
New?
Framework
Continue
Claims on Banks is 20% subject to the
fact that CRAR of borrowing Bank is 8
% and above. And it is scheduled Bank.
https://www.youtube.com/watch?v=PbeWP
4GA_
M0
Risk Matrix
Low Financial Impact High financial Impact
High High Probability
High Probability
Loss Given
Low Financial Impact High Financial Impact
Default
Low Low Probability Low Probability
Low Impact High
Impact
Probability of Default
Claims on corporates
Credit AAA AA A BBB BB Unrat
assessment and ed
by domestic below
rating
agencies
Risk weight 20% 30% 50% 100% 150% 100%
Unrated exposure of Rs.50(Rs.10 crores) will attract 150% risk weight.
Mapping process – draft guidelines
Short term ratings Risk
weights
CARE CRISIL FITCH ICRA
PR1+ P1+ F1+ A1+ 20%
PR1 P1 F1 A1 30%
PR2 P2 F2 A2 50%
PR3 P3 F3 A3 100%
PR4/PR5 P4/P5 B/C/D AR/A5 150%
UNRATED UNRATED UNRATE UNRATE 100%
D D
Retail Portfolio - Criteria
• Orientation criterion - exposure to individual person
or persons or to a small business.
• Product criterion - revolving credit, line of credit,
personal term loan and lease small business
facilities and commitments.
• Granularity criterion- regulatory retail portfolio is
sufficiently diversified to a degree that reduces the
risk in the portfolio – no aggregate exposure to one
counterpart can exceed 0.2% of the overall
regulatory retail portfolio
• Low value of individual exposures- the maximum
aggregate retail exposure to one counterpart cannot
exceed an absolute threshold of euro 1 million.( Rs.
5 Crores for our Bank)
• Turnover Rs.50 Crores.(AVERAGE FOR LAST 3
Capital charge for Credit risk contd…
• Past due loans
– The unsecured portion of any loan that is past due for
more than 90 days, net of specific provisions, to be given
higher risk weight
– 150% if specific provision <20% o/s
– 100% if provision >or= 20%
– if provision = or > 50% with supervisory discretion for 50%
weight
– 100% if provision > or = 15% if fully secured
Exclusion in Regulatory Retail.
• Mortgage loans to the extent they qualify for treatment as
claims secured by residential property: Margin 25% : RW upto
Rs.20 lakhs :50% and Rs.20 lakh and above 75% Margin less
than 25% RW 100%
• Consumer credit, credit card exposure etc. RW125%
• Capital market exposure and NBFCs RW125%
• Commercial Real Estate : RW 150%
• Staff loans: 20% if covered by superanuation funds or
mortgage.
• Other staff loans : 75% RW
Operational Risk
• Explicit charge on capital
• Basic Indicator approach – 15% of gross
income
• Gross income = net interest income plus net
non interest income
GROSS INCOME
• GROSS INCOME = NET PFORIT+
PROVISIONS+OPERATING EXPENSES-PROFIT
ON SALE OF INVSTEMENT-INCOME FROM
INSURANCE-EXTRA ORDINARY ITEM OF
INCOME+ LOSS ON SALE OF INVESTMENT
Operational Risk
Standardised Approach- Capital charge is calculated as a simple
summation of capital charges across 8 business lines
Business lines % of gross income
Corporate finance 18
Trading & sales 18
Retail Banking 12
Commercial Banking 15
Payment & Settlement 18
Agency Services 15
Asset Management 12
Retail Brokerage 12
Continue
• CREDIT RISK MITIGATION
• HAIR CUT TO EXPOSURE
• HAIR CUT TO FINANCIAL COLLATETAL.
Interest Rates
Yield Curve
11.0000%
10.0000%
9.0000%
YTM
8.0000%
7.0000%
6.0000%
5.0000%
0 1 2 3 4 5 6 7 8 9 10
Time Period in Years
04/01/25 26
Yield Curve – Parallel Shifts
Yield Curve - Parallel Shifts
10.2500%
9.7500%
9.2500%
8.7500%
8.2500%
YTM
7.7500%
7.2500%
6.7500%
6.2500%
5.7500%
1 2 3 4 5 6 7 8 9 10
Te nor in Ye ars
YC1 YC-Rate Rise YC-Rate Fall
04/01/25 27
Yield Curve – Stiffening &
Flattening
Yield Curve -Stiffening & Flattening
11.0000%
10.0000%
9.0000%
YTM
8.0000%
7.0000%
6.0000%
1 2 3 4 5 6 7 8 9 10
Tenor in Years
YC1 YC-Stiff YC-Flat
04/01/25 . 28
Duration Analysis
04/01/25 SPBT COLLEGE. 29
DURATION
A methodology is required for following purposes:
To assess ALM mis-matches between
assets and liabilities
To compare two portfolios - Both can be
assets / liabilities or one asset and one
liability portfolio
To decide between various options for
contracting assets or liabilities
“DURATION ANALYSIS”
04/01/25 . 30
DURATION
• In financial analysis, any intermittent cash flow
earned from a financial asset is presumed to be
reinvested at current interest rates.
• Thus, when current interest rates go up, price of
a bond falls while the reinvestment income will
go up for period to maturity. Thus capital loss
and higher income occur together.
• At some point of time in the life of the asset, the
capital loss will equal the rise in reinvestment
income This point of time is defined as Duration
of the Asset.
04/01/25 31
DURATION
• Duration is also termed as effective life of
an asset / liability or as weighted average
life.
• Duration can be applied to any asset /
liability that is of fixed income type. It
cannot be applied to floating rate
instruments.
• Duration is a direct outcome of maturity (to
term) and interest rates.
• Hence Duration is also viewed as primary
measurement of price sensitivity.
• Duration measure (D) is expressed in years.
04/01/25 . 32
DURATION ANALYSIS – An
Example
Calculate Duration of a bond of Rs 100 carrying coupon at
6.00%, payable annually and maturity of 10 ye ars. Principal
to be re paid upon maturity. Curre nt e xpe ctation of Inte re st
Rate is 8.00%
Year (Y) Inflow DF at 8% PV PV*Y
(1) (2) (3) (4)=(2*3) (5)=(1*4)
1 6 0.92593 5.55556 5.55556
2 6 0.85734 5.14403 10.28807
3 6 0.79383 4.76299 14.28898
4 6 0.73503 4.41018 17.64072
5 6 0.68058 4.08350 20.41750
6 6 0.63017 3.78102 22.68611
7 6 0.58349 3.50094 24.50660
8 6 0.54027 3.24161 25.93291
9 6 0.50025 3.00149 27.01344
10 106 0.46319
49.09851 490.98510
Total 86.57984 659.31497
D= 7.61511
Duration is arrived at by dividing total of Col 5 by
total of Col 4.
Discouting Factor is arrived at by "1/ (1+r)^n"
04/01/25 . 33
Duration
• Duration in expressed in years and is
comparable across portfolios.
• Duration of a Zero Coupon Bond is equal
to its maturity.
• Duration is additive. Hence, Duration of a
portfolio is the weighted average duration
of all instruments of the portfolio.
• Duration of a coupon paying bond / asset
is less than its maturity.
• Longer the maturity of a bond, longer is
Duration.
• Duration is inversely related to Coupon.
04/01/25 . 34
Duration
• Duration is directly related to market
interest rates / Yield.
• Higher the frequency of coupons, lower
the Duration.
• Duration of a Floating Rate bond is equal
to its interest reset period or the period
remaining to next reset of interest.
• For small changes in yield, Duration
multiplied by percentage change in yield
gives percentage change in price for
bonds.
04/01/25 35
Duration & Price Change
• If current price of a bond is Rs 98.50, its Duration
is 2.7613 and yield is likely to change from 6.00%
to 5.80%, then the likely price of the bond is
computed as under:
% change in Price = D*(percentage change in
Yield)
= 2.7513 * (6.00 - 5.80)
= 0.55226%
Absolute change in Price = 98.50 * 0.55226%
= 0.54398.
As Yield has come down, price will increase and
therefore, expected bond price will be
Rs 99.04398.
04/01/25 . 36
Modified Duration
• Duration is not preferred to compute price
changes when change in yield is large. For this
purpose, Modified Duration (MD) is used.
MD = Duration / (1+Yield)
• In our Bond example, D=2.76129 and yield is
6.00%. Therefore, MD = 2.76129/(1+0.06) or
2.60500. Let current market price be Rs 98.50.
• If yield changes from 6.00% to 5.80%, percentage
change in price will be 0.52100% and absolute
change in price will be 0.51318.
• Hence changed price will be Rs 99.01318.
04/01/25 . 37
Duration & Interest Rate Risk
• In a bank’s balance sheet, If DA = DL, there
is no IRR faced by the bank. IRR manifests
itself if DA > DL or DA < DL, depending on
the direction of movement of interest
rates.
• Hence, the strategy for containing IRR will
be to aim at a mix of assets and liabilities
in such a way that their Duration matches.
• Duration Gap is the difference between
the Duration of Assets less the effective
Duration of Liabilities.
04/01/25 . 38
Duration & Interest Rate Risk
• If a bank has Asset Duration of 3 years,
Assets of Rs 200 crore and Liabilities
(excluding Equity) of Rs 150 crore, the
bank should target Liability Duration of 4
years (200*3/150).
• In that case, Duration of Equity will be
(3*200) – (4*150) = 0.
• In other words, bank’s net worth is
immunized against changes in interest
rates.
04/01/25 39
