RISK MANAGEMENT

DEFINITION OF RISK:

1. Risk in finance is defined in terms of the variability of actual returns on an investment, around an expected return, even when those returns represent positive outcomes. 2. The decisions on how much risk to take and what type of risks to take are critical to the success of the business. 3. The essence of good management is making the right choices when it comes to dealing with different risks. 4. In banking, the risk is the possibility that a borrower or counterparty will fail to meet its obligations in accordance with the agreed terms, both in terms of time and quantity. 5. Risk does not come alone – the default of one firm may cripple affiliated firms such as suppliers, customers and banks.

RISK MANAGEMENT:

1. Risk Management is a planned method of dealing with the potential loss or damage. It is an ongoing process of risk appraisal through various methods and tools. 2. Risk Management involves not only to protect oneself against some risks but also to decide which risks are to be exploited and how to exploit them. 3. Risk Management covers credit decision making, performance assessment, pricing, capital computation, provisioning etc. 4. Risk Management covers the following: a. It assesses what could go wrong b. It determines which risks are important to be dealt with c. It implements strategies to deal with those risks. 5. Risk Management is not – d. A guarantee to avoid all future losses e. Limited to compliance and disclosure requirements f. A method to eliminate all risks g. A substitute for internal controls to detect fraud etc.

BASEL ACCORD:

1. In 1988, Basel I accord was introduced with the central focus on credit risk. 2. In 1996, Basel I was modified to include Market Risks. 3. In 2004, Basel II guidelines was introduced with a. New Capital Adequacy framework b. Capital requirement for operational risk management c. Guidelines for supervisory review process and market discipline 4. In 2009, Basel II framework was modified with following changes d. Changes to capital requirements for complex and illiquid credit products, certain complex securitisations etc. e. Exposures to off-balance sheet items were proposed 5. In 2010, Basel III guidelines were issued. 6. Basel III strengthens bank capital requirements and introduces new regulatory requirements on liquidity management and leverage. 7. Basel III reforms are the response of Basel Committee on Banking Supervision (BCBS) to improve the banking sector’s ability to absorb shocks arising from financial and economic stress. 8. Basel III continues with the three pillars, viz., - f. Minimum Capital Requirements g. Supervisory Review h. Market Discipline

DEFINITION OF REGULATORY CAPITAL:

1. Banks are required to maintain a minimum Pillar 1 capital to Risk Weighted Assets Ratio (CRAR) of 9 % on an on-going basis (other than capital conservation buffer and countercyclical capital buffer). 2. The RBI will take into account the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is commensurate with the bank’s overall risk profile. 3. RBI will consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. 4. Further, in terms of the Pillar 2 requirements of the New Capital Adequacy Framework, banks are expected to operate at a level well above the minimum requirement.

SUMMARY OF BASEL III CAPITAL REQUIREMENTS:

1. Present capital requirements of a bank are – a. Bank’s capital comprises Tier 1 and Tier 2 capital b. Tier 2 capital cannot be more than 100 % of Tier 1 capital c. Innovative instruments are limited to 15 % of Tier 1 capital d. Perpetual Non-cumulative Preference shares alongwith innovative Tier 1 instruments should not exceed 40 % of total Tier 1 capital at any point of time. e. Within Tier 2 capital, subordinated debt is limited to a maximum of 50 % of Tier 1 capital. 2. Capital requirements under Basel III – f. With a view to improve the quality of capital, Tier 1 capital will predominantly consist of common equity. g. Qualifying criteria for instruments to be included in Additional Tier 1 capital outside the Common Equity element and under Tier 2 capital will be strengthened. h. Thus there will be Tier 1 capital with Common Equity Element, Additional Tier 1 capital and Tier 2 capital.
COMPONENTS OF CAPITAL UNDER BASEL III :

1. Tier 1 capital (going-concern capital) a. Common Equity Tier 1 b. Additional Tier 1 2. Tier 2 capital (gone-concern capital)

CAPITAL REQUIREMENTS UNDER BASEL III :

1. Banks in India shall maintain a minimum total capital of 9 % of the total risk weighted assets. 2. This will be further divided into different components. 3. Common Equity Tier 1 (CET 1) capital must be at least 5.5 % of risk weighted assets – i.e. for credit risk + market risk + operational risk on an ongoing basis. 4. Tier 1 capital must be at least 7 % of Risk weighted assets on an ongoing basis. 5. Thus within the minimum Tier 1 capital, additional Tier 1 capital can be admitted upto a maximum of 1.5 % of risk weighted assets. 6. Total capital – Tier 1 capital plus Tier 2 capital – must be at least 9 % of the risk weighted assets on an ongoing basis. 7. Thus within the minimum CRAR of 9 %, Tier 2 capital can be admitted upto a maximum of 2 %. 8. If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then the excess Additional Tier 1 capital can be admitted for compliance with the minimum CRAR of 9 % of risk weighted assets. 9. In addition to the minimum Common Equity Tier 1 capital of 5.5 % of risk weighted assets, banks are also required to maintain a capital conservation buffer (CCB) of 2.5 % of risk weighted assets, in the form of Common Equity Tier 1 Capital. 10. Capital requirements summary –
As % of RWA a. Minimum common equity tier 1 ratio 5.5 b. Capital conservation buffer under common equity 2.5 c. Minimum Common equity Tier 1 ratio plus
Capital conservation buffer (a + b) 8.00 d. Additional Tier 1 capital 1.50 e. Minimum Tier 1 capital ratio (a + d) 7.00 f. Tier 2 capital 2.00 g. Minimum Total Capital Ratio (e + f) 9.00 h. Minimum total capital ratio plus capital
Conservation buffer (b + g) 11.5

ELEMENTS OF COMMON EQUITY TIER 1 CAPITAL:

1. Common shares (Paid-up equity capital) 2. Stock surplus (Share Premium) 3. Statutory reserves 4. Capital reserves representing surplus arising out of sale proceeds of assets 5. Other disclosed free reserves, if any 6. Balance in P & L account as at the end of previous financial year. 7. Banks may reckon the profits in current financial year for CRAR calculation on a quarterly basis as per the stipulated formula.

ELEMENTS OF ADDITIONAL TIER 1 CAPITAL:

1. Perpetual Non cumulative Preference Shares (PNCPS) 2. Stock surplus (Share Premium) under Additional Tier 1 capital 3. Eligible Debt capital instruments 4. Any other instruments notified by RBI under this capital

ELEMENTS OF TIER 2 CAPITAL:

1. General provisions and Loss reserves 2. Provisions ascribed to identified deterioration of particular assets or loan liabilities should be excluded. 3. Debt capital instruments issued by the banks 4. Preference Share Capital Instruments – Perpetual cumulative Preference shares / Redeemable Non-cumulative Preference shares / Redeemable cumulative preference shares issued by banks 5. Stock surplus (share premium) under Tier 2 capital

CREDIT RISK:

1. Credit analysis focuses on Character, Capacity, Capital, Collateral and Conditions. 2. Credit Risk is the default by a counterparty on a contractual obligation leading to a loss to the bank, resulting in NPAs. 3. Credit Risk results when the borrower defaults repayment on principal and interest on loans or when the counterparty commits default leading to invocation of non-fund based LCs and BGs.

DIFFERENT FORMS OF CREDIT RISK:

1. Direct Lending – Principal and / or interest amount not repaid. 2. Treasury operations – Payments due from counter-parties under the contracts not forthcoming 3. Securities trading business – Funds settlement not taking place 4. Guarantees or Letters of Credit – Funds not forthcoming from the constituents upon crystallization of liability 5. Cross Border exposure – Availability and free transfer of foreign currency funds may either cease or restrictions imposed 6. Credit quality – Potential losses from deterioration of credit quality of counterparty.

BASEL II TREATMENT OF CREDIT RISK:

BASEL II provisions on credit risk are as follows - 1. Assigns different risk weights to individual credit exposures to calculate the Credit Risk Weighted Assets. 2. Identifies 3 different approaches to calculate Risk Weights – Standardised approach, Internal Rating Based Approaches – Foundation Internal Rating Based approach and Advanced Internal Rating Based Approaches. 3. Recognizes the effects of risk mitigants like eligible financial collateral and guarantees. 4. Under Standardized approach for calculation of capital charge, the bank calculates risk weights for banking book exposures using ratings from External Credit Assessment Institutions, like CRISIL, ICRA, CARE, FITCH and Brickwork. 5. For risk weighting of assets, exposures are divided into 15 asset classes as per RBI guidelines. 6. Risk weights for each asset category have been prescribed by RBI which is then multiplied with the relevant exposure to arrive at the credit risk weighted assets. 7. Banks have been following Standardized approach to start with. 8. The Standardized approach is divided into following broad topics – a. Assignment of risk weights b. External Credit Assessments c. Credit Risk Mitigation

Assignment of risk weights:

9. In Standardized approach, all the exposures are first classified into various customer types. 10. Thereafter, assignment of standard risk weights is done either on the basis of customer type or on the basis of customer type or on the basis of asset quality. 11. Risk weights to various borrowers / asset classes are allotted based on the risk perception of each customer / asset type, which is subject to review by the Regulator based on market conditions and risk apprehensions.

External Credit Assessments:

12. The Regulator recognizes certain Risk Rating Agencies as External Credit Assessment Institutions (ECAIs) and rating assigned by these ECAIs to the borrowers may be taken as a basis for assigning risk weights to the borrowers. 13. Better rating means better quality of assets and lesser risk weight and hence lesser requirement of capital allocation.

Credit Risk Mitigation:

14. Following securities can be taken as collaterals, subject to haircut – d. Cash e. Gold f. Securities issued by Central / State Government g. Kisan Vikas Patra, NSC, LI Policy h. Rated debt securities with risk weight of 100 % i. Unrated debt securities issued by a bank, listed on a recognized stock exchange, classified as a senior debt j. Units of Debt Mutual Funds k. Guarantees issued by sovereign, sovereign entities, banks l. Guarantees issued by other entities rated AA or better 15. The value of these securities is reduced from the gross exposure before arriving at the Risk weighted assets by applying appropriate risk weight on net exposures. 16. Haircut is the value of security being adjusted for market volatility. This adjustment in the value of security is termed as Haircut.

Internal Ratings Based approach: (IRB)

17. The IRB approach attempts to calculate risk weighted assets for banking books, uses ratings generated from the internal rating systems of the bank. 18. An internal risk rating system can be defined as the process used to categorize bank borrowers under various risk grades. 19. As per Basel II, the term rating system comprises all of the methods, processes, controls, data collection and IT systems that support the assessment of credit risk,l the assignment of internal rating grades (presently 8 grades starting with Low risk to High risk). 20. Each rating grade defines certain level of risks and quantifies loss or default estimates. 21. When the internal rating for a client begins to deteriorate, the bank has to automatically reduce its exposure to that client and forestalls losses. 22. Specific risk estimates such as Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M) would be used to calculate risk weights and to arrive at capital charge for credit risk. 23. Probability of Default is the likelihood that a loan will not be repaid and will fall into default. 24. Loss Given Default (LGD) and Exposure at Default (EAD) are risk components which reflect facility characteristics. 25. LGD is expressed as a percentage and is the portion of the exposure that will be lost in case of default. It depends on the factors such as collateral, seniority of loan etc. 26. EAD refers to the amount to which the bank is exposed to at the time of default. 27. Maturity is an indicator of the lifetime of the exposure and is defined as the greater of one year and the remaining effective maturity in years.

CREDIT RISK MEASUREMENT APPROACHES:

Standardised approach:

1. This method calculates risk-weighted assets for banking book for sovereigns, banks and corporates etc. using the ratings from External Credit Assessment Institutions – viz., Standard & Poors, Moody’s, Fitch, CRISIL, ICRA etc.

Internal Ratings Based Approach: (IRB)

2. This method calculates risk-weighted assets for banking books using ratings generated from internal rating systems. 3. Calculates risk weights using specific risk measures as follows – a. Probability of Default – PD b. Loss Given Default – LGD c. Exposure at Default - EAD 4. IRB – Foundation: d. Depending on the exposure category, Probability of Default is measured internally e. LGD and EAD are provided by the banking regulator 5. IRB – Advanced: PD, LGD, EAD are measured internally and serve as risk components in formula calculating capital for asset classes such as Corporates, banks, sovereigns, SME, retail assets classes, specialized functions such as high volatility commercial real estate etc.

Expected Loss: (EL)

1. In the event of default, how much the bank of the risky debt / loan stands to lose is termed as expected loss. 2. Credit losses naturally fluctuate over time and with economic conditions. 3. However, there is a statistically measurable long-run average loss level. 4. For example, if a bank, based on historical performance, expects around 1 % of its loans to default every year with an average recovery rate of 50 %, then for a credit portfolio of Rs. 100 lakhs the Expected Loss would be Rs. 0.5 lakh (Rs. 100 lakhs X 1 % x 50 %). 5. Expected Loss is based on the following parameters – a. The likelihood that default will take place over a specified time horizon (PD) b. The amount owned by the borrower at the moment of default (EAD) c. The fraction of the exposure, net of any recoveries, which will be lost following a default event (LGD) d. EL = PD*LGD*EAD (All the three multiplied with each other) 6. These losses are managed by pricing and provisioning etc. 7. When the losses exceed the average expected levels of loss, the same is termed as unexpected loss.
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OPERATIONAL RISK:

1. Operational risk has been defined by Basel as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. 2. Operational risk includes legal risk but excludes strategic risk and reputational risk.

Different Operational Risks:

3. People risk – Operational risk loss incidents / events relating to people (internal / external) are covered under this risk – Hiring of unsuitable staff, improper succession planning etc. 4. Process risk – Operational risk loss incidents / events occurred on account of processes involved in the Bank – frequent transgressions without proper authority, accounting errors etc. 5. System risk – Operational risk loss incident / events on account of system break down / disruption and other technological related problems – system failure, network failure, server failure etc. 6. External risk – Operational risk loss incidents occurred on account of external events like earthquake, flood, strikes, vandalism etc. 7. Legal risk – a. Legal risk can be defined as the risk arising from failure to comply with statutory or regulatory obligations. b. Legal risk also arises from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.
SIGNIFICANCE OF OPERATIONAL RISK:

Operational risk gains significance due to the following reasons – 1. Deregulation and globalization of financial services 2. Complex structure of products – derivatives 3. Emergence of e-commerce (e-banking) 4. Mergers / Acquisitions / Consolidations 5. Cross selling of products 6. Sophistication of technology in financial services 7. Financial crisis and bank failures 8. Outsourcing 9. Growing use of financial technology 10. Constant upgrading of banking business profile

BANK FAILURES DUE TO OPERATIONAL RISK:

1. Barings Bank 2. Allied Irish Bank – 2002 3. Royal Bank of Canada – 2004

QUALITATIVE MANAGEMENT OF OPERATIONAL RISK:

1. Risk Identification 2. Risk Assessment 3. Risk Mitigation 4. Risk Reporting and Monitoring

Risk Identification:

1. Risk identification is a process of listing out the operational risk loss incidents / events as per Basel classifications. 2. Risk loss incidents are classified as under: a. Internal fraud – undertaking an unauthorized activity etc. b. External fraud – outsider commits fraud or misappropriation c. Employment practices and workplace safety –Losses due to employee health and safety laws d. Clients, products and business practice – Losses from unintentional or negligent failure to meet professional obligation to specific clients etc. e. Damage to physical assets f. Business disruption and system failures g. Execution, delivery and process management – Losses on account of failed transaction processing of wrong data entry made etc.

Risk Assessment:

3. Frequency – Frequency is the reference to the number of error events that the product type / risk type is exposed to. 4. Severity – Severity is the reference to the loss / potential loss amount that the operational risk is exposed to, when the risk event materializes. 5. The identified risks are graded as follows – h. Low frequency High impact events – Terrorist attack, Tsunami etc. i. High frequency low impact events – System failure etc. j. Low frequency impact low impact events – Minor accounting error k. High frequency high impact events – Loss due to frequent floods etc. 6. High frequency and High impact events should first be analysed incident-wise and reasons for occurrence of the events are to be studied. 7. Expected loss is the loss resulting from a particular loss event that is anticipated – bad loans etc. 8. Unexpected loss – This is the estimate of loss whose likelihood cannot be expected in the near future – loss due to fire etc.

Risk Mitigation:

9. Risk mitigation is a process of reducing exposure to frequency or severity of events – eg. Taking an insurance policy to cover losses. 10. Risk mitigation is for both expected and unexpected operational risk loss events. 11. Following tools are practiced by banks under risk mitigation – l. Internal controls and internal audit m. Fixing operational limits n. Outsourcing some of the activities o. Insurance p. Estimating future losses based on historical loss experience

Reporting and monitoring of Operational risk:

12. Any operational risk loss incidents / events has to be reported in a structured format to the controlling office. 13. Risk monitoring is receiving continuous information from branches and offices about the occurrence of loss incidents etc. and taking appropriate mitigation measures.

Operational Risk Measurement Approaches:

1. Basic Indicator approach – a. Operational risk capital = Gross revenue multiplied by the percentage set by the regulator. b. Banks should hold capital for operational risk equal to the average over the previous three years positive annual gross income multiplied by 15 %. 2. Standardized approach – c. Operational risk capital = Gross revenue multiplied the percentage set by the regulator. d. Banks activities are divided into 8 business lines and capital charge is calculated at different rates for each business line ranging from 12 % to 18 % of gross profit. e. The 8 business lines are – Retail banking, Commercial Banking, Payment and Settlement, Trading & Sales, Corporate Finance, Agency Services, Asset Management, Retail brokerage. 3. Advanced Measurement Approach – f. Operational risk capital = The risk measure generated by the banks own operational risk measurement systems g. Under this, the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system. Banks use their own method to assess the exposure to operational risk.

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MARKET RISK:

1. Market risk is defined as the risk of losses in on and off balance sheet positions arising from movements in market prices including interest rates, exchange rates and equity and commodity values. 2. Different components of Market risk are as follows – a. Interest Rate risk – Change in value of assets and liabilities with the changes in interest rates b. Equity risk – change in value of investments with stock market dynamics c. Foreign Exchange risk – Exposure rate risk – Exposure to unanticipated currency rate changes d. Liquidity risk e. Counterparty or specific risk f. Country risk

Exchange Rate risk: Exchange rate risk may be defined as the loss that a bank may suffer as a result of adverse exchange rate movements, either spot or forward or a combination of the two, in an individual foreign currency.

Liquidity Risk: ** (Refer under Asset Liability Management)

Interest Rate risk: ** (Refer under Asset Liability Management)

Value at Risk: ** (Refer under Asset Liability Management)

ECONOMIC CAPITAL:

1. Economic capital is the amount of capital that a bank needs to ensure that it stays solvent. 2. It is usually defined as the capital level that is required to cover the bank’s losses with a certain probability or confidence level, which is related to a desired rating. 3. Basel II defines economic capital as the amount of capital, as self-assessed by a bank, needed to support a given set of risks and absorb losses upto a specified probability. 4. Economic capital is based on a probabilistic assessment of potential future losses and is therefore a potentially more forward-looking measure of capital adequacy.

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ASSET LIABILITY MANAGEMENT (ALM):

Assets of a bank:

Loans and Advances, Investments, Balances with RBI, Balances with other banks, Cash, Fixed Assets, Other Assets

Liabilities of a bank:

Deposits, Borrowings, Capital, Reserves and surplus

Asset-Liability Management:

1. Asset-liability management is the process of decision making to control the risk of existence, stability and growth of a system through dynamic balancing of its assets and liabilities. 2. With the deregulation of interest rates, liberalization of exchange rate system, development of secondary markets for bonds etc. Banks are exposed to interest rate risk, liquidity risk, exchange rate risk etc. 3. Asset Liability Management deals with these risk management measures. 4. Asset Liability Management outlays a comprehensive and dynamic framework for measuring, monitoring and managing various risks.

Scope of ALM function:

1. Liquidity risk management 2. Management of market risk 3. Trading risk management 4. Funding and capital planning 5. Profit planning and growth projection

Contractual maturity:

Contractual maturity is the maturity period for which an instrument is contracted for. For example, a deposit which is contracted on 1.8.2013 and maturing on 1.8.2014, the contractual maturity is one year.

Residual maturity:

Residual maturity is the maturity remaining for an instrument as on a particular date. For example, a deposit was contracted on 1.1.2014 for one year will have the contractual maturity on 1.1.2015. As on 1.8.2014, the residual maturity will be 5 months, i.e. 1.8.2014 to 1.1.2015.

Mismatch in ALM:

Mismatch is the difference between the assets (inflow) and the liabilities (outflow) in a particular time bucket, viz., 15 days, upto 30 days, upto 90 days, upto 180 days and so on.

Positive mismatch:

Positive mismatch in a particular time bucket arises when maturing assets are more than the maturing liabilities.

Negative mismatch:

1. Negative mismatch in a particular time bucket arises when more liabilities are maturing than the assets. 2. Since there is less inflows (assets) to meet the liabilities, there will be always a liquidity risk with the negative mismatch in the respective time buckets when they are in the immediate time zone.

Cumulative mismatch:

1. Cumulative mismatch for a particular time bucket is the total carried forward mismatches of all the previous time buckets. 2. The cumulative mismatch in the 3 months time buckets will be the total mismatches from 1 day to 15 days, upto 30 days, upto 60 days, upto 90 days etc.
LIQUIDITY RISK:

1. Liquidity risk is the risk of not meeting the maturing liabilities due to insufficient liquid assets. 2. It arises when a bank is unable to generate cash to cope with the situation – it will arise with a decline in deposits or increase in assets. 3. It originates from the mismatches in the maturity pattern of assets and liabilities. 4. Liquidity risk in turn consists of funding risk, time risk and call risk. 5. Funding risk is the need to replace the net outflows due to unanticipated incidents like premature closure or non-renewal of deposits. 6. Time risk is the need to compensate for the non-receipt of expected inflows. For example, performing assets turn into non-performing assets. 7. Call risk occurs due to the crystallization of contingent liabilities and the inability to take up the profitable ventures when desired. 8. Liquidity is measured by calculating the mismatch between the maturing assets and liabilities. 9. Following ratios are used for liquidity management: a. Core deposits vis-à-vis core assets b. Liquid assets vis-à-vis short term liabilities c. Purchased funds vis-à-vis liquid assets d. Commitment ratio 10. Core deposits to core assets ratio indicates the long term liability position. Core deposits are those deposits that are with the bank for long time and core assets means the assets that are receivable in long term. 11. Liquid assets are those that can be quickly converted to cash. Short term liabilities are those maturing in short term. 12. Purchased funds include bulk deposits of above Rs. 10 crores that is contracted at a higher interest rate. Liquid asset consists of assets that can be converted into cash quickly. 13. Commitment ratio is the ratio of total Line of Credit committed and LCs and Guarantees to the total advances.

INTEREST RATE RISK:

1. Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. 2. Interest rate risk arises from holding assets and liabilities with different principal amount, different maturity date etc. 3. The immediate impact of changes in interest rate is one on the Net Interest income. 4. The long term impact of changing interest rates will be on the bank’s net worth since the economic value of the bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. 5. Interest rate risk can be defined as the risk of change in the earnings and economic value of equity of bank to the interest rate fluctuations. 6. The following are the different types of interest rate risk: a. Gap / Mismatch risk b. Basis risk c. Embedded options risk d. Reinvestment risk 7. GAP / MISMATCH RISK: It is the risk arising due to the difference in the maturity or amount or re-pricing date of assets and liabilities, thereby creating exposure to unexpected interest rate fluctuations. 8. BASIS RISK: It is the risk due to the increase in the interest rates of assets and liabilities in different magnitude. 9. EMBEDDED OPTIONS RISK: e. Embedded options risk consists of premature closure of deposits before their maturity and prepayment of loans and advances. f. Premature closure of term deposit necessitate the immediate requirement of funds. g. Prepayment of loans and advances may lead to deployment of funds at a lower rate. 10. REINVESTMENT RISK: It is the risk of deploying the intermediate cash flows from an asset at a lower rate resulting in lesser income. 11. EARNING AT RISK: h. The management of interet rate risk by analyzing the change in the Net Interest Income is known as earnings perspective. i. The immediate impact of change in interest rate is on the Net Interest income and it is the management of interest rate risk in short term. 12. ECONOMIC VALUE PERSPECTIVE: j. Fluctuation in interest rates changes the values of assets and liabilities and thus the economic value of future cash flows. k. Any decrease in the values of assets affect the networth of the bank and, in the long run, it further affects the value of networth by limiting the leverage capacity of the bank. l. Economic value perspective of interest rate risk is estimated through the duration of equity.

MEASUREMENT OF INTEREST RATE RISK:

1. The mismatch risk is measured by calculating the gap over the time interval as at a given date. 2. The gap is the difference between Rate Sensitive Assets and Rate Sensitive Liabilities. 3. Gap report is generated by grouping the total assets and liabilities into rate sensitive and bucketing them according to residual maturity or next re-pricing date, whichever is earlier. 4. The non-sensitive portion is bucketed in the last time bucket. 5. The mismatch in each time bucket as a percentage of assets in each time bucket is calculated and presented in the report. 6. For monitoring the interest rate risk, prudential limits are set for the mismatch percentage and monitored continuously for any changes.

TRADITIONAL GAP METHOD:

1. Gap analysis measures the interest rate risk from the earnings perspective. 2. It measures the variation in the Net Interest Income using the rate sensitive gap. 3. The positive gap indicates that the Rate Sensitive Assets are more than the Rate sensitive liabilities. 4. Negative gap indicates that the Rate Sensitive Liabilities are more than the rate sensitive assets. 5. If there is a positive gap, the bank will be able to benefit from the rising interest rates as the Net Interest Income increases. 6. If there is a negative gap, the bank will be able to benefit from the falling interest rates as the re-priceable liabilities are more than the re-priceable assets.

DURATION METHOD:

1. Duration is the weighted averate time to maturity using the relative present values of assets or liability cash flows as weights. 2. It is the average life of the asset or the liability. 3. It is the weighted average of time to recover principal and interest. 4. Duration varies from the maturity on the view that the intermediate cash flows are reinvested. 5. It is also a direct measure of sensitivity of prices to interest rate fluctuations. 6. Generally, the longer the maturity and smaller the cash flows, the higher will be the duration. 7. Higher duration implies that for a given change in the interest rates, the higher will be the change in the economic value. 8. Modified duration is duration divided by change in yield. 9. Modified duration is also defined as approximate change in price for 100 bps change in interest rate. 10. Duration gap analysis compares the duration of assets with duration of liabilities and calculates the market value of equity when interest rate fluctuates.

VALUE AT RISK (VaR):

1. Value at Risk is defined as an estimate of potential loss in a position or asset or liability or portfolio of assets or liabilities over a given holding period at a given level of certainty. 2. The given period may be one day for typical trading activities or a month or longer for portfolio management. 3. VaR is a measure of likely loss, not the actual loss. 4. VaR is a single number that tells what the risk exposure is on the next day. 5. VaR is a figure that tells us what is our loss figure, such that there is a very low probability of the actual loss being greater than the VaR figure. 6. VaR measures the probability of loss for a given time period over which the position is held. 7. VaR is calculate by 3 methods – viz., a. Co-relation method b. Historical simulation method c. Monte-Carlo simulation method 8. For calculating all the models, three basic parameters would be required – viz., holding period, confidence interval and the historical time horizon over which the asset prices are observed.

DYNAMIC GAP ANALYSIS:

1. In a dynamic gap analysis, the Gap is prepared for the simulated balance sheet. 2. Bucket-wise assets and liabilities are classified as per the simulated balance sheet. 3. Simulation is carried by varying the deposits and advances. 4. Dynamic gap indicates the possible bucket-wise gap in assets and liabilities with the variation in business parameters.

ALM ORGANISATION:

1. The Asset Liability Management is managed by the Asset Liability Committee (ALCO). 2. ALCO is headed by Chairman and Managing Director and Executive Director as alternate to Chairman and consists of senior executives of the Bank. 3. There will be other members like Chief of Credit, Planning, Information, Treasury, Risk Management etc. 4. The Risk Management Committee of the Board will be overseeing the implementation and working of the ALCO system in the Bank. 5. ALCO will normally meet once in a month and discuss the important matters and takes decision. 6. ALCO would consider the product pricing for deposits and advances, desired maturity profile and mix of incremental assets and liabilities etc. 7. ALCO would take stock of the liquidity position of the Bank and would also review the results and progress in implementation of the decisions made. 8. ALCO would be assisted by ALCO support group consisting of members from Risk, Management, Treasury and International Operation, Planning and Development, Corporate Credit etc.