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Post  Admin on Fri 23 Mar 2012 - 16:58

Question 1.

The Federal Reserve System has established a banking risk framework that consists of these risk factors:

1.Credit risk ;

The potential for loss due to failure of a borrower to meet its contractual obligation to repay a
debt in accordance with the agreed terms.Credit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated loan payment. For banks, credit risk typically resides in the assets in its banking book (loans and bonds held to maturity.

2.Market risk;

Market risk is the potential loss due to changes in market prices or values. Market Risk may be defined as the possibility of loss to bank caused by the changes in the market variables. It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices. Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and
equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy.
Scenario analysis and stress testing is yet another tool used to assess areas of potential problems in a given portfolio. Identification of future changes in economic conditions like – economic/industry overturns, market risk events, liquidity conditions etc that could have unfavourable effect on bank’s portfolio is a condition precedent for carrying out stress testing. As the underlying assumption keep changing from time to time, output of the test should be reviewed periodically as market risk management system should be responsive and sensitive to the happenings in the market.

a) Liquidity risk,

Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk.

Funding Risk : It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit

Time risk : It is the need to compensate for nonreceipt of expected inflows of funds,i.e. performing assets turning into nonperforming assets.

Call risk : It happens on account of crystalisation of contingent liabilities and inability to undertake profitable business opportunities when desired.

b) Interest Rate Risk

Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability
of an institution’s financial condition to the movement in interest rates. Changes in interest rate affect earnings,
value of assets, liability off-balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensue the adequacy of the compensation received for the risk taken and effect risk return trade-off.

3.Operational risk,
Always banks live with the risks arising out of human error, financial fraud and natural disasters. The recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the potential losses on account of operational risk. Exponential growth in the use of technology and increase in global financial inter-linkages are the two primary changes that contributed to such risks. Operational risk, though defined as any risk that is not categorized as market or credit risk, is the risk of loss arising from inadequate or failed internal processes, people and systems or from external events. In order to mitigate this, internal control and internal audit systems are used as the primary means.Risk education for familiarizing the complex operations at all levels of staff can also reduce operational risk. Insurance cover is one of the important mitigators of operational risk. Operational risk events are associated with weak links in internal control procedures. The key to management of operational risk lies in the bank’s ability to assess its process for vulnerability and establish controls as well as safeguards while providing for unanticipated worst-case scenarios. Operational risk involves breakdown in internal controls and corporate governance leading to error, fraud, performance failure, compromise on the interest of the bank
resulting in financial loss. Putting in place proper corporate governance practices by itself would serve as an effective
risk management tool. Bank should strive to promote a shared understanding of operational risk within the organization, especially since operational risk is often interwined with market or credit risk and it is difficult to isolate.

4.Foreign exchange risk,

Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches. There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one
center and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the maturity mismatch of foreign currency position. The Value at Risk (VaR) indicates the risk that the bank is exposed due to uncovered position of mismatch and these gap positions are to be valued on daily basis at the prevalent forward market rates announced by FEDAI for the remaining maturities. Currency Risk is the possibility that exchange rate
changes will alter the expected amount of principal and return of the lending or investment. At times, banks may
try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk. By setting appropriates limits-open position and gaps, stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored.

5.Solvency risks;

This relates to the risk of having insufficient capital to cover losses generated by all types of risks, and is thus effectively the risk of default of the bank. From a regulatory viewpoint, the issue of adequate capital is critically
important for the stability of the banking system. The regulatory approach to ensuring sufficient capital to minimise banks’ solvency risk was discussed in detail in Chapter 2.To address solvency risk, it is necessary to define the level of capital which is appropriate for given levels of overall risk. The key principles involved can be summarised as follows:
• Risks generate potential losses.
• The ultimate protection for such losses is capital.
• Capital should be adjusted to the level required to ensure capability to absorb the potential losses generated by all risks.To implement the latter, all risks should be quantified in terms of potential losses, and a measure of aggregate potential losses should be derived from the potential losses of all component risks.

6.Country risk;

Another type of risk that is important in international banking is country risk. Country risk refers to the ability and willingness of borrowers within a country to meet their obligations. It is thus a credit risk on obligations
advanced across borders. Assessment of country risk relies on the analysis of economic, social and political variables that relate to the particular country in question. Although the economic factors can be measured objectively, the
social and political variables will often involve subjective judgments.Country risk can be categorised under two headings. The first sub-category of country risk is sovereign risk, which refers to both the risk of default by a sovereign government on its foreign currency obligations, and the risk that direct or indirect actions by the sovereign government may affect
the ability of other entities in that country to use their available funds to meet foreign currency debt obligations. In the former case, sovereign risk addresses the credit risk of national governments, but not the specific
default risks of other debt issuers. Here, credit risk relates to two key aspects: economic risk, which addresses the government’s ability to repay its obligations on time, and political risk, which addresses its willingness to
repay debt. In practice, these risks are related, since a government that is unwilling to repay debt is often pursuing economic policies that weaken its ability to do so.

7.Systemic risk.
This is when the financial system may undergo contagious failure following other forms of shock/risk

Question 2.

1) Credit Risk Management.

The instruments and tools, through which credit risk
management is carried out, are detailed below:

a) Exposure Ceilings:

Prudential Limit is linked to Capital Funds – say 15% for individual borrower entity, 40% for a group with additional 10% for infrastructure projects undertaken by the group,Threshold limit is fixed at a level lower than
Prudential Exposure; Substantial Exposure, which is the sum total of the exposures beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to eight times).

b) Review/Renewal:
Multi-tier Credit Approving
Authority, constitution wise delegation of powers, Higher delegated powers for better-rated customers; discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for fresh exposures and periodicity for renewal based on risk rating, etc are formulated.

c) Risk Rating Model:
Set up comprehensive risk scoring system on a six to nine point scale. Clearly define rating thresholds and review the ratings periodically preferably at half yearly intervals. Rating migration is to be mapped to estimate the expected loss.

d) Risk based scientific pricing:
Link loan pricing to expected loss. High-risk category borrowers are to be priced high. Build historical data on default losses. Allocate capital to absorb the unexpected loss. Adopt the RAROC framework.

e) Portfolio Management :

The need for credit portfolio management emanates from the necessity to optimize the benefits associated with diversification and to reduce the potential adverse impact of concentration of exposures to a particular borrower, sector or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating categories, distribution of borrowers in various industry, business group and conduct rapid portfolio reviews. The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of the entire loan book. There should be a proper & regular on-going system for identification of credit weaknesses well in advance. Initiate steps to preserve the desired portfolio quality and integrate portfolio reviews with credit decision-making process.

f) Loan Review Mechanism :
This should be done independent of credit operations. It is also referred as Credit Audit covering review of sanction process, compliance status, review of risk rating, pick up of warning signals and recommendation of corrective action with the objective of improving credit quality. It should target all loans above certain cut-off limit ensuring that at least
30% to 40% of the portfolio is subjected to LRM in a year so as to ensure that all major credit risks embedded in the balance sheet have been tracked. This is done to bring about qualitative improvement in credit administration. Identify loans with credit weakness. Determine adequacy of loan loss provisions. Ensure adherence to lending policies and procedures. The focus of the credit audit needs to be broadened from account level to overall portfolio level. Regular, proper & prompt
reporting to Top Management should be ensured.Credit Audit is conducted on site, i.e. at the branch that has appraised the advance and where the main operative limits are made available. However, it is not required to visit borrowers factory/office premises.

2) Market Risk Management:

i) Liquidity risk management

The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their
a) maturity profiles,
b) cost,
c) yield,
d) risk exposure, etc.
It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities. Tolerance levels on mismatches should be fixed for various maturities depending upon the asset liability profile, deposit mix, nature of cash flow etc. Bank should track the impact of pre-payment of loans & premature closure of deposits so as to realistically estimate the cash flow profile.

ii) Interest rate risk management

Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective.Earnings perspective involves analyzing the impact of
changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in
the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense.
In order to manage interest rate risk, banks should begin evaluating the vulnerability of their portfolios to
the risk of fluctuations in market interest rates. One such measure is Duration of market value of a bank asset or
liabilities to a percentage change in the market interest rate. The difference between the average duration for
bank assets and the average duration for bank liabilities is known as the duration gap which assess the bank’s
exposure to interest rate risk. The Asset Liability Committee (ALCO) of a bank uses the information contained in the duration gap analysis to guide and frame strategies. By reducing the size of the duration gap, banks can minimize the interest rate risk.

3. Foreign Exchange risk

Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and
return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by
shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk. By setting appropriates limits-open position and gaps,stop-loss limits, Day Light as well as overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits, clear cut and well defined division of responsibilities between front, middle and back office the risk element in foreign exchange risk can be managed/monitored.

4. Operational Risk Management

Over a period of time, management of credit and market risks has evolved a more sophisticated fashion than operational risk, as the former can be more easily measured, monitored and analysed. And yet the root causes of all the financial scams and losses are the result of operational risk caused by breakdowns in internal control mechanism and staff lapses. So far, scientific measurement of operational risk has not been evolved. Hence 20% charge on the Capital Funds is earmarked for operational risk and based on subsequent data/feedback, it was reduced to 12%. While measurement of operational risk and computing capital charges as envisaged in the Basel proposals are to be the ultimate goals, what is to be done at present is start implementing the Basel proposal in a phased manner and carefully plan in that direction. The incentive for banks to move the measurement chain is not just to reduce regulatory capital but more importantly to provide assurance to the top management that the bank holds the required capital.

Basel's new capital accord

Bankers’ for International Settlement (BIS) meet at Basel situated at Switzerland to address the common issues concerning bankers all over the world. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries and has been developing standards and establishment of a framework for bank supervision towards
strengthening financial stability through out the world. In consultation with the supervisory authorities authorities of a few non-G-10 countries including India, core principles for effective banking supervision in the form of minimum requirements to strengthen current supervisory regime, were mooted. The 1988 Capital Accord essentially provided only one option for measuring the appropriate capital in relation to the risk-weighted assets of the financial institution. It focused on the total amount of bank capital so as to reduce the risk of bank solvency at the potential cost of bank’s failure for the depositors. As an improvement on the above, the New Capital Accord was published in 2001, to be implemented by the financial year 2003-04. It provides spectrum of approaches for the measurement of credit, market and operational risks to determine the capital required. The spread and nature of the ownership structure is important as it impinges on the propensity to induct additional capital. While getting support from a large body of shareholders is a difficult proposition when the bank’s
performance is adverse, a smaller shareholder base constrains the ability of the bank to garner funds. Tier I capital is not owed to anyone and is available to cover possible unexpected losses. It has no maturity or repayment requirement, and is expected to remain a permanent component of the core capital of the counter party. While Basel standards currently require banks to have a capital adequacy ratio of 8% with Tier I not less than 4%, RBI has mandated the banks to maintain CAR of 9%. The maintenance of capital adequacy is like aiming at a moving target as the composition of risk-weighted assets gets
changed every minute on account of fluctuation in the risk profile of a bank. Tier I capital is known as the core capital providing permanent and readily available support to the bank to meet the unexpected losses. In the recent past, owner of PSU banks, the government provided capital in good measure mainly to weaker banks. In doing so, the government was not acting as a prudent investor as return on such capital was never a consideration. Further, capital infusion did not result in
any cash flow to the receiver, as all the capital was required to be reinvested in government securities yielding low
interest. Receipt of capital was just a book entry with the only advantage of interest income from the securities.

Ashneema Seebun student id 111438

i would like to apologize for the delay, there was connection issues at my place since this morning due to the bad weather i guess.


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