Sapna Final Black Book

Chapter 1 Introduction Risk management in Indian banks is a relatively newer practice, but has already shown to increase efficiency in governing of these banks as such procedures tend to increase the corporate governance of a financial institution. In times of volatility and fluctuations in the market, financial institutions need to prove their mettle by withstanding the market variations and achieve sustainability in terms of growth and well as have a stable share value. Hence, an essential component of risk management framework would be to mitigate all the risks and rewards of the products and service offered by the bank. Thus the need for an efficient risk management framework is paramount in order to factor in internal and external risks.

The financial sector in various economies like that of India are undergoing a monumental change factoring into account world events such as the ongoing Banking Crisis across the globe. The 2007–present recession in the United States has highlighted the need for banks to incorporate the concept of Risk Management into their regular procedures. The various aspects

of

increasing

global

competition

to Indian

Banks by

Foreign

banks,

increasing Deregulation, introduction of innovative products, and financial instruments as well as innovation in delivery channels have highlighted the need for Indian Banks to be prepared in terms of risk management.

Indian Banks have been making great advancements in terms of technology, quality, as well as stability such that they have started to expand and diversify at a rapid rate. However, such expansion brings these banks into the context of risk especially at the onset of increasing Globalization and Liberalization. In banks and other financial institutions, risk plays a major part in the earnings of a bank. The higher the risk, the higher the return, hence, it is essential to maintain a parity between risk and return. Hence, management of Financial risk incorporating a set systematic and professional methods especially those defined by the Basel II becomes an essential requirement of banks. The more risk averse a bank is, the safer is their Capital base. 1

1.1 Objective

• To identify and prioritise potential risk events • Help develop risk management strategies and risk management plans • Use established risk management methods, tools and techniques to assist • in the analysis and reporting of identified risk events • Find ways to identify and evaluate risks • Develop strategies and plans for lasting risk management strategies

1.2 Scope

1. as credit risks, market risks, liquidity risks, operational risks, strategic and reputational risks, etc. To advise the To propose to the Board a policy for overall risk management, including major risks such Board on its risk appetite, tolerance and strategy for the Bank and its business units. To recommend the risk and concentration levels for approval by the Board, in alignment with the Board’s risk appetite. To approve significant policies and framework that govern the management of risks, including risk governance matters, and which have been delegated to RMC by the Board. 2. . To formulate strategies that are consistent with the risk management policy and which can assess, monitor, and ensure that the financial institution’s risks are at appropriate levels. 2

3. To approve the supplemental risk limits as defined in the relevant policies and frameworks. To review the adequacy of the Bank’s risk management policy and systems, and the effectiveness of policy and systems implementation in terms of identifying, measuring, aggregating, controlling and reporting these risks. 4. To review and monitor all risks and risk management practices, including internal control and compliance processes and systems. 5. To approve the appointment, review of committee structure and composition, and roles and duties of the management – level risk management committees. 6. To report the risk management performance and all risk management matters and measures to the Board, and to the Audit Committee for any improvements needed to ensure the effectiveness of the policy implementation. 7. To advise on the development and maintenance of a supportive culture, in relation to the management of risk, appropriately embedded through procedures, training and leadership actions so that all employees are alert to the wider impact of their actions on the Bank and its business units. 8. To advise on the alignment of compensation structures in relation to the management of risk, within the Board’s risk appetite.

Chapter 2 3

Types of risk in banks

2.1 Meaning / Definition Of Risks

What is Risk?

Risk refers to ‘a condition where there is a possibility of undesirable occurrence of a particular result which is known or best quantifiable and therefore insurable’. A risk can be defined as an unplanned event with financial consequences resulting in loss or reduced earnings. An activity which may give profits or result in loss may be called a risky proposition due to uncertainty or unpredictability of the activity of trade in future. In other words, it can be defined as the uncertainty of the outcome. As risk is directly proportionate to return, the more risk a bank takes, it can expect to make more money.

Banks and risk Banks have to take risks all the time. Any bank has to take on risk to make money. This includes full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), or any other financials included in an ETF like the Financial Select Sector SPDR Fund (XLF).

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2.2 Eight types of bank risks There are many types of risks that banks face. We’ll look at eight of the most important risks. 1.

Credit risk

2.

Market risk

3.

Operational risk

4.

Liquidity risk

5.

Business risk

6.

Reputational risk

7.

Systemic risk

8.

Moral hazard 5

Out of these eight risks, credit risk, market risk, and operational risk are the three major risks. The other important risks are liquidity risk, business risk, and reputational risk. Systemic risk and moral hazard are unrelated to routine banking operations, but they do have a big bearing on a bank’s profitability and solvency. All banks set up dedicated risk management departments to monitor, manage, and measure these risks. The risk management department helps the bank’s management by continuously measuring the risk of its current portfolio of assets, or loans, liabilities, or deposits, and other exposures. The department also communicates the bank’s risk profile to other bank functions and takes steps, either directly or in collaboration with other bank functions, to reduce the possibility of loss or to mitigate the size of the potential loss.

 Credit risk

According to the Bank for International Settlements (BIS), credit risk is defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. Credit risk is most likely caused by loans, acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions. In simple words, if person A borrows loan from a bank and is not able to repay the loan because of inadequate income, loss in business, death, unwillingness or any other reasons, the bank faces credit risk. Similarly, if you do not pay your credit card bill, the bank faces a credit risk. Hence, to minimize the credit risk on the bank’s end, the rate of interest will be higher for borrowers if they are associated with high credit risk. Factors like unsteady income, low credit score, employment type, collateral assets and others determine the credit risk associated with a borrower. As stated earlier, credit risk can be associated with interbank transactions, foreign 6

transactions and other types of transactions happening outside the bank. If the transaction at one end is successful but unsuccessful at the other end, loss occurs. If the transaction at one end is settled but there are delays in settlement at the other end, there might be lost investment opportunities. Look at it like person a sending US dollars to his family in India at the rate of 60 INR (Indian Rupee) per dollar. The person B, who is the recipient however receives the payment late and doesn’t get the exchange rate of 60 INR. Instead he receives the money at the exchange rate of 58 INR. This means they incurred a loss in the transaction. Similar situations occur during big transactions in banks. If the bank is not able to settle a transaction at an expected time or during an expected time duration, they may incur a credit risk. However, this kind of risk is called “Settlement Risk” and it is closely associated with credit risk. It depends on the timing of the exchange of value, payment/settlement finality and the role of intermediaries and clearing houses.

 Market risk McKinsey defines market risk as the risk of losses in the bank’s trading book due to changes in equity prices, interest rates, credit spreads, foreign-exchange rates, commodity prices, and other indicators whose values are set in a public market. Bank for International Settlements (BIS) defines market risk as the risk of losses in on- or off-balance sheet positions that arise from movement in market prices. Market risk is prevalent mostly amongst banks who are into investment banking since they are active in capital markets. Investment banks include Goldman Sachs, Bank of America, JPMorgan, Morgan Stanley and many others. Market risk can be better understood by dividing it into 4 types depending on the potential cause of the risk: 

Interest rate risk: Potential losses due to fluctuations in interest rate



Equity risk: Potential losses due to fluctuations in stock price



Currency risk: Potential losses due to international currency exchange rates (closely associated with settlement risk)

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

Commodity risk: Potential losses due to fluctuations in prices of agricultural, industrial and energy commodities like wheat, copper and natural gas respectively

 Operational risk According to the Bank for International Settlements (BIS), operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk. Operational risk can widely occur in banks due to human errors or mistakes. Examples of operational risk may be incorrect information filled in during clearing a check or confidential information leaked due to system failure. Operational risk can be categorized in the following way for a better understanding: 

Human risk: Potential losses due to a human error, done willingly or unconsciously



IT/System risk: Potential losses due to system failures and programming errors



Processes risk: Potential losses due to improper information processing, leaking or hacking of information and inaccuracy of data processing Operational risk may not sound as bad but it is. Operational risk caused the decline of Britain’s oldest banks, Barings in 1995. Since banks are becoming more and more digital and shifting towards Information technology to automate their processes, operational risk is an important risk to be taken into consideration by the banks. Security breaches in which data is compromised could be classified as an operational risk, and recent instances in this area have underlined the need for constant technology investments to mitigate the exposure to such attacks.

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 Liquidity risk

Investopedia defines liquidity risk as the risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. However if you find this definition complex, the term ‘liquidity risk’ speaks for itself. It is the risk that may disable a bank from carrying out day-to-day cash transactions. Look at this risk like person A going to a bank to withdraw money. Imagine the bank saying that it doesn’t have cash temporarily! That is the liquidity risk a bank has to save itself from. And this is not just a theoretical example. A small bank in Northern England and Ireland was taken over by the government because of its inability to repay the investors during the 2007-08 global crisis.

 Reputational risk

The organization’s

reputation

capital. The Federal Reserve Board in the US defines

reputational risk as the potential loss in reputational capital The Financial Times Lexicon defines reputation risk as the possible loss of based on either real or perceived losses in reputational capital. Just like any other institution or brand, a bank faces reputational risk which may be triggered by bank’s activities, rumors about the bank, willing or unconscious non-compliance with regulations, data manipulation, bad customer service, bad customer experience inside bank branches and decisions taken by banks during critical situations. Every step taken by a bank is judged by its customers, investors, opinion leaders and other stakeholders who mould a bank’s brand image

 Business risk

9

In general, Investopedia defines business risk as the possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. In the context of a bank, business risk is the risk associated with the failure of a bank’s long term strategy, estimated forecasts of revenue and number of other things related to profitability. To be avoided, business risk demands flexibility and adaptability to market conditions. Long term strategies are good for banks but they should be subject to change. The entire banking industry is unpredictable. Long term strategies must have backup plans to avoid business risks. During the 2007-08 global crisis, many banks collapsed while many made way out it. The ones that collapsed didn’t have a business risk management strategy.

Systemic risk and moral hazard are two types of risks faced by banks that do not causes losses quite often. But if they cause losses, they can cause the downfall of the entire financial system in a country or globally  Systemic risk

The global crisis of 2008 is the best example of a loss to all the financial institutions that occurred due to systemic risk. Systemic risk is the risk that doesn’t affect a single bank or financial institution but it affects the whole industry. Systemic risks are associated with cascading failures where the failure of a big entity can cause the failure of all the others in the industry.

 Moral hazard 10

Moral hazard is a risk that occurs when a big bank or large financial institution takes risks, knowing that someone else will have to face the burden of those risks. Economist Paul Kerugma described moral hazard as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly. Economist Mark Zandt of Moody’s Analytics described moral hazard as a root cause of the subprime mortgage crisis of 2008-09

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Chapter3

RISK IN DIFFERENT BANKS Banking sectors plays a pivotal role in the management of the economy of a country. You as the aspirants of RBI Grade B Officer needs to know about what are the Risks of Banking sector, Risk Management and what is the role of RBI in the risk management.

Type of Risks 3.1 RISK OF INDIAN BANKS: The major risks in banking business as commonly referred can be broadly classified into:

12



Liquidity Risk



Interest Rate Risk



Market Risk



Credit or Default Risk



Operational Risk

Liquidity Risk 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

(a) Funding Risk: Funding

–

Liquidity Risk is defined as the inability to obtain funds to

meet cash flow obligations. For banks, funding liquidity risk is crucial. This arises from the need to replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale and retail).

(b) Time Risk: Time risk arises from the need to compensate for non-receipt of expected inflows of funds i.e., performing assets turning into non-performing assets.

(c) Call Risk: Call risk arises due to crystallisation of contingent liabilities. It may also arise when a bank may not be able to undertake profitable business opportunities when it arises.

2.

Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity (MVE) of an institution is affected due to changes in the interest rates.

13

IRR can be viewed in two ways – its impact is on the earnings of the bank or its impact on the economic value of the bank’s assets, liabilities and Off-Balance Sheet (OBS) positions. Interest rate Risk can take different forms.

3.

Market Risk

The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to market movements, during the period required to liquidate the transactions is termed as Market Risk. This risk results from adverse movements in the level or volatility of the market prices of interest rate instruments, equities, commodities, and currencies. It is also referred to as Price Risk. The term Market risk applies to (i) that part of IRR which affects the price of interest rate instruments, (ii) Pricing risk for all other assets/ portfolio that are held in the trading book of the bank and (iii) Foreign Currency Risk.

(a) Forex Risk: 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. (b) Market Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude a large transaction in a particular instrument near the current market price.

4.

Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to fail to meet its obligations in accordance with the agreed terms. For most banks, loans are the largest and most obvious source of credit risk. It is the most significant risk, more so in the Indian scenario where the NPA level of the banking system is significantly high. Now, let’s discuss the two variants of credit risk –

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(a) Counterparty Risk: This is a variant of Credit risk and is related to non-performance of the trading partners due to counterparty’s refusal and or inability to perform. The counterparty risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk.

(b) Country Risk: This

is also a type of credit risk where non-performance of a

borrower or counterparty arises due to constraints or restrictions imposed by a country. Here, the reason of non-performance is external factors on which the borrower or the counterparty has no control

Credit Risk depends on both external and internal factors. The internal factors include Deficiency in credit policy and administration of loan portfolio, Deficiency in appraising borrower’s financial position prior to lending, Excessive dependence on collaterals and Bank’s failure in post-sanction follow-up, etc. The major external factors are the state of Economy, Swings in commodity price, foreign exchange rates and interest rates, etc. Credit Risk can’t be avoided but can be mitigated by applying various risk-mitigating processes –



Banks should assess the credit-worthiness of the borrower before sanctioning loan i.e., Credit rating of the borrower should be done beforehand. Credit rating is the main tool of measuring credit risk and it also facilitates pricing the loan.



By applying a regular evaluation and rating system of all investment opportunities, banks can reduce its credit risk as it can get vital information of the inherent weaknesses of the account.



Banks should fix prudential limits on various aspects of credit – benchmarking Current Ratio, Debt-Equity Ratio, Debt Service Coverage Ratio, Profitability Ratio etc.

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

There should be maximum limit exposure for single/ group borrower.



There should be provision for flexibility to allow variations for very special circumstances.



Alertness on the part of operating staff at all stages of credit dispensation – appraisal, disbursement, review/ renewal, post-sanction follow-up can also be useful for avoiding credit risk

. 5.

Operational Risk

Basel Committee for Banking Supervision has defined operational risk as ‘the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events’. Managing operational risk has become important for banks due to the following reasons – 

Higher level of automation in rendering banking and financial services



Increase in global financial inter-linkages



Scope of operational risk is very wide because of the above-mentioned reasons.

Two of the most common operational risks are discussed below –

(a) Transaction Risk: Transaction risk is the risk arising from fraud, both internal and external, failed business processes and the inability to maintain business continuity and manage information.

(b) Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial loss or reputation loss that a bank may suffer as a result of its failure to comply with any or all of the applicable laws, regulations, codes of conduct and standards of good practice. It is also called

16

integrity risk since a bank’s reputation is closely linked to its adherence to principles of integrity and fairt dealing.

6 .Other risks

Apart from the above-mentioned risks, following are the other risks confronted by Banks in course of their business operations –

(a) Strategic Risk: Strategic Risk is the risk arising from adverse business decisions, improper implementation of decisions or lack of responsiveness to industry changes.

(b) Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This risk may expose the institution to litigation, financial loss or decline in customer base.

3.2 Role of RBI in Risk Management in Banks:

Here, we will discuss the role of RBI in Risk Management and how the tools called CAMELS was used by RBI to evaluate the financial soundness of the Banks. CAMELS is the collective tool of six components namely 

Capital Adequacy



Asset Quality



Management



Earnings Quality



Liquidity 17



Sensitivity to Market risk

The CAMEL was recommended for the financial soundness of bank in 1988 while the sixth component called sensitivity to market risk (S) was added to CAMEL in 1997. In India, the focus of the statutory regulation of commercial banks by RBI until the early 1990s was mainly on licensing, administration of minimum capital requirements, pricing of services including administration of interest rates on deposits as well as credit, reserves and liquid asset requirements. RBI in 1999 recognized the need of an appropriate risk management and issued guidelines to banks regarding assets liability management, management of credit, market and operational risks. The entire supervisory mechanism has been realigned since 1994 under the directions of a newly constituted Board for Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the demanding needs of a strong and stable financial system. A process of rating of banks on the basis of CAMELS in respect of Indian banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect of foreign banks has been put in place from 1999.

3.3 RISK OF INTERNATIONAL BANKS The banking industry was transformed in the 1970s, until then most banks concentrated on their home markets, considering themselves as domestic institutions that handled foreign business. With the rapid expansion of international networks, the emphasis was on global banks (Glover, 1986). Global banks occupies an important position in the economy (Malul, Shoham, and Rosenboim, 2009), as it has access to the capital, the technological capabilities, and the international network to facilitate these activities. In addition, they monitor the business sector through the evaluation, pricing, and credit-granting functions (Arteaga, Arbelaez, and Jeffus

2007). In the context

of

a

bank

activity, the operations of

an

international trade of services, that has creation and management of financial means, or the transport of capital from surplus units of country in another, or the mediation in the frame of 18

national financier system are called “International Banking activity”. When studies refer to “the internationalization of

banks”, they are concerned

with two different aspects of

internationalization .The first aspect refers to the exchange in terms of import and export of banking services and transactions in foreign currency. The second aspect , however, is related to the strategy of banks when internationalising (Vasiliadis, 2009). Regardless of the aspect of

internationalization

of

banks, previous

studies show

that

the

motive

behind

internationalisation of a bank is to maximise shareholder value by providing return on equity (Rosen, 2004). Banks that are successful

in doing so have a dopted

two strategies; (i)

maximized profits, via either an efficient manage a level of leverage that is optimal from the standpoint of equity holders. These firm level decisions may be seen as the proximate drivers of expansion and contraction in international activities (Carney, 2010). However, a daptation of global expansion strategy faces many challenges and one such challenge is increased risk, which enhances the possibility of bank failures. Therefore, it is important to understand the risk faced by the international banking industry to overcome and limit the probability

of

bank

failures. End of costs or an inc After

the

introduction of

term

international banking and its motive, the reminder of the paper is outlined as follow. Section 2 briefs the risks faced by the international banking. Section 3 outlines the importance of managing the risk. Section 4 is discussion and conclusion. Rebased volume of activities, and (ii) chosen

3.4 Risk Faced by the International Banking Internationalisation can

affect the risk

profile and

resilience of banks through risk

diversification, competition and efficiency gains. The geographic diversification of a bank’s counterparties often translates into a diversification of its exposures, which reduces the riskiness of its aggregate portfolio. However, research has found that banks that enjoy diversification benefits tend to build riskier portfolios in order to maximize shareholder return and therefore, international banks are equally risky and face multiple risks due to being global (Carney, 2010). Before, further explaining the different types of risk faced by the banks it is important to 19

understand what the term "Risk" means, as a prerequisite for the theoretical analysis of a problem is the definition of terms. Risk is not understood merely as “uncertainty about the future” or the “probability of sustaining a loss” but is defined as “an expression of the danger that the effective future outcome will deviate from the expected or planned outcome in a negative way” (Geiger, 1999). This definition implies that a bank does not accept risks simply as fate but deals with them actively to avoid failures. Therefore, understanding of risk from banking perspective is vital. The focus of this section is to provide an analytical framework for the risks associated with the international banking. The international banking industry faces many risks based on its internal and external environment and the risks that can be classified as interrelated. Some of the key risks faced by international banks are briefly explained below:

 Operational Risk is one the oldest risk that banks face. A newly established international bank can be confronted with operational risks before it even decides on its first credit transaction or market position. The term is explained, as “Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.” (Geiger, 2010) There are two key elements of this definition. First, the focus is on internal aspects, which the bank can and should shape and influence. These are often actions or failure of bank internal processes, systems and its staff. Second, the focus is on external aspects such as market and credit risks (Geiger, 2010).  Interest Rate Risk: A bank's main source of profit is converting the liabilities of deposits and borrowings into assets of loans and securities. It profits by paying a lower interest on its liabilities than it earns on its assets—the difference in these rates is the net interest margin.

 Foreign Exchange Risk: International banks trade large amounts of currencies, which introduces foreign exchange risk, when the value of a currency falls with respect to another. A bank may hold assets denominated in a foreign currency while holding 20

liabilities in their own currency. If the exchange rate of the foreign currency falls, then both the interest payments and the principal repayment will be worth less than when the loan was given, which reduces a bank's profits (Spaulding, 2011).

 Sovereign Risk: Many foreign loans are paid in U.S. dollars and repaid with dollars. Some of these foreign loans are to countries with unstable governments. If political problems arise in the country that threatens investments, investors will pull their money out to prevent losses arising from sovereign risk. In this scenario, the native currency declines rapidly compared to other currencies, and governments will often impose capital controls to prevent more capital from leaving the country. It also make foreign currency held in the country more valuable; hence, foreign borrowers are often prohibited from using foreign currency, such as U.S. dollars, in repaying loans in an attempt to conserve the more valuable currency when the native currency is declining in value (Spaulding, 2011). The above mentioned, operational risk can be classified as internal; the interest rate and foreign exchange rate risk s are external and sovereign risk is interrelated. The internal and external risk can affect the international banks directly, while the interrelated risk can affect multiple banks. Therefore, managing of all the three types of risks are crucial for international banks and in the next section, the importance of managing risks is outlined.

3.5 International Banking and Foreign Exchange Risk Management



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

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

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

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

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

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

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Chapter 4

Risk Management Risk management is the identification, assessment, and prioritization of risks (defined in ISO 31000 as the effect of uncertainty on objectives) followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. Risk management’s objective is to assure uncertainty does not deflect the endeavor from the business goals. Risks can come from various sources including uncertainty in financial markets, threats from project failures (at any phase in design, development, production, or sustainment life-cycles), legal liabilities, credit risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of uncertain or unpredictable root-cause. There are two types of events i.e. 22

negative events can be classified as risks while positive events are classified as opportunities. Several risk management standards have been developed including the Project Management Institute, the National Institute of Standards and Technology, actuarial societies, and ISO standards. Methods, definitions and goals vary widely according to whether the risk management method is in the context of project management, security, engineering, industrial, financial portfolios, actuarial assessments, or public health and safety. Risk sources are identified and located in human factor variables, mental states and decision making as well as infrastructural or technological assets and tangible variables. The interaction between human factors and tangible aspects of risk highlights the need to focus closely on human factors as one of the main drivers for risk management, a "change driver" that comes first of all from the need to know how humans perform in challenging environments and in face of risks (Daniele Trevisani, 2007). As the author describes, «it is an extremely hard task to be able to apply an objective and systematic self-observation, and to make a clear and decisive step from the level of the mere "sensation" that something is going wrong, to the clear understanding of how, when and where to act. The truth of a problem or risk is often obfuscated by wrong or incomplete analyses, fake targets, perceptual illusions, unclear focusing, altered mental states, and lack of good communication and confrontation of risk management solutions with reliable partners. This makes the Human Factor aspect of Risk Management sometimes heavier than its tangible and technological counterpart Strategies to manage threats (uncertainties with negative consequences) typically include avoiding the threat, reducing the negative effect or probability of the threat, transferring all or part of the threat to another party, and even retaining some or all of the potential or actual consequences of a particular threat, and the opposites for opportunities (uncertain future states with benefits). Certain aspects of many of the risk management standards have come under criticism for having no measurable improvement on risk; whereas the confidence in estimates and decisions seem to increase.[1] For example, it has been shown that one in six IT projects experience cost overruns of 200% on average, and schedule overruns of 70%.

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4.1 Measures of risk management

Risk management is a crucial process used to make investment decisions. The process involves identifying the amount of risk involved and either accepting or mitigating the risk associated with an investment. Some common measures of risk are standard deviation, beta, value at risk (VaR) and conditional value at risk.

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Standard deviation measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility, or risk, associated with an investment relative to its annual rate of return. It indicates how much the current return is deviating from its expected historical normal returns. For example, a stock that has a high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock. Beta is another common measure of risk. Beta measures the amount of systematic risk a security has relative to the whole market. The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market. Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the market. For example, suppose a security's beta is 1.5. In theory, the security is 50% more volatile than the market. A third common measure of risk used in risk management is the value at risk. The VaR is a statistical measure used to assess the level of risk associated with a portfolio or company. The VaR measures the maximum potential loss with a degree of confidence for a specified period. For example, suppose a portfolio of investments has a one-year 10% VaR of $5 million. Therefore, the portfolio has a 10% chance of losing more than $5 million over a one-year period. Conditional VaR is another risk measure used to assess the tail risk of an investment. The conditional VaR assesses the likelihood, with a certain degree of confidence, that there will be a break in the VaR. This measure is used as an extension to the VaR and seeks to assess what happens to an investment beyond its maximum loss threshold. This measure is more sensitive to events that happen in the tail end of a distribution, also known as tail risk. For example, suppose a risk manager believes the average loss on an investment is $10 million for the worst 1% of possible outcomes for a portfolio. Therefore, the conditional VaR, or expected shortfall, is $10 million for the 1% tail. Risk Management is actually a combination of management of uncertainty, risk, equivocality and error. Uncertainty – where the outcomes cannot be estimated even randomly, arises due to 25

lack of information and this uncertainty gets transformed into risk (where the estimation of outcome is possible) as information gathering progresses. Initially, the Indian banks have used risk control systems that kept pace with legal environment and Indian accounting standards. But with the growing pace of deregulation and associated changes in the customer’s behaviour, banks are exposed to mark-to-market accounting. Therefore, the challenge of Indian banks is to establish a coherent framework for measuring and managing risk consistent with corporate goals and responsive to the developments in the market. As the market is dynamic, banks should maintain vigil on the convergence of regulatory frameworks in the country, changes in the international accounting standards and finally and most importantly changes in the clients’ business practices. Therefore, the need of the hour is to follow certain risk management norms suggested by the RBI and BIS.

4.2 Risk Management in Banking In the course of their operations, banks are invariably faced with different types of risks that may have a potentially negative effect on their business. Risk management in bank operations includes risk identification, measurement and assessment, and its objective is to minimize negative effects risks can have on the financial result and capital of a bank. Banks are therefore required to form a special organizational unit in charge of risk management. Also, they are required to prescribe procedures for risk identification, measurement and assessment, as well as procedures for risk management. 26

The risks to which a bank is particularly exposed in its operations are: liquidity risk, credit risk, market risks (interest rate risk, foreign exchange risk and risk from change in market price of securities, financial derivatives and commodities), exposure risks, investment risks, risks relating to the country of origin of the entity to which a bank is exposed, operational risk, legal risk, reputational risk and strategic risk. Liquidity risk is the risk of negative effects on the financial result and capital of the bank caused by the bank’s inability to meet all its due obligations. Credit risk is the risk of negative effects on the financial result and capital of the bank caused by borrower’s default on its obligations to the bank. Market risk includes interest rate and foreign exchange risk. Interest rate risk is the risk of negative effects on the financial result and capital of the bank caused by changes in interest rates. Foreign exchange risk is the risk of negative effects on the financial result and capital of the bank caused by changes in exchange rates. A special type of market risk is the risk of change in the market price of securities, financial derivatives or commodities traded or tradable in the market. Exposure risks include the risks of bank’s exposure to a single entity or to a group of related entities. Investment risks include the risks of bank’s investment in non-financial sector entities, fixed assets and investment real estate. Risks relating to the country of origin of the entity to which a bank is exposed (country risk) is the risk of negative effects on the financial result and capital of the bank due to bank’s inability to collect claims from such entity for reasons arising from political, economic or social conditions in such entity’s country of origin. Country risk includes political and economic risk, and transfer risk. Operational risk is the risk of negative effects on the financial result and capital of the bank caused by omissions in the work of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events. Legal risk is the risk of loss caused by penalties or sanctions originating from court disputes due to breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body.

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Reputational risk is the risk of loss caused by a negative impact on the market positioning of the bank. Strategic risk is the risk of loss caused by a lack of a long-term development component in the bank’s managing team.

4.3 Risk Control Methods and Measures

Risk Control Methods Avoidance – There’s a great deal of risk. You don’t want to assume the risk and it can’t be transferred, so you avoid the risk altogether. This method eliminates any possibility of loss. It is achieved either by abandoning or never undertaking an activity or asset. Loss Prevention – Reduces the frequency or likelihood of a “particular” loss. Examples include: 28

 

  





Improve security measures to reduce the possibility of arson or theft. Improve maintenance of facilities to reduce the possibility of a tripping hazard. o Loss Reduction – Reduces the severity or cost of a “particular” loss. Examples include: Require the use of seatbelts to reduce the chance of bodily injury in a vehicle collision. Require the use of hearing protection to reduce the chance of a hearing loss. Reduce the cost of workers’ compensation claims through the use of return to work programs. o Segregate Losses – Arrange your agency’s activities and assets to prevent one event from causing loss to the whole. There are two methods – duplication and separation. Separation – your activities or assets are distributed among multiple locations

Duplication – relies on spare or duplicates that are only used if assets or activities suffer a loss. o Contractually transfer the risk.

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Examples of Risk Control Measures



Personal Protective Equipment



Housekeeping



Inspections



Tools and Equipment



Policies, Procedures, Processes



Supervision



Contract Management and Administration



Performance Expectations



Training

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Chapter 5

Case study

5.1 Case Study on State Bank of India History The State Bank of India (SBI), the largest and oldest bank in India, had computerized its branches in the 1990s, but it was losing market share to private-sector banks that had implemented more modern centralized core processing systems. • To remain competitive with its private-sector counterparts, in 2002, SBI began the largest implementation of a centralized core system ever undertaken in the banking industry.

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• The State Bank of India selected Tata Consultancy Services to customize the software, implement the new core system, and provide ongoing operational support for its centralized information technology. • Although SBI initially planned to convert only 3,300 of its branches, it was so successful that it expanded the project to include all of the more than 14,600 SBI and affiliate bank branches. • The State Bank of India has achieved its goal of offering its full range of products and services to all its branches and customers, spreading economic growth to rural areas and providing financial inclusion for all of India's citizens.

. Profile of the State Bank of India and Associate Banks (May 2008) Source: State Bank of India Group 32

Unlike private-sector banks, SBI has a dual role of earning a profit and expanding banking services to the population throughout India. Therefore, the bank built an extensive branch network in India that included many branches in low-income rural areas that were unprofitable to the bank. Nonetheless, the branches in these rural areas bought banking services to tens of millions of Indians who otherwise would have lacked access to financial services. This tradition of "banking inclusion" recently led India's Finance Minister P. Chidambaram to comment, "The State Bank of India is owned by the people of India." A lack of reliable communications and power (particularly in rural areas) hindered the implementation of computerization at Indian banks throughout the 1970s and 1980s. During this period, account information was typically maintained at the local branches with either semiautomated or manual ledger card processing. During the 1990s, the Indian economy began a period of rapid growth as the country's low labor costs, intellectual capital, and improving telecommunications technology allowed India to offer its commercial services on a global basis. This growth was also aided by the government's decision to allow the creation of private-sector banks (they had been nationalized in the 1960s). The private-sector banks, such as ICICI Bank and HDFC Bank, altered the banking landscape in India. They implemented modern centralized core banking systems and electronic delivery channels that allowed them to introduce new products and provide greater convenience to customers. As a result, the private-sector banks attracted middleand upper-class customers at the expense of the public-sector banks. Additionally, foreign banks such as Standard Chartered Bank and Citigroup used their advanced automation capabilities to gain market share in the corporate and high-net-worth markets. PRODUCTS AND SERVICES SBI offers :1. Working Capital Finance 2. Project Finance 3. Deferred Payment Gaurantees 4. Corporate Term Loans 5. Structured Finance 33

6. Dealer Financing 7. Channel Financing 8. Equipment Leasing 9. Loan Syndication 10. Financing Indian Firms Overseas Subsidiaries or JVs 11. Construction Equipment Loan 

Payments/Transfer o Funds Transfer o Intra-Bank Transfer o RTGS/NEFT o Credit Card (VISA) o IMPS Payments o NRI eZ Trade Funds Transfer



E – Deposits o E-TDR/e-STDR o E-TDR/e-STDR under Income Tax Savings Scheme o SBI Flexi Deposit o E-Annuity Deposit Scheme o E- Recurring Deposits



Smart Cards o Gift Card 34

o State Bank Virtual Card o Smart Pay-out Card o VISA Foreign Travel Card o MasterCard Foreign Travel Card 

State Bank Collect



Bill Payments



Western Union Service



NPS Contribution



Power Jyoti Fee Collection (PUL)



Loan against Shares

Risk of SBI Mutual Funds and Securities Investments are subject to market risks and there is no assurance or guarantee that the objective of scheme(s)/plan(s) will be achieved. As with any other investment in securities, the NAV of the Magnums/Units issued under the scheme(s)/plan(s) can go up or down depending on the factors and forces affecting the securities market. Past performance of the Sponsor/AMC/Mutual Fund/Scheme(s)/Plan(s) and their affiliates do not indicate the future performance of the scheme(s) of the Mutual Fund. The names of the schemes do not in any manner indicate either the quality of the scheme, its future prospects or returns.

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5.2 Case study on International bank of HSBC: History of HSBC HSBC is named after its founding member, The Hongkong and Shanghai Banking Corporation Limited, which was established in 1865 to finance the growing trade between Europe, India and China. HSBC was established in 1865 to finance trade between Europe and Asia. For over 150 years we have connected customers to opportunities. We enable businesses to thrive and economies to prosper, helping people to realise their ambitions HSBC was born from one simple idea – a local bank serving international needs. In March 1865, HSBC opened its doors for business in Hong Kong, and today we serve around 46 million customers in 71 countries and territories. The experiences of the past 150 years have formed the character of HSBC. A glance at our history explains why we believe in capital strength, in strict cost control and in building longterm relationships with customers. HSBC has weathered change in all forms – revolutions, economic crises, new technologies – and adapted to survive. The resulting corporate character enables HSBC to meet the challenges of the 21st century.

Product & Service 1. 2. 3. 4. 5. 6.

Overdraft Protection Checking Saving Certificate of Deposit Credit Cards Debit Cards

Risk of HSBC 36

Foreign exchange risk The most common causes of foreign exchange risk are: 

making overseas payments for your imports that are priced in a foreign currency



receiving foreign currency for your exports.

For example, if you plan to import $100,000 worth of stock from a supplier in the Far East in three months' time. If you simply wait and buy your US dollars in three months when you need to make payment, you have no idea how much that stock will cost you in sterling because of FX fluctuations. Failing to protect against movements in foreign exchange rates effectively means buying or selling without having agreed a price in sterling. Other causes of foreign exchange risk are: 

foreign currency borrowing or deposits



overseas subsidiaries



assets located overseas.

How we can help to manage your foreign exchange risk Our specialist Global Markets team will work with you to develop a four-point plan to help minimise your foreign exchange risk and protect your profitability. 

Understand your exposures



Understand the solutions



Develop a strategy



Implement your plan

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Chapter 6

Conclusion

Every business has some degree of risk to it. It is important for you to think through and outline possible risks in your company. This will demonstrate that you understand the risks and, to the extent that you can, have made allowances for them. Detail how you plan to minimize or address the risks inherent to your business. Remember that the most important reason for writing a business plan is that it is an important tool to help you start and manage your business. Feel free to incorporate all identified risks within their respective sections of your business plan and make them clearly understood by any perspective reader of your business plan. For example, you can discuss human resource risks such as not being able to find skilled labour. Be honest about your risks and take them seriously because you can avoid many problems by thinking ahead.

Consider the following: 1.

What are the possible risks within your industry? What are the possible health and safety risks in your business/work site?

2.

What if you discover that the business you bought carried liabilities? For example, what if the business you leased or bought has an outstanding balance in its account with your provincial workers' compensation board/commission?

3.

What if the demand for your goods or services decreases?

4.

What if the number of competitors increases?

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5.

What risks do you face in producing your product or service?

6.

What risks do you face with the marketing plan you have outlined?

7.

What if your major ad campaign turns sour?

8. 9.

What human resources risks do you face? Consider your management team, advisors and your employees. What if your key employees quit? What if they get seriously hurt on the job?

10. What if you run out of cash? Where else would you go? 11. What if your major supplier has financial difficulties? What other suppliers exist?

12. What, if any, environmental risks does your product or service face? Do they conform to environmental rules of government, municipality, etc.?

Having considered the risks and your ability to deal with them, what's the verdict? Remember, your business plan should be as vital and strong as the dream you have for your company. Clearly restate the goals and objectives for your business. If the purpose of your business plan is to get financing - state the amount required and what it will be used for. Your conclusion section should be concise, clear and leave a positive impression. To see the Risks & Conclusions section of a sample business plan, click on any of the company logos below:

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Chapter 7 7.Bibliography

1. https://en.wikipedia.org/wiki/risk-management-in Indian-banks 2.1.pape.ssm / com/ so13/ papers .cfm? abstract-id=2172016 2.2http//www.zoinsbank.com//treasury-management/risk-management/international-banking-jsp 3. gradestack.com/blogs/what is-risk-management-in-indian-banking-sector-and-the-role-of-irbi/ 4. https://www-google.coin/search?q=image+management&tbm=isch&imgel 5.www.investoPeDIA.com 6.

https://www.google.co.in/search?q=types+of

risk+of+image&thm=idch&imgil-0420ho7h-

pleM%2525318GtgxLRvmrM%25Bhttp%25253Ahttp%25251=kalyn-city.blogspot. 7. https//www.portlandaragen.gov/bibs/article/321711? 6. ofv.sa.gov.au/-data/assets/pdf-file/0004/8464/risk-management-workbook.pdf 7.www,tes.com/sitecollectiondocuments/case%20studies/bancs-case-sbi.pdf 8.www.slideshare.net/Llmarketingsolutions/hsbc-case-study 9.globelink.ca/case-study-hsbc/ 10.www.rbcroyalbank.com/business/starting-abusiness/risk.html.

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