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Dr NeelamDr Neelam

TandonTandon

Risk Management SystemsRisk Management Systems

in Banksin BanksGenesis, Significance andGenesis, Significance and

ImplementationImplementation

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CONTENTSCONTENTS

What is Risk?What is Risk?

Classification of RiskClassification of Risk

Objectives of Risk ManagementObjectives of Risk Management

Tools for Managing RiskTools for Managing Risk

Risk Management in PNBRisk Management in PNB

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TheThe potentialpotential lossloss anan assetasset

oror aa portfolioportfolio isis likelylikely totosuffersuffer duedue toto aa varietyvariety ofof

reasonsreasons..

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Financial risk in a banking organization isFinancial risk in a banking organization is

possibility that the outcome of an action orpossibility that the outcome of an action or

event could bring up adverse impacts.event could bring up adverse impacts. Such outcomes could either result in a directSuch outcomes could either result in a direct

loss of earnings / capital or may result inloss of earnings / capital or may result in

imposition of constraints on banks ability toimposition of constraints on banks ability to

meet its business objectives.meet its business objectives.

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Such constraints pose a risk as these couldSuch constraints pose a risk as these could

hinder a bank's ability to conduct its ongoinghinder a bank's ability to conduct its ongoing

business or to take benefit of opportunitiesbusiness or to take benefit of opportunitiesto enhance its business.to enhance its business.

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Regardless of the sophistication of theRegardless of the sophistication of the

measures, banks often distinguish betweenmeasures, banks often distinguish between

expected and unexpected losses.expected and unexpected losses. Expected losses are those that the bExpected losses are those that the bankank

knows with reasonable certainty will occurknows with reasonable certainty will occur

((e.g., the expected default ratee.g., the expected default rate ofof

corporate loan portfolio or credit cardcorporate loan portfolio or credit card

portfolio) and are typically reserved for inportfolio) and are typically reserved for in

some manner.some manner.

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Unexpected losses are those associatedUnexpected losses are those associated

with unforeseenwith unforeseenevents (e.g. lossesevents (e.g. losses

experienced by banks due to a suddenexperienced by banks due to a suddendown turn in economy or falling interestdown turn in economy or falling interest

rates). Banks rely on their capital as a bufferrates). Banks rely on their capital as a buffer

to absorb such losses.to absorb such losses.

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While the types and degree of risks anWhile the types and degree of risks an

organization may be exposed to dependorganization may be exposed to depend

upon a number of factors such

as its size,upon a number of factors such

as its size,complexity business activities, volume etc, itcomplexity business activities, volume etc, it

is believed that generally the banks faceis believed that generally the banks face

Credit, Market, Liquidity, Operational,Credit, Market, Liquidity, Operational,

Compliance / legal / regulatory andCompliance / legal / regulatory andreputation risks.reputation risks.

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Risk Management is a discipline at the coreRisk Management is a discipline at the core

of every financial institution andof every financial institution and

encompasses all the activities t

hat affect itsencompasses all t

he activities t

hat affect itsrisk profile.risk profile.

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It involves identification,It involves identification,

measurement, monitoring and controllingmeasurement, monitoring and controlling

risks to ensure thatrisks to ensure that a) The individuals who take or manage risksa) The individuals who take or manage risks

clearly understand it.clearly understand it.

b) The organizations Risk exposure isb) The organizations Risk exposure iswithin the limits established by Boardwithin the limits established by Board

of Directors.of Directors.

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c) Risk taking Decisions are in line with thec) Risk taking Decisions are in line with the

business strategy and objectives set bybusiness strategy and objectives set by

BOD.BOD.

d) The expected payoffs compensate for thed) The expected payoffs compensate for the

risks takenrisks taken

e) Risk taking decisions are explicit ande) Risk taking decisions are explicit and

clear.clear.

f) Sufficient capital as a buffer is available tof) Sufficient capital as a buffer is available to

take risktake risk

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The acceptance and management ofThe acceptance and management of

financial risk is inherent to the business offinancial risk is inherent to the business of

banking and banks roles as financialbanking and banks roles as financialintermediaries.intermediaries.

Risk management as commonly perceivedRisk management as commonly perceived

does not mean minimizing risk; rather thedoes not mean minimizing risk; rather the

goal of risk management is to optimize riskgoal of risk management is to optimize risk--

reward tradereward trade --off.off.

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Notwithstanding the fact that banks are inNotwithstanding the fact that banks are in

the business of taking risk, it should bethe business of taking risk, it should be

recognized th

at an institution need notrecognized th

at an institution need notengage in business in a manner thatengage in business in a manner that

unnecessarily imposes risk upon it: nor itunnecessarily imposes risk upon it: nor it

should absorb risk that can be transferred toshould absorb risk that can be transferred to

other participants.other participants.

Rather it should accept those risks that areRather it should accept those risks that are

uniquely part of the array of banks services.uniquely part of the array of banks services.

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Survival of the organizationSurvival of the organization

Efficiency in OperationsEfficiency in Operations

Uninterrupted OperationsUninterrupted OperationsIdentifying and achieving acceptable level ofIdentifying and achieving acceptable level of

riskrisk

Earning StabilityEarning StabilityContinued and sustained GrowthContinued and sustained Growth

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RISKSRISKS

FINANC

IAL R

ISK NON

FINANC

IAL R

ISK

CREDIT RISK MARKET RISK

TRANSACTION RISK

PORTFOLIO RISK

INTEREST RATE RISK

LIQUIDITY RISK

FOREX RISK

OPERATING RISK

SYSTEMATIC RISK

POLITICAL RISK

HUMAN RISK

TECHNOLOGY RISK

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CREDIT RISKCREDIT RISKRisk that the counterparty will fail to perform orRisk that the counterparty will fail to perform or

meet the obligation on the agreed terms .meet the obligation on the agreed terms .

TYPES OF CREDIT RISKSTYPES OF CREDIT RISKS

Transaction RiskTransaction RiskRiskRisk relatingrelating toto specificspecific tradetrade transactions,transactions,

sectorssectors oror groupsgroups..

PortfolioPortfolio RiskRisk

RiskRisk arisingarising fromfrom lendinglending toto sectorssectors nonnon relatedrelated

toto thethe corecore competenciescompetencies ofof thethe BankBank //

concentratedconcentrated creditscredits toto aa particularparticular sectorsector //

lendinglending toto aa fewfew bigbig borrowersborrowers..

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MARKET RISKMARKET RISKMarket risk is the risk to a banks financial condition thatMarket risk is the risk to a banks financial condition that

could result from adverse movements in market price.could result from adverse movements in market price.

TYPES OF MARKET RISKTYPES OF MARKET RISK

InterestInterest RateRate RiskRisk

RiskRisk felt,felt, whenwhen changeschanges inin thethe interestinterest rateratestructurestructure putput pressurepressure onon thethe netnet interestinterest marginmargin ofof

thethe BankBank..

LiquidityLiquidity RiskRiskRiskRisk arisingarising duedue toto thethe potentialpotential forfor liabilitiesliabilities totodraindrain fromfrom thethe BankBank atat aa fasterfaster raterate thanthan assetsassets..

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TYPES OF MARKET RISKTYPES OF MARKET RISK

(continued)(continued)

FOREX RISKFOREX RISKThis risk can be classified into three types.This risk can be classified into three types.

TransactionTransaction RiskRiskisis observedobserved whenwhen movementsmovements inin priceprice ofof aa

currencycurrency upwardsupwards oror downwards,downwards, resultresult inin aa lossloss onon aa particularparticulartransactiontransaction..

TranslationTranslation RiskRiskarisesarises duedue toto adverseadverse exchangeexchange raterate movementsmovementsandand changechange inin thethe levellevel ofof investmentsinvestments andand borrowingsborrowings inin foreignforeigncurrencycurrency..

CountryCountry RiskRisk.. TheThe buyersbuyers areare unableunable toto meetmeet thethe commitmentcommitment dueduetoto restrictionsrestrictions imposedimposed onon transfertransfer ofof fundsfunds byby thethe foreignforeign govtgovt.. ororregulatorsregulators..WhenWhen thethe transactionstransactions areare withwith thethe foreignforeign govtgovt.. thethe riskrisk isis calledcalled asasSovereignSovereign RiskRisk..

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NONNON--FINANCIAL RISKSFINANCIAL RISKS

OperationalOperational RiskRisk arisesarises asas aa resultresult ofof failurefailure ofofoperatingoperating systemsystem inin thethe bankbank duedue toto certaincertain reasonsreasonslikelike fraudulentfraudulent activities,activities, naturalnatural disaster,disaster, humanhumanerror,error, omissionomission oror sabotagesabotage etcetc..

SystemicSystemic RiskRisk isis seenseen whenwhen thethe failurefailure ofof oneone

financialfinancial institutioninstitution spreadsspreads asas chainc

hain reactionreaction totothreatenthreaten thethe financialfinancial stabilitystability ofof thethe financialfinancial systemsystem

asas aa wholewhole..

PoliticalPolitical RiskRisk arisesarises duedue toto introductionintroduction ofof ServiceServicetaxtax oror increaseincrease inin incomeincome tax,tax, freezingfreezing thethe assetsassets ofofthethe bankbank byby thethe legallegal authorityauthority etcetc..

HumanHuman RiskRisk LabourLabour unrest,unrest, lacklack ofof motivation,motivation,inadequateinadequate skills,skills, problemsproblems facedfaced byby thethe bankbank afterafterimplementationimplementation ofof VRSVRS leadlead toto HumanHuman RiskRisk..

TechnologyTechnology RiskRisk Obsolescence,Obsolescence, mismatches,mismatches,breakdowns,breakdowns, adoptionadoption ofof latestlatest technologytechnology byby

competitors,competitors, etc,etc, comecome underunder technologytechnology riskrisk

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MANAGEMENT OF CREDITMANAGEMENT OF CREDIT

RISKRISKMeasurementMeasurement throughthrough CreditCredit RatingRating //

scoringscoring

QuantificationQuantification throughthrough estimateestimate ofofexpectedexpected loanloan losseslosses

PricingPricing onon aa scientificscientific basisbasis

ControllingControlling throughthrough EffectiveEffective loanloan

reviewreview mechanismmechanism andand portfolioportfolio

managementmanagement

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TOOLS OF CREDIT RISKTOOLS OF CREDIT RISK

MANAGEMENTMANAGEMENTEXPOSUREEXPOSURECEILINGSCEILINGS::SettingSetting ofof prudentialprudentialnormsnorms relatedrelated toto thethe BanksBanks exposureexposure toto aa singlesingle borrowerborrower //groupgroup borrowersborrowers // sectorialsectorial borrowersborrowers

REVIEWREVIEW //RENEWALRENEWAL :: ThisThis involvesinvolves multimulti--tiertiercreditcredit approvingapproving authority,authority, constitutionconstitution wisewise delegationdelegation ofofpowers,powers, higherhigher delegateddelegated powerspowers forfor betterbetter ratedrated

borrowers,borrowers, discriminatorydiscriminatory timetime forfor creditcredit reviewreview // renewal,renewal,hurdlehurdle ratesrates // benchmarksbenchmarks forfor freshfresh exposuresexposures && periodicityperiodicityforfor renewalrenewal basedbased onon riskrisk ratingrating..

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COMPREHENSIVECOMPREHENSIVE RISKRISK RATINGRATINGMODELSMODELS

RISKRISK BASEDBASED SCIENTIFICSCIENTIFICPRICINGPRICING:: LinkingLinkingloanloan pricingpricing toto expectedexpected lossloss

PORTFOLIOPORTFOLIO MANAGEMENTMANAGEMENT :: StipulateStipulatequantitativequantitative ceilingceiling onon specificspecific ratingrating categories,categories,distributiondistribution ofof borrowersborrowers inin variousvarious industriesindustries // businessbusiness

groupsgroups ,, rapidrapid portfolioportfolio reviews,reviews, onon--goinggoing systemsystem forforidentificationidentification ofof creditcredit weaknessesweaknesses wellwell inin advance,advance, initiateinitiatestepssteps toto preservepreserve thethe desireddesired portfolioportfolio qualityquality andand integrateintegrateportfolioportfolio reviewsreviews withwith creditcredit decisiondecision makingmaking processprocess..

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TOOLS OF CREDIT RISKTOOLS OF CREDIT RISK

MANAGEMENTMANAGEMENT

LOANLOAN REVIEWREVIEW MECHANISMMECHANISM :: ThisThis

shouldshould bebe donedone independentindependent ofof creditcredit

operationsoperations && administrationadministration andand covercover allall

thethe loansloans aboveabove certaincertain cutcut--offoff limitlimit

ensuringensuring thatthat atat leastleast 3030 4040%% ofof thetheportfolioportfolio isis subjectedsubjected toto LRMLRM inin aa yearyear..

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RISKMANAGEMENTINPNBRISKMANAGEMENTINPNB

NewNew CapitalCapital AdequacyAdequacy FrameworkFramework::BankBank hashas migratedmigrated toto NewNew CapitalCapital AdequacyAdequacyFramework,Framework, popularlypopularly knownknown asas BASELBASEL IIII ww..ee..ff..fromfrom MarchMarch 20082008.. TheThe approachesapproaches prescribedprescribed bybythethe 'Regulator','Regulator', namelynamely StandardisedStandardised ApproachApproachunderunder CreditCredit RiskRisk andand BasicBasic IndicatorIndicator ApproachApproachunderunder OperationalOperational RiskRisk havehave beenbeen

implementedimplemented..TheThe BankBank hadhad adoptedadopted StandardStandardDurationDuration ApproachApproach forfor MarketMarket Risk,Risk, sincesince MarchMarch20062006..

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RISKMANAGEMENTINRISKMANAGEMENTIN

PNB(contd)

PNB(contd)

BankBank hashas alreadyalready placedplaced creditcredit riskrisk ratingrating modelsmodelsonon centralcentral serverserver basedbased systemsystem PNBPNB TRAC,TRAC,whichwhich providesprovides aa scientificscientific methodmethod forfor assessingassessing

creditcredit riskrisk ratingrating ofof aa clientclient.. TheThe BankBank hashasdevelopeddeveloped andand placedplaced onon centralcentral serverserver scorescorebasedbased ratingrating modelmodel PNBPNB SCORESCORE inin respectrespect ofofretailretail loansloans andand traderstraders upup toto totaltotal limitslimits ofof RsRs 5050lacslacs.. Accept/RejectAccept/Reject decisionsdecisions areare alsoalso basedbased ononthethe scorescore obtainedobtained.. ScoringScoring modelsmodels forfor remainingremainingsectorssectors likelike SMESME segmentssegments havehave beenbeen developeddevelopedandand areare underunder testingtesting stagestage..

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BankBank isis alsoalso developingdeveloping frameworkframework forfor

estimatingestimating LGDLGD (Loss(Loss GivenGiven Default)Default) andand EADEAD ((

ExposureExposure atat Default)Default) andand alsoalso frameworkframework forfor

identifyingidentifying concentrationconcentration riskrisk.. AA datadata warehousewarehouseisis beingbeing establishedestablished forfor effectiveeffective datadata

managementmanagement andand useuse ofof applicationapplication toolstools forfor

quantificationquantification ofof risksrisks..

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ForFor thethe MarketMarket riskrisk bankbank hashas aa MidMid--OfficeOffice withwith

separateseparate desksdesks forfor TreasuryTreasury && AssetAsset LiabilityLiability

ManagementManagement (ALM)(ALM).. AssetAsset LiabilityLiability ManagementManagement

CommitteeCommittee (ALCO)(ALCO) isis primarilyprimarily responsibleresponsible forforestablishingestablishing thethe marketmarket RiskRisk Management,Management, assetasset

liabilityliability managementmanagement ofof thethe bank,bank, implementingimplementing

thethe riskrisk managementmanagement ofof thethe bankbank.. TheThe policiespolicies forfor

hedginghedging andand mitigatingmitigating riskrisk areare discusseddiscussed inin

ALCALCOO..

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AA separateseparate independentindependent DivisionDivision knownknown asas

CreditCredit AuditAudit && ReviewReview DivisionDivision hashas beenbeenformedformed toto ensureensure LRMLRM implementationimplementation.. LRMLRM

examinesexamines compliancecompliance withwith extantextant sanctionsanction

andand postpost--sanctionsanction process/proceduresprocess/procedures laidlaiddowndown byby thethe BankBank fromfrom timetime toto timetime..

PreventivePreventive MonitoringMonitoring SystemSystem (PMS)(PMS):: ItIt isis aa

tooltool usedused byby bankbank forfor detectiondetection ofof earlyearly

warningwarning signalssignals withwith aa viewview toto

prevent/minimizeprevent/minimize thethe loanloan losseslosses..

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LiquidityLiquidity RiskRisk ofof bankbank isis assessedassessed throughthrough gapgapanalysisanalysis forfor maturitymaturity mismatchmismatch basedbased onon residualresidual

maturitymaturity inin differentdifferent timetime bucketsbuckets && managementmanagement

ofof samesame isis donedone throughthrough prudentialprudential limitslimits fixedfixed

thereonthereon..

BankBank isis alsoalso monitoringmonitoring thethe liquidityliquidity throughthrough

variousvarious stockstock optionsoptions..

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TheThe BankBank isis proactivelyproactively usingusing durationduration gapgap andand

interestinterest raterate forecastingforecasting toto minimizeminimize impactimpact ofof

interestinterest raterate changeschanges..

AdvanceAdvance techniquestechniques suchsuch asas StressStress testing,testing,

simulation,simulation, sensitivitysensitivity analysisanalysis etc,etc, areare conductedconducted

atat regularregular intervalsintervals toto drawdraw contingencycontingency fundingfunding

planplan underunder differentdifferent liquidityliquidity scenariosscenarios..

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CONCLUSIONCONCLUSION

InIn thethe BankingBanking industryindustry wherewhere riskrisk isis thethenormnorm ,, ratherrather thanthan thethe exception,exception, BanksBankshavehave toto adoptadopt manymany measuresmeasures likelike reducingreducing

exposureexposure inin highhigh riskrisk areas,areas, emphasizingemphasizingmoremore onon thethe promisingpromising industries,industries, optimizingoptimizingthethe returnreturn byby strikingstriking aa balancebalance betweenbetween thetheriskrisk andand thethe returnreturn onon thethe assetsassets.. BanksBanksmottomotto shouldshould bebe effectiveeffective managementmanagement ofofrisksrisks towardstowards ensuringensuring qualityquality creditcreditportfolioportfolio..

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