1

INDEX
Acknowledgement Executive Summary Chapter-1

Introduction to risk management in banking.. 2 Problem in study. 2 Objectives in study..3 Research methodology .3 Proposed chapter scheme ...3

Chapter-2

Conceptual Framework of ALM ...5 Review of existing literature summary ..14

Chapter-3

History and Growth of the bank 16

Chapter-4

Performance evaluation of bank 24

Conclusion & Recommendation .28

CHAPTER 1
INTRODUCTION TO RISK MANAGEMENT
Risk management is recognised in todays business world as an integral part of good management practice. In its broadest sense, it entails the systematic application of management policies, procedures and practices to the tasks of identifying, analyzing, assessing, treating and monitoring risk. The past decade has also heralded enormous developments in new financial products. Mortgages and residential mortgages have given institutional and individual investors powerful new tools with which to disperse risk both domestically and internationally. Advances in complex financial products, together with improvements in technology, have lowered the cost of and expanded opportunities for hedging risk. With the raid growth in new tools, quantifying risk and interpreting risk measurements have never been more important. These developments have enabled all companies to take a more proactive view towards risk. Instead of only associating risk as a potential downside of their operations, increasing numbers of firms are considering how risk can be managed positively to enhance the firms value.

PROBLEM
Bank in the process of financial intermediation are confronted with various kinds of financial and non financial risk viz, credit risk, liquidity risk, forex risk etc.These risk are highly interdependent and event that affect one area of risk can have ramification for a range of other risk categories so based on this problem we are going to do our research that how commercial banks monitor such risk and control the overall level of risk.

OBJECTIVES
To know the concept of risk management in banking. To know the guidelines setup by R.B.I for commercial banks To know whether the banks are following those guidelines or not. To know the banks performance.

RESEARCH METHODOLOGY
To get the conclusion from the undertaken project one should must go through a proper methodology. Here in this project our methodology is based on two source, primary and secondary source

Primary source.
Under primary source we have data in the form of questionnaire which we got filled from the bank. and various data from the bank.

Secondary source
Under secondary source we have data collected from outside the bank such as internet, stock exchange, ficci library.

PROPOSED CHAPTER SCHEME

LIMITATION Time Constraint
Since our project had to submit in five to six weeks, so obviously it was a bit tedious.

Insufficient Data
Data was not sufficient in balance sheets for us to prepare new table for maturity pattern. No bank was prepared to give full information.

SCOPE OF THE STUDY

Through effective and efficient asset-liability management, the banks can increase their productivity and reduce cost-inefficiency. If inefficient banking firms have a tendency to remain inefficient, it would be of interest for the policy makers to investigate how these banks can remain economically viable and not be driven out of the banking market and this can be done through asset-liability management. The asset-liability management plays a very important role in the banks and has a very vital scope in these institutions.

CHAPTER 2
CONCEPTUAL FRAMEWORK
An Overview Historical Background In the context of present days rapidly changing business environment, asset liability management in the financial sector especially banking refers to a holistic approach to risk management, concerning not only individual trading or balance sheet positions but with overall balance sheet perspective. It requires assessing all available avenues for managing risks through natural methods, diversification, pricing, exposure control, and use of derivatives. Risk can be categorized into credit and market risk. Historically, credit risk constituted the major challenge to the banking sector. However, during the last two decades market risk has gained prominence and especially after the Basle Committee Accord of 1988, which was instrumental in framing broad guidelines for determining the various risks associated with financial sector. Asset Liability Management (ALM) encompasses the effects of market risk. Concept of ALM ALM has gradually gained currency in Indian conditions in the wake of the financial sector reforms during the last decade with particular emphasis on interest rate deregulation. The technique of managing both assets and liabilities has come into being as a strategic response of banks to inflationary pressure, volatility in interest rates and adverse business environments including the recessionary trends in global economy, if any. Simply put, asset-liability management is the management of total balance sheet dynamics with regard to its size and quality. It involves,

6 a) Quantification of risk and b) Conscious decision making with regard to asset-liability structure in order to maximize interest earnings within the framework of perceived risk. The profitable growth and at times survival of a financial institution depends on effective ALM. Scope and objectives of ALM The primary objectives of ALM is not to eliminate risk ; but to manage it in such a way that volatility of net interest income is minimized in the short term time horizon and net economic value of the organization is protected in a long term time horizon. In banking scenario, this would control the volatility of net income, net interest margin, capital adequacy, and liquidity risk and finally ensuring an acceptable balance between profitability, growth, and risk. A sound ALM system should focus on Review of interest rate outlook Fixation of interest/product pricing on both assets and liabilities Examining loan portfolio Examining investment portfolio Measuring foreign exchange risk Managing liquidity risk Review of actual performance vis--vis projections in respect of net profit, interest spread and other balance sheet ratios Budgeting and strategic planning Examine the profitability of new products

ALM-An Exercise for Risk Return Trade-Off

7 Risk is an inherent part of banking business and in simple words may be defined as a profitability of loss or damage. Given the complexities of banks balance sheets and rapidity of changes, chances of loss or risks are only complex in nature but also varied in dimension. Broadly speaking, banks are exposed to both categories of risk viz.credit risk and market risk. While credit risk which is mainly on account of the counter party failure in performing the repayment obligation on due date i.e. loan defaults are managed by the credit policy of the bank, the market risk is related to the Asset Liability Management process and is caused by changes in market variables, involving one or more of the following: Interest rate risk Foreign exchange risk Commodity price risk Stock market risk

ALM as a process not only encompasses market risk but also involves liquidity management, funding and capital planning, profitability growth and at times management of certain credit risks which are caused by market risk variables for e.g. in a highly volatile interest rate environment, loan defaults may increase thereby deteriorating the credit quality. Interest Rate Risk The Basle Committee on Banking Supervision whose recommendations have been accepted by the Banking Community throughout the world has called for the Banks to have a comprehensive risk management process in place that effectively identifies, measures, monitors and control interest rate risk exposure and that is subject to appropriate board and senior management oversight (source-www.bis.org; Amendment to the Capital Accord to Incorporate Market Risks, January 1996). Traditionally, interest rate risk means changes in the interest income due to changes in the rate of interest. While this focus is not misplaced, it is definitely

8 incomplete in as much as it overlooks an important aspect-changes in interest rate resulting in the value of assets/liabilities. Thus, interest rate risk may be viewed from two different complementary perspectives- earning sensitivity to rate fluctuations and price sensitivity of instruments/products to changes in interest rate. Changes in interest rates can affect banks with regard to changes in a) Market value of assets/liabilities and off balance sheet (OBS) items; ultimately having impact on the value of net worth.
b)

Net interest income arising out of mismatch in the reprising terms of the assets and liabilities;

c) Net income as a result of changes in interest income; d) Net income margin owing to changes in interest income and sensitivity of non-interest income to rate changes and e) Capital-asset ratio due to changes in net margin. The supervisory capital requirements established by Basle Committee from the end of 1997 covers interest rate risks in the trading activities of banks. Accordingly, interest Rate risks in the trading activities of banks. Accordingly, interest rate risk management process has been constituted to include development of business strategy, the assumption of assets and liabilities in banking and trading activities, as well as a system of internal controls. The focus has been on the need for effective interest rate risk measurement, monitoring, and control functions within the interest rate risk management process (Source- Principles for management of interest rate risk by BIS). According to the studies conducted by Basle Committee based on working experience of Banks in more than 100 countries, the banks are normally exposed to following forms of interest rate risk.
a)

Reprising risk

9 b) c) d) Yield curve risk Basis risk Optionally

Reprising risk: arises from timing differences in the maturity (for fixed rate) and reprising (for floating rate) of banks assets , liabilities and off balance sheet (OBS) positions while such reprising mismatches are fundamental to the business of banking , they can expose a banks income and underlying economic value to unanticipated fluctuations as interest rate varies. For instance, a bank that funded a long term fixed. Rate loan with a short term deposit could face a decline in both the future income arising from the position and its underlying value if the interest rate increases. These declines arises because the cash flows on the loan are fixed over its lifetime , while the interest paid on the funding is variable, and increases after the short term deposits matures. Yield Curve Risk: arises when unanticipated shifts of the yield curve have adverse effects on a banks income or underlying economic value. For example, the underlying economic value of a long position in 10 yr government bonds hedged by a short position in 5yr government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve. Basis Risk: arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar reprising characteristics. When interest rates changes, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or reprising frequencies for example a strategy of funding one year loan that reprises monthly based on one month LIBOR, exposes the institution to the risk that the spread between the two index rates may change unexpectedly. The concept of basis risk is applicable for any set of two different interest rates. For example, basis risk between thee following the following rates can be analyzed:

10 Prime/LIBOR Treasury Bill/LIBOR Certificate of deposits/LIBOR LIBOR/Commercial Paper Prime/Certificate of Deposit

The reasons for basis risk depend on particula4r set of rates, for example, Prime/LIBOR basis risks are as follows: a) Prime is an administered rate while LIBOR is market rate. The LIBOR changes everyday, but the prime changes infrequently. b) In US context, prime is a rate applicable for loans in the US_LIBOR is applicable for intermediated outside the US. Thus other things remaining the same, costs of certain types of regulation (e.g. Deposit Insurance Premium Change) may impact prime only and not LIBOR. c) During a declining rate environment, Prime tends to lag changes in LIBOR, leading to wider spread. In an increasing rate environment, there is an urgency to increase Prime Rate, resulting in declining spread. This kind of pricing is usual in products market also when costs are increasing, prices go up quickly, when costs are declining, and prices go down slowly. The rate of change is different in different environments. Optionality: option provides the holder the right but not the obligations to buy, sell or in some manner alter the cash flow of an instrument or financial contract. Options, may be in the form of standard alone instruments such as exchange traded options or embedded within an otherwise standard instrument like the various type of bonds and notes with caller put provisions, loans which give borrowers the right to repay balances and various type of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical pay off

11 characteristic of options held both explicit and embedded are generally exercised to the advantage of the holder and disadvantage of seller. Effects of Interest Rate Risk: Interest rate risk effects both on banks earning as well as its economic value. Earnings, comprising of net interest income i.e., difference between total interest income and total interest expense has been the focus of main attention traditionally, and the impact of interest rate change on net interest income has been accepted from time to time. However, in the emerging new scenario increasing focus on fee-based income and other non-interest bearing income and expenses have led to changes in the dimension of the game. The noninterest income arising from many activities can also be highly sensitive to market interest rates. In international arena, banks are providing the servicing and loan-administration function for mortgage loan pools in return for a feebased on the volume of assets it administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages get prepared. In addition, even traditional sources of non-interest income such as transaction processing fee are becoming more interest rate sensitive. This increased sensitivity has led both bank management and supervisors to take a broader view of potential effects of changes in market interest rates on bank earnings and to factor these broader effects into their estimated earnings under different interest rates environment. The economic value, of a banks assets, liabilities, and OBS position can get affected due to fluctuation in interest rates. The economic value of a bank can be viewed as the present value of banks expected net cash, defined as the expected cash flow on liabilities plus the expected net cash flows on OBS positions. Since economic value considered the potential impacting interest rate changes on the present value of all future cash flows, it provides a comprehensive view of the potential long term effects of changes in interest rates. Than is offered by the earlier earnings perspectives. While the above two perspectives focus on the impact of changes in future interest rates on a banks future performances, evaluation of impact past

12 interest rate changes may have on future performance is also of great significance. In particular instruments that are not marked to market may already contain embedded gains or losses due to past rate movements and may ultimately affect bank earnings. For example, a long term fixed rate loan entered into when interest rates were low and refunded more recently with liabilities bearing a higher rate of interest will over its remaining, represent a drain on banks resources Foreign Exchange Risk: It refers to potential impact of movement in foreign exchange rates. The risk here is that the adverse fluctuations in exchange rates may result in a loss. Foreign exchange risk arises when there are unhinged current mismatches in an institution assets and liabilities. This risk persists until the open position is covered by means of hedging transactions. The amount at risk is a function of the magnitude of the potential exchange rate changes and the size and duration of the foreign currency exposures. Indian banks normally do not undertake currency exposure for funding operation (i.e. unhinged conversion of resources in one currency for funding assets in another currency). Currency position in Indian banks is concentrated in dealing rooms and these are subjected to constant monitoring through separate daylight and overnight limits and exception reporting. Commodity Risk: It is a risk associated with trading in commodities. Commodity trading is not practiced by Banks and Financial Institutions in India. Stock Market Risk: Arises primarily because of movement of portfolio value, which may have an overall impact on Banks financial position in adverse condition. The liquidation of Barings and Daiwa Bank is related to the market related risk associated with over exposure to stock market to influence their profitability and long term viability.

13 In addition to market risk associated with Asset and Liability Management process the two other important aspects which are also of importance while discussing asset liability management include a) Liquidity Risk Management b) Capital risk and capital planning Liquidity Risk: It is the potential inability to generate cash to cope with the decline in deposits or increase in assets. Liquidity risk originates from mismatches in the maturity patterns of assets and liabilities since banks deal with assets and liabilities with varied maturity patterns and risk profile, they need to strike a trade-off between been overtly liquid and relatively liquid. An effective measurement and monitoring process assessing all of banks cash inflows against its outflow to identify the potential for any net shortfalls going forward forms an essential ingredient to overall liquidity risk management. This includes funding requirements for off balance sheet commitments. As all banks are affected by changes in the economic climate and market conditions, the monitoring of economic and market trends is also a key to liquidity risk management. Traditionally, banks have been relying on core deposits for their funding. However, in todays environment, banks have resorted to other means of sources also for managing the liquidity on ongoing basis. Cash inflows arise from such things as maturing assets, saleable non-maturing assets, access to deposit liabilities, established credit lines that can be tapped and in developed world through asset securitization also. These need to be matched against cash flows stemming from liabilities and contingent liabilities falling due, especially committed lines of credit that can be drawn down. A maturity ladder is therefore a useful device to compare cash outflows and cash inflows both on a day to day basis and over a period of time. The banks historical experience of the patterns of flows and knowledge of market conventions can also guide a banks decision on liquidity risk management especially in a difficult scenario. Use of what if analysis situations can also help in building different liquidity scenarios for practical applications. An effective system of internal control in banks against liquidity risk will involve:-

14 A strong control environment An adequate process for identifying and evaluating liquidity risk Establishment of policy and procedure for handling such risks An adequate information system Control review of adherence to established policies and procedures.

Capital Risk: Maintaining adequate capital on a continuous basis is the sine quo-non for sound banking practice. In a business situation, banks require capital to insulate themselves from the risks of business that they undertake. The capital accord of 1988 calls for detailed guidelines for maintaining adequate capital by banks to mitigate themselves from problems arising in business development on account of inadequate capital structure.

REVIEW OF EXISTING LITERATURE SUMMARY

The article is remark from Wlliam J McDonough on risk management, supervision and the new Basel Accord. According to the article in recent times the are fail to develop the commitment to manage risk appropriately to avoid this recent past requires a clear and consisted message, as well as transparent pattern of behaviour. Also according to william the work of financial supervision is moving away from a purely retrospective, rules based approach. This is particularly in banking world. Banks supervisor in many countries around the world are assessing the safety and soundness of banks based les on the strength of the balance sheet today, and more on the strength of controls that will safeguard bank financial health tomorrow but William J believed that evaluating the strength of control is, in itself, not enough in deed financial sector required innovation in the good and services offered. Also the member of Basel committee believes that public policy can best support the enhancement of risk management by building incentives directly to their system of supervision. According to William J the whole article based on how supervisor have worked to embrace and encourage the developments, how

15 enhancement in banks risk management processes, driven by business imperatives, have concurrently led supervisor to move to a more processoriented, risk focused approach to supervision. Secondly how provision in New Basel Accord support further changes in there supervisory approach, and promote further enhancement in risk management of market risk and thirdly how those development will be coming together in there supervisory approach going forward-particularly in terms of there supervisory expectations for management of market risk, credit risk and operational risk by large banking organization.

Summary of article
The following article has been delivered by Dr Rakesh Mohan, Deputy Governer of the Reserve Bank of India. The article highlights the need to work toward reducing the real lending rates of banks. Also it focused on the need to increase credit to SMEs as also look into aspects of creating an enabling environment for long term financing. The article also state about the NPAs level ,the absolute amount of NPAs continues to be a major drag on the performance of banks. The large volume of NPAs reflects both an overhang of past dues and on-going problems of fresh accretion. Therefore reducing in NPA level and appropriate risk management by banks would go a long way in improving efficiency of banks and inculcating a sound credit culture

16

CHAPTER 3
HISTORY AND GROWTH OF ICICI BANK
ICICI Bank Ltd. was formed in 1994 as a new private sector bank. Its initial equity capital of Rs 150 crores was fully subscribed by ICICI, and as a result, ICICI Bank became a wholly owned subsidiary of ICICI. In May 1994, when ICICI obtained its commercial banking license to establish ICICI Bank, the Reserve Bank of India (RBI) imposed a condition regarding dilution of promoters holding in the bank. This condition required ICICI to reduce its shareholding in ICICI Bank in stages, first to not more than 75% of its equity share capital, and ultimately to not more than 40%. This took place in the following ways: Year (FY) Event IPO of 15 million equity shares of Rs. 10 each at a price of Rs. 1998 35 per share ADR issue on NYSE for 763.4 crores 236 crores 62.20% 55.60% 2000 US$175 million 2001 Acquisition of Bank of Madura (BOM): 2 equity shares in lieu of every 1 share of BOM Disinvestment ICICI Disinvestment of shares by 2002 ICICI 0.88 crores of shares by 19.39 crores 46.40% 46%(on August 2002) 52.5 crores 74.80% Amount Raised (Rs.) Holding of ICICI

During 2001, the senior managements of ICICI and ICICI Bank explored the possibility amalgamation of ICICI with ICICI Bank. As a bank, ICICI would have the ability to accept low-cost demand deposits and offer wider range on

17 products and services. In view of such benefits and RBIs guidelines on universal banking, ICICI explored various corporate restructuring alternatives for its transformation into a universal bank. Subsequently, the shareholders of both the institutions approved such amalgamation and the exchange ratio determined was 1 fully paid-up equity share of ICICI Bank in lieu of 2 fully paidup equity shares of ICICI. As a result of such amalgamation, which was approved by RBI on April 26, 2002, the paid-up capital increased to Rs. 613 crores. The scheme of amalgamation became effective on May 3, 2002.

RBI approved the merger subject to the following major conditions: Compliance with Reserve Requirements: ICICI Bank would comply with the Cash Reserve Requirements (CRR) and Statutory Liquidity Reserve (SLR) Requirements as applicable to banks on the net demand and time liabilities of the bank, inclusive of the liabilities pertaining to ICICI from the date of merger. Other Prudential Norms: ICICI Bank will continue to comply with all prudential requirements and other instructions as applicable to banks issued by RBI from time to time on the entire portfolio of assets and liabilities of the bank after the merger. Priority Sector Lending: considering that the advances of ICICI were not subject to the requirement applicable to banks in respect of priority sector lending, ICICI Bank would after merger, maintain an additional 10% over and above the requirement of 40%, i.e., a total of 50% of the net bank credit on the residual portion of the banks advances. This additional 10% will apply until such time as the aggregate priority sector advances reaches a level of 40% of the total net bank credit. Equity Exposure Ceiling of 5%: The investments of ICICI acquired by way of project finance as on the date of merger would be kept outside the exposure ceiling of 5% of advances towards exposure to equity and equity-linked instruments for a period of 5 years. ICICI Bank should, however, mark-to-market the above instruments and provide for any loss in their value in the manner prescribed for investments.

18

Following the amalgamation, ICICI Bank has become the second largest among all scheduled commercial banks (SCBs) in India, ranked on the basis of their total assets, coming after the State Bank of India. At end-FY2002, ICICI Bank had a network of 359 branches and 44 extension counters in 251 centers across several India states. Nearly 51% (183 branches) of ICICIs branches are in urban/metropolitan areas. The balance is in rural/semi-urban areas. Till this time ICICI Bank had also installed 1,000 ATMs.

SUBSIDIARIES
At end-FY2001, ICICI Bank had no subsidiaries. Consequent to the merger, ICICIs subsidiary companies have become subsidiaries of ICICI Bank. At endFY2002, ICICI Bank had 11 subsidiaries. The major subsidiaries are described below:

1. ICICI Securities and Finance Co. Ltd. - performs key merchant baking activities including underwriting, placement of debt and equity, issue management and corporate advisory services. 2. ICICI Brokerage Services Ltd. engaged in security brokerage activities on NSE and BSE. 3. ICICI Securities Holdings Inc. incorporated in the US, this arm has been set up to provide investment banking services to investors in the US who wish to enter the Indian financial market and to investors in India who wish to enter the financial markets in the US. 4. ICICI Securities Inc. incorporated in the US, this subsidiary has been set up to provide brokerage, research and investment banking services to investors in the US who wish to enter the Indian financial markets. 5. ICICI Venture Funds Management Co. Ltd. provides venture capital funding to a wide spectrum of industrial sectors.

19 6. ICICI Prudential Life Insurance Co. Ltd. carries out the business of Life Insurance. This subsidiary has entered into an MoU with ICICI Bank for distribution of its life insurance policies through the banks branch network. 7. ICICI Lombard General Insurance Co. Ltd. carries out the business of general insurance. 8. ICICI Home Finance Co. Ltd. provides finance for housing.

MANAGEMENT
The management team of ICICI Bank consists of the following individuals who are very well qualified, possess rich experience and are competent professionals from their field. Name Mr. K.V. Kamath Mr. H.N. Sinor Ms. Lalita D. Gupte Ms. Kalpana Morparia Mr. S. Mukherji Ms. Chanda D. Kochhar Dr. Nachiket Mor Executive Director, In charge of retail banking Executive Director, In charge of wholesale banking Designation Managing Director & CEO Joint Managing Director; In charge of domestic banking Joint Managing Director; In charge of international business Executive Director; In charge of legal department Executive Director; In charge project finance

BUSINESS & OPERATIONS

ICICI Banks asset base of Rs. 1,041 billion (at end FY2002) places it as the second largest scheduled commercial bank in India behind only State Bank of India (SBI). ICICI Banks asset base is nearly 4.4 times larger than the secondlargest new private sector bank in India HDFC Bank (assets of Rs. 238 billion as end-FY2002).

20 ICICI Banks principal activities include corporate banking, retail banking and treasury operations.

RELATIONSHIP WITH THE GOVERNMENT

The GoI has never directly held any shares of ICICI Bank. However, GoIs controlled institutions held a 20.8% stake in ICICI Bank at end August 2002. These include the LIC (8.6%), the GIC and its subsidiaries (7.3%), UTI (3.3%), and others (1.6%). Under the terms of the loan and guarantee facilities provided by the GoI to ICICI that have been transferred to ICICI Bank, the GoI is entitled to appoint and has appointed one representative to the BoD of ICICI Bank. Comparison of key ratios is done on the basis of previous year and the current year.

RISK MANAGEMENT AT ICICI

Risk is an inherent part of ICICI Banks business, and effective Risk Compliance & Audit Group is critical to achieving financial soundness and profitability. ICICI Bank has identified Risk Compliance & Audit Group as one of the core competencies for the next millennium. The Risk Compliance & Audit Group (RC & AG) at ICICI Bank benchmarks itself to international best practices so as to optimise capital utilisation and maximise shareholder value. With well defined policies and procedures in place, ICICI Bank identifies, assesses, monitors and manages the principal risks:

Credit risk (the possibility of loss due to changes in the quality of counterparties)

Market Risk (the possibility of loss due to changes in market prices and rates of securities and their levels of volatility)

Operational risk (the potential for loss arising from breakdowns in policies and controls, human error, contracts, systems and facilities)

21 The ability to implement analytical and statistical models is the true test of a risk methodology. In addition to three departments within the Risk Compliance & Audit Group handling the above risks, an Analytics Unit develops quantitative techniques and models for risk measurement.

CREDIT RISK MANAGEMENT

Credit risk, the most significant risk faced by ICICI Bank, is managed by the Credit Risk Compliance & Audit Department (CRC & AD) which evaluates risk at the transaction level as well as in the portfolio context. The industry analysts of the department monitor all major sectors and evolve a sect oral outlook, which is an important input to the portfolio planning process. The department has done detailed studies on default patterns of loans and prediction of defaults in the Indian context. Risk-based pricing of loans has been introduced. The functions of this department include:

Review of Credit Origination & Monitoring Credit rating of companies/structures Default risk & loan pricing Review of industry sectors Review of large exposures in industries/ corporate groups/

companies Ensure Monitoring and follow-up by building appropriate

systems such as CAS

Design appropriate credit processes, operating policies & procedures Portfolio monitoring Methodology to measure portfolio risk Credit Risk Information System (CRIS)

Focussed attention to structured financing deals Pricing, New Product Approval Policy, Monitoring

22

Monitor adherence to credit policies of RBI

During the year, the department has been instrumental in reorienting the credit processes, including delegation of powers and creation of suitable control points in the credit delivery process with the objective of improving customer response time and enhancing the effectiveness of the asset creation and monitoring activities. Availability of information on a real time basis is an important requisite for sound risk management. To aid its interaction with the strategic business units, and provide real time information on credit risk, the CRC & AD has implemented a sophisticated information system, namely the Credit Risk Information System. In addition, the CRC & AD has designed a web-based system to render information on various aspects of the credit portfolio of ICICI Bank.

MARKET RISK COMPLIANCE & AUDIT GROUP ICICI Bank is exposed to all categories of Market Risk, viz., Interest Rate Risk (risk due to changes in interest rates) Exchange Rate Risk (risk due to changes in exchange rates) Equity Risk (risk due to change in equity prices) Liquidity Risk (risk due to deterioration in market liquidity for tradable instruments) The Market Risk Compliance & Audit Department evaluates, tests and approves market risk methodologies developed by the Treasury. It also participates in the new product approval process on a firm-wide basis and evaluates all new products from a market risk perspective

OPERATIONAL RISK MANAGEMENT ICICI Bank, like all large banks, is exposed to many types of operational risks. These include potential losses caused by events such as breakdown in

23 information, communication, transaction processing and settlement systems/ procedures. The Audit Department, an integral part of the Risk Compliance & Audit Group, focusses on the operational risks within the organisation. In recent times, there has been a shift in the audit focus from transactions to controls. Some examples of this paradigm shift are: Adherence to internal policies, procedures and documented processes Risk Based Audit Plan Widening of Treasury operations audit coverage Use of Computer Assisted Audit Techniques (CAATs) Information Systems Audit Plans to develop/ buy software to capture the workflow of the Audit Department The Audit Department conceptualised and put into operation a Risk Based Audit Plan during the year 1998-99. The Risk Based Audit Plan envisages allocation of audit resources in accordance with the risk constituents of ICICI Banks business.

24

CHAPTER 4
PERFORMANCE OF ICICI BANK
1)

Credit-Deposit (%): This ratio is compared as under: We notice that in the year 1997 credit deposit ratio is 69.8% which fell to 21.37% in the year 1998. In 1999 it further drop to 11.22%. In 2000 it drop to 1.03%. In the year 2001 it rose to 4.55%. In the year 2002 it rose to 70.83%.

2)

Investment/Deposit (%): This ratio is compared as under: We notice that in the year 1997 investment ratio is 33.64% it rose to 3.04% in the year 1998. In the year 1999 again it rose to 7.96%. In the year 2000 it rose to 1.02%. In the year 2001 it rose to 2.36%.In the year 2002 it rose to 42.93% which is a significant increase.

3)

Cash /Deposit(%) : This ratio is compared as under: We notice that in the year 1997 Cash /deposit ratio is 12.27% which fell to 0.69% in the year 1998. In the year 1999 it again fell to 2.66%. In the year 2000 it fell to 1.47%.In the year 2001 it again fell to 0.01%.In the year 2002 it fell to 1.24%.

4)

Interest Expended/Interest Earned(%): This ratio is compared as under : We notice that In the year 1997 interest earned(%) is 64.1% which rose to7.78%.in the year 1998. again it rose to 6.33%. in the year 1999. in the year 2000 it fell to 0.01%. in the year 2001 again it fell to 10.76%. in the year 2002 it fell to 5%.

5)

Other Income/Total Income(%) : This ratio is compared as under: We notice that in the year 1997 percentage of other income/total income is 18.93% which rose to 5.75% in the year 1998. In the year 1999 it fell to 10.6%. In the year 2000 there is a significant increase of 4.47%. in the year 2001 it fell to 3.1%. in the year 2002 It rose to 6.5%.

6)

Operating Expenses/Total Income(%) : This ratio is compared as under :

25 We notice that the percentage of operating expenses in the year 1997 is 17.98% which fell to 1.26% in the year 1998.In the year 1999 again it fell to 3.6%.In the year 2000 it rose to 0.59%.in the year 2001 it rose to 8.36%.in the year 2002 it rose to 0.71%.
7)

Interest Income/Total funds(%): This ratio is compared as under: We notice that percentage of interest income in the year 1997 is 12.43% which fell to 2.17% in the year 1998.In the year 1999 it rose to 0.34%.in the year 2000 it fell to 1.65%.in the year 2001 it fell to 1.14%.in the year 2002 it further fell to 4.33%.

8)

Interest Expended/Total Funds(%) : This ratio is compared as under 1997:- 7.97% 1998:-0.59%(decrease) 1999: 0.91%(increase) 2000:1.29%(decrease) 2001:1.73%(decrease) 2002:2.75%(decrease)

9) Net interest income/Total funds(%) : This ratio is compared as under 1997 : 4.46% 1998 : 1.57%(decrease which take it to 2.89%) 1999 : 0.58%(decrease which take it to 2.31%) 2000 : 0.36%( decrease) 2001 : 0.59%(increase) 2002 : 1.58%(decrease) 10) Non interest income/total funds (%): This ratio is compared as under 1997: 2.9% 1998:0.46 %( increase) 1999:1.62 %( decrease) 2000: 0.3 %( increase)

26 2001 :0.61%(decrease) 2002:0.45%(decrease) 11. Operating expense/Total funds(%) : This ratio is compared as under : 1997 :2.76% 1998 :0.48%(decrease) 1999:0.66%(decrease further) 2000:0.11%(decrease) 2001:0.53%(increase) 2002:1.03%(decrease)
12.)

Profit before provisions/total funds(%) : Comparison of this I s done as under: 1997 : 4.61% 1998 :0.64%(decrease) 1999:1.54%(decrease) 2000:0.11%(increase) 2001:0.55%(decrease) 2002:1.01%(decrease)

13.)

Net Profit/Total funds(%): Comparison of this is given as under: 1997: 2.73% 1998 :0.75%(decrease) 1999:0.75%(decrease) 2000:0.12%(decrease) 2001:0.1%(decrease) 2002:0.59%(decrease)

14.)

RONW(%) : Comparison of this is done as under : 1997:23.7% 1998:1.31%(decrease)

27 1999:0.35%(decrease)

GAP ANALYSIS
Outflow 1-14 days 15-28 days 29-3 months 3-6 months 6-1 year 1-3 year 3-5 year Above 5 Total

Deposits Borrowings Total Inflow Loans/adv. Invest/Sect. Total

315206 99649 414855

92177 149971 242148

481706 441520 923226

277906 322932 600838

579855 894286 1474141

1289359 1416256 2705615

40318 395130 435448

14421 284823 299244

3090948 4004567 7095515

82564 131998 214562

35692 68624 104316

255294 289018 544312

233150 267530 500680

371087 521877 892964

1322562 736576 2059138

763733 447461 121119 4 775746

1370069 1155706 2525775

4424151 3618790 8052941

Mismatch (B-A)

-200293

-137832

-378914

-100158

-581177

-646477

2226531

1603903

Gap report indicates that there is a mismatch in the maturity buckets of 1-14 days to 1-3 years. However this means RSL>RSA this shows the bank in a position to benefit from declining interest rate by a negative gap.

28

CONCLUSION
So on the basis of the data provided to us we can say that the banks are not strictly following the ALM Guidelines.

RECOMMENDATION
ALCO should keep a vigil on the working of the banks and ensure

that all the guidelines are met. RBI should show the banks as to how the banks can benefit by

following their guidelines. All the banks should provide complete information so that there is

more transparency.

29

ANNEXTURE
ICICI BANK

FINANCIAL OVERVIEW 2002-03 Equity Paid Up Net worth Capital Employed Gross Block Sales PBIDT PBDT PBIT PBT PAT CP Revenue earnings in forex Revenue expenses in forex Book Value (Unit Curr) Market Capitalisation CEPS (annualised) (Unit Curr) EPS (annualised) (Unit Curr) Dividend (annualised%) Payout (%) Cash Flow From Operating Activities Cash Flow From Investing Activities Cash Flow From Financing Activities Rate of Growth (%) Net Worth (%) Capital Employed (%) Gross Block (%) Sales (%) PBIDT (%) PBDT (%) PBIT (%) PBT (%) PAT (%) CP (%) Revenue earnings in forex (%) 220.36 5855.9 104109.92 4494.29 2151.93 1912.31 353.39 1848.22 289.3 258.3 322.39 0 0 265.74 2732.46 14.43 11.52 20 17.36 2241.2 -23.68 131.4 2001-03 196.82 1289.08 19736.59 589.67 1242.13 1100.57 262.9 1063.82 226.15 161.1 197.85 0 0 65.5 3255.4 9.82 7.96 20 28.14 -394.02 -78.39 -27.47 2000-03 196.82 1149.51 12072.63 315.14 852.87 823.64 156.69 798.85 131.9 105.3 130.09 0 0 58.4 5117.32 6.47 5.21 15 24.13 1091.57 -56.03 741.37 1999-03 165 308.33 6981.68 261.57 544.05 536.41 110.89 518.88 93.36 63.36 80.89 0 0 18.69 452.1 4.78 3.72 12 32.26 662.9 -47.69 150.15 1998-03 165 266.75 3279.43 218.97 259.7 271.67 84.99 257.2 70.52 50.22 64.69 0 0 16.17 755.7 3.82 2.95 10 33.4 568.37 -105.9 37.5 1997-03 150 181.88 1781.87 110.58 182.68 178.86 61.77 170.62 53.53 40.13 48.37 0 0 12.13 0 3.22 2.68 10 37.38 281.8 -60.11 -11.73

354.27 427.5 662.17 73.25 73.76 34.42 73.73 27.92 60.34 62.95 0

12.14 63.48 87.11 45.64 33.62 67.78 33.17 71.46 52.99 52.09 0

272.82 72.92 20.48 56.76 53.55 41.3 53.96 41.28 66.19 60.82 0

15.59 112.89 19.45 109.49 97.45 30.47 101.74 32.39 26.16 25.04 0

46.66 84.04 98.02 42.16 51.89 37.59 50.74 31.74 25.14 33.74 0

16.03 53.97 110.75 57.31 68.83 193.86 68.21 224.23 143.06 130.11 0

30
Revenue expenses in forex (%) Market Capitalisation (%) Key Ratios Credit-Deposit(%) Investment / Deposit (%) Cash / Deposit (%) Interest Expended / Interest Earned (%) Other Income / Total Income (%) Operating Expenses / Total Income (%) Interest Income / Total Funds (%) Interest Expended / Total Funds (%) Net Interest Income / Total Funds (%) Non Interest Income / Total Funds (%) Operating Expenses / Total Funds (%) Profit before Provisions / Total Funds (%) Net Profit / Total funds (%) RONW (%) BS 200203 CAPITAL AND LIABILITIES Capital + Reserves and Surplus + Deposits + Borrowings + Other Liabilities & Provisions + TOTAL 220.36 5635.54 32085.11 48681.21 17487.7 196.82 1092.26 16378.21 1032.79 1036.51 196.82 952.69 9866.02 491.47 565.63 165 143.33 6072.94 199.89 400.52 165 101.75 2629.02 192.23 191.43 150 31.88 1347.6 92.99 159.4 200103 200003 199903 199803 199703 0 -16.06 0 -36.38 0 1031.9 0 -40.17 0 0 0 0

111.56 90.95 6.2 72.44 21.95 22.78 3.48 2.52 0.96 0.98 1.01 0.92 0.42 7.23

40.73 48.02 7.44 67.44 15.45 22.07 7.81 5.27 2.54 1.43 2.04 1.93 1.01 13.21

36.18 45.66 7.45 78.2 18.55 13.71 8.95 7 1.95 2.04 1.51 2.48 1.11 14.45

37.21 44.64 8.92 78.21 14.08 13.12 10.6 8.29 2.31 1.74 1.62 2.43 1.23 22.04

48.43 36.68 11.58 71.88 24.68 16.72 10.26 7.38 2.89 3.36 2.28 3.97 1.98 22.39

69.8 33.64 12.27 64.1 18.93 17.98 12.43 7.97 4.46 2.9 2.76 4.61 2.73 23.7

104109.92

19736.59

12072.63

6981.68

3279.43

1781.87

31

ASSETS Cash & Balances with RBI Balances with Banks & money at Call & Short Notice Investments + Advances + Fixed Assets + Other Assets + TOTAL Contingent Liabilities + Bills for collection PL 200203 (12) I. INCOME : Interest Earned + Other Income + TOTAL II. EXPENDITURE : Interest expended + Operating Expenses + Provisions & Contingencies + TOTAL III. PROFIT/LOSS Net Profit for the year Prior Year Adjustments + Profit brought forward TOTAL IV. APPROPRIATIONS Transfer to Statutory Reserves Transfer to Other Reserves + Proposed Dividend / Transfer to Government + Balance c/f to Balance Sheet TOTAL 2151.93 605.02 2756.95 200103 (12) 1242.13 226.96 1469.09 200003 (12) 852.87 194.19 1047.06 199903 (12) 544.05 89.14 633.19 199803 (12) 199703 (12) 259.7 85.09 344.79 182.68 42.65 225.33 1774.47 11011.88 35891.08 47034.87 4239.34 4158.28 104109.92 39446.59 1323.42 1231.66 2362.03 8186.86 7031.46 384.75 539.83 19736.59 13848.01 1229.8 721.89 2693.27 4416.68 3657.35 222.12 361.32 12072.63 9780.47 761.44 465.81 1172.44 2861.23 2110.12 199.64 172.44 6981.68 5013.97 438.46 310.09 562.79 1023.39 1127.87 183.7 71.59 3279.43 2906.24 218.19 150.34 222.58 435.35 798 96.37 79.23 1781.87 1495.76 123.01

1558.92 628.09 311.64 2498.65

837.67 324.28 146.04 1307.99

666.95 143.54 131.27 941.76

425.52 83.08 61.23 569.83

186.68 57.65 50.24 294.57

117.09 40.51 27.6 185.2

258.3 0 0.83 259.13

161.1 0 0.8 161.9

105.3 0 0.13 105.43

63.36 0 0.39 63.75

50.22 0 0.02 50.24

40.13 0 0.39 40.52

65 126 48.57 19.56 259.13

80 32.5 48.57 0.83 161.9

25 52.82 27.47 0.14 105.43

20 21.84 21.78 0.13 63.75

27 5 17.85 0.39 50.24

25.5 0 15 0.02 40.52

32

Equity Dividend Corporate Dividend Tax Equity Dividend (%) Earning Per Share (Rs.)(Unit Curr.) Book Value(Unit Curr.) Extraordinary Items + BS SCHEDULES

44.07 4.5 20 11.52 265.74 -0.03

44.07 4.5 20 7.96 65.5 -0.09

24.75 2.72 15 5.21 58.4 -0.1

19.8 1.98 12 3.72 18.69 -0.07

16.23 1.62 10 2.95 16.17 -0.03

15 0 10 2.68 12.13 -0.03

200203 CAPITAL AND LIABILITIES Capital Equity Authorised Preference Capital Authorised Unclassified Authorised Equity Issued Equity Subscribed Equity Called Up Less : Equity Calls in Arrears Equity Forfeited Equity Suspense Adjustments to equity Equity Paid Up Preference Capital Paid Up Unclassified Shares paid -up TOTAL CAPITAL Equity converted during the year GDRs Issued During the Year Bonus in Equity Reserves and Surplus Contingency Reserve Other Statutory Reserve Capital Reserves Capital Redemption Reserve Debt Redemption Reserve

200103

200003

199903

199803

199703

300 0 0 220.36 220.36 220.36 0 0 392.67 0 220.36 0 0 220.36 0 0 0

300 0 0 196.82 196.82 196.82 0 0 23.54 0 196.82 0 0 196.82 0 0 0

300 0 0 196.82 196.82 196.82 0 0 0 0 196.82 0 0 196.82 0 0 0

300 0 0 165 165 165 0 0 0 0 165 0 0 165 0 0 0

300 0 0 165 165 165 0 0 0 0 165 0 0 165 0 0 0

300 0 0 150 150 150 0 0 0 0 150 0 0 150 0 0 0

0 249.43 0 0 0

0 184.43 0 0 0

0 103.86 0 0 0

0 78.86 0 0 0

0 58.86 0 0 0

0 31.86 0 0 0

33
Debenture Redemption Reserve Exchange fluctuation Reserve Amalgamation Reserve Share Premium Revenue & other Reserves Other Reserves Profit & Loss A/c
TOTAL RESERVES EXCLUDING REVALUATION RESERVE

10 0 0 804.54 4524.67 27.34 19.56 5635.54

0 0 0 804.54 91.12 11.34 0.83 1092.26

0 0 0 769.03 79.66 0 0.14 952.69

0 0 0 37.5 26.84 0 0.13 143.33

0 0 0 37.5 5 0 0.39 101.75

0 0 0 0 0 0 0.02 31.88

Revaluation Reserve TOTAL RESERVES AND SURPLUS Deposits Demand Deposits Saving Deposits Term & Other Deposits TOTAL DEPOSITS Borrowings Borrowings in India RBI Borrowings in India -Other Banks Borrowings in India -Other agencies Borrowings outside India Convertible Debentures Non Convertible Debentures Partly Convertible Debentures Less : Debentures Calls in arrears TOTAL BORROWINGS Secured Borrowings included above Other Liabilities & Provisions Bills Payable Inter Office Adjustment (Net) Interest Accrued Share Application Money Unclaimed Dividend

0 5635.54

0 1092.26

0 952.69

0 143.33

0 101.75

0 31.88

2736.15 2497 26851.96 32085.11

2621.86 1880.64 11875.71 16378.21

1587.47 533.26 7745.29 9866.02

576.62 227.12 5269.2 6072.94

363.17 103.74 2162.11 2629.02

316.33 49.67 981.6 1347.6

140.89 2687.6 9265.09 22709.97 0 13744.47 133.19 0 48681.21 0

301.24 397.8 333.75 0 0 0 0 0 1032.79 0

218.67 192.18 80.62 0 0 0 0 0 491.47 0

148.48 41.77 9.64 0 0 0 0 0 199.89 0

0 29.29 162.94 0 0 0 0 0 192.23 0

0 80.04 12.95 0 0 0 0 0 92.99 0

817.33 33.05 2289.51 1280.12 0

380.56 0 55.65 23.54 0

142.2 0 33.52 0 0

112.19 0 23.49 0 0

107.81 0 17.56 0 0

68.79 0 5.67 0 0

34
Other Liabilities (Including Provisions) TOTAL OTHER LIABILITIES AND PROVISIONS TOTAL 13067.69 17487.7 576.76 1036.51 389.91 565.63 264.84 400.52 66.06 191.43 84.94 159.4

104109.92

19736.59

12072.63

6981.68

3279.43

1781.87

ASSETS Cash & Balances with RBI

Balances with Banks & money at Call & Short Notice

1774.47

1231.66

721.89

465.81

310.09

150.34

11011.88

2362.03

2693.27

1172.44

562.79

222.58

Investments Quoted Government Securities Other Approved Secutires Shares Debentures & Bonds Investment in Subsidiaries Units Other Investments TOTAL INVESTMENTS Market Value of Quoted Investments Advances Bills Purchased & Discounted Cash Credits, Overdraft & Loans Repayable on Demand Term Loans TOTAL ADVANCES Fixed Assets Premises Other Fixed Assets Gross Block Accumulated Depreciation Net Block Capital Work-inProgress TOTAL FIXED ASSETS

22722.31 70.46 1908.65 6436.36 608.18 0 4145.12 35891.08 0

4070.44 41.49 125.12 3070.08 0 0 879.73 8186.86 0

2814.94 0 160.95 1137.22 0 0 303.57 4416.68 0

1527.36 0 138 666.61 0 0 529.26 2861.23 0

704.67 0 47.03 216.51 0 0 55.18 1023.39 0

313.36 0 10.47 69.34 0 0 42.18 435.35 0

2484.7 2402.51

1087.04 4970.91

701.3 2577.67

454.96 1383.5

140.92 841.59

76.4 632.1

42147.66 47034.87

973.51 7031.46

378.38 3657.35

271.66 2110.12

145.36 1127.87

89.5 798

1443.17 3051.12 4494.29 254.95 4239.34 0 4239.34

203.09 386.58 589.67 204.92 384.75 0 384.75

144.74 170.4 315.14 93.02 222.12 0 222.12

130.21 131.36 261.57 61.93 199.64 0 199.64

106.62 112.35 218.97 35.27 183.7 0 183.7

28.82 81.76 110.58 14.21 96.37 0 96.37

35

RISK MANAGEMENT GUIDELINES FOR COMMERCIAL BANKS

Introduction Banks in the process of financial intermediation are confronted with various kinds of financial and non-financial risks viz., credit, interest rate, foreign exchange rate, liquidity, equity price, commodity price, legal, regulatory, reputational, operational, etc. These risks are highly interdependent and events that affect one area of risk can have ramifications for a range of other risk categories. Thus, top management of banks should attach considerable importance to improve the ability to identify, measure, monitor and control the overall level of risks undertaken. The broad parameters of risk management function should encompass:
i) ii) iii)

Organizational structure; Comprehensive risk measurement approach; Risk management policies approved by the Board which should be consistent with the broader business strategies, capital strength, management expertise and overall willingness to assume risk;

iv)

Guidelines and other parameters used to govern risk taking including detailed structure of prudential limits; Strong MIS for reporting, monitoring and controlling risks; Well laid out procedures, effective control and comprehensive risk reporting framework; Separate risk management framework independent of operational departments and with clear delineation of levels of responsibility for management of risk; and

v) vi)

vii)

viii)

Periodical review and evaluation.

RISK MANAGEMENT STRUCTURE

A major issue in establishing an appropriate risk management organization structure is choosing between a centralized and decentralized structure. The global trend is towards centralizing risk management with integrated treasury

36 management function to benefit from information on aggregate exposure, natural netting of exposures, economies of scale and easier reporting to top management. The primary responsibility of understanding the risks run by the bank and ensuring that the risks are appropriately managed should clearly be vested with the Board of Directors. The Board should set risk limits by assessing the banks risk and risk-bearing capacity. At organizational level, overall risk management should be assigned to an independent Risk Management Committee or Executive Committee of the top Executives that reports directly to the Board of Directors. The purpose of this top level committee is to empower one group with full responsibility of evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. At the same time, the Committee should hold the line management more accountable for the risks under their control, and the performance of the bank in that area. profile of the bank. The functions of Risk Management Committee should essentially be to identify, monitor and measure the risk The Committee should also develop policies and procedures, verify the models that are used for pricing complex products, review the risk models as development takes place in the markets and also identify new risks. The risk policies should clearly spell out the quantitative prudential limits on various segments of banks operations. Internationally, the trend is towards assigning risk limits in terms of portfolio standards or Credit at Risk (credit risk) and Earnings at Risk and Value at Risk (market risk). The Committee should design stress scenarios to measure the impact of unusual market conditions and monitor variance between the actual volatility of portfolio value and that predicted by the risk measures. The Committee should also monitor compliance of various risk parameters by operating Departments. A prerequisite for establishment of an effective risk management system is the existence of a robust MIS, consistent in quality. The existing MIS, however, requires substantial up gradation and strengthening of the data collection machinery to ensure the integrity and reliability of data. The risk management is a complex function and it requires specialized skills and expertise. Banks have been moving towards the use of sophisticated models for measuring and managing risks. Large banks and those operating in

37 international markets should develop internal risk management models to be able to compete effectively with their competitors. As the domestic market integrates with the international markets, the banks should have necessary expertise and skill in managing various types of risks in a scientific manner. At a more sophisticated level, the core staff at Head Offices should be trained in risk modeling and analytical tools. It should, therefore, be the Endeavour of all banks to upgrade the skills of staff. Given the diversity of balance sheet profile, it is difficult to adopt a uniform framework for management of risks in India. The design of risk management functions should be bank specific, dictated by the size, complexity of functions, the level of technical expertise and the quality of MIS. The proposed guidelines only provide broad parameters and each bank may evolve their own systems compatible to their risk management architecture and expertise. Internationally, a committee approach to risk management is being adopted. While the Asset - Liability Management Committee (ALCO) deal with different types of market risk, the Credit Policy Committee (CPC) oversees the credit /counterparty risk and country risk. Thus, market and credit risks are managed in a parallel two-track approach in banks. Banks could also set-up a single Committee for integrated management of credit and market risks. Generally, the policies and procedures for market risk are articulated in the ALM policies and credit risk is addressed in Loan Policies and Procedures. Currently, while market variables are held constant for quantifying credit risk, credit variables are held constant in estimating market risk. The economic crises in some of the countries have revealed a strong correlation between unhinged market risk and credit risk. Forex exposures, assumed by corporates who have no natural hedges, will increase the credit risk which banks run vis-vis their counterparties. The volatility in the prices of collateral also significantly affects the quality of the loan book. Thus, there is a need for integration of the activities of both the ALCO and the CPC and consultation process should be established to evaluate the impact of market and credit risks on the financial strength of banks. Banks may also consider integrating market risk elements into their credit risk assessment process.

38 CREDIT RISK Lending involves a number of risks. In addition to the risks related to creditworthiness of the counter party, the banks are also exposed to interest rate, forex and country risks. Credit risk or default risk involves inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions. The Credit Risk is generally made up of transaction risk or default risk and portfolio risk. The portfolio risk in turn comprises intrinsic and concentration risk. The credit risk of a banks portfolio depends on both external and internal factors. The external factors are the state of the economy, wide swings in commodity/equity prices, foreign exchange rates and interest rates, trade restrictions, economic sanctions, Government policies, etc. The internal factors are deficiencies in loan policies/administration, absence of prudential credit concentration limits, inadequately defined lending limits for Loan Officers/Credit Committees, deficiencies in appraisal of borrowers financial position, excessive dependence on collaterals and inadequate risk pricing, absence of loan review mechanism and post sanction surveillance, etc. Another variant of credit risk is counter party risk. The counter party risk arises from non-performance of the trading partners. The non-performance may arise from counter partys refusal/inability to perform due to adverse price movements or from external constraints that were not anticipated by the principal. The counter party risk is generally viewed as a transient financial risk associated with trading rather than standard credit risk. The management of credit risk should receive the top managements attention and the process should encompass: a) Measurement of risk through credit rating/scoring; b) Quantifying the risk through estimating expected loan losses i.e. the amount of loan losses that bank would experience over a chosen time horizon (through tracking portfolio behaviour over 5 or more years) and unexpected loan losses i.e. the amount by which actual losses exceed the expected loss (through standard deviation of losses or the difference between expected loan losses and some selected target credit loss quantile); c) Risk pricing on a scientific basis; and

39 d) Controlling the risk through effective Loan Review Mechanism and portfolio management. The credit risk management process should be articulated in the banks Loan Policy, duly approved by the Board. Each bank should constitute a high level Credit Policy Committee, also called Credit Risk Management Committee or Credit Control Committee etc. to deal with issues relating to credit policy and procedures and to analyse, manage and control credit risk on a bank wide basis. The Committee should be headed by the Chairman/CEO/ED, and should comprise heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The Committee should, inter alia, formulate clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory/legal compliance, etc. Concurrently, each bank should also set up Credit Risk Management Department (CRMD), independent of the Credit Administration Department. The CRMD should enforce and monitor compliance of the risk parameters and prudential limits set by the CPC. The CRMD should also lay down risk assessment systems, monitor quality of loan portfolio, identify problems and correct deficiencies, develop MIS and undertake loan review/audit. Large banks may consider separate set up for loan review/audit. The CRMD should also be made accountable for protecting the quality of the entire loan portfolio. test the resilience of the loan portfolio. Instruments of Credit Risk Management Credit Risk Management encompasses a host of management techniques, which help the banks in mitigating the adverse impacts of credit risk. Credit Approving Authority Each bank should have a carefully formulated scheme of delegation of powers. The banks should also evolve multi-tier credit approving system where the loan The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to

40 proposals are approved by an Approval Grid or a Committee. The credit facilities above a specified limit may be approved by the Grid or Committee, comprising at least 3 or 4 officers and invariably one officer should represent the CRMD, who has no volume and profit targets. Banks can also consider credit approving committees at various operating levels i.e. large branches (where considered necessary), Regional Offices, Zonal Offices, Head Offices, etc. Banks could consider delegating powers for sanction of higher limits to the Approval Grid or the Committee for better rated / quality customers. The spirit of the credit approving system may be that no credit proposals should be approved or recommended to higher authorities, if majority members of the Approval Grid or Committee do not agree on the creditworthiness of the borrower. In case of disagreement, the specific views of the dissenting member/s should be recorded. The banks should also evolve suitable framework for reporting and evaluating the quality of credit decisions taken by various functional groups. The quality of credit decisions should be evaluated within a reasonable time, say 3 6 months, through a well-defined Loan Review Mechanism. Prudential Limits In order to limit the magnitude of credit risk, prudential limits should be laid down on various aspects of credit:
a)

Stipulate benchmark current/debt equity and profitability ratios, debt service coverage ratio or other ratios, with flexibility for deviations. The conditions subject to which deviations are permitted and the authority therefor should also be clearly spelt out in the Loan Policy;

b)

Single/group borrower limits, which may be lower than the limits prescribed by Reserve Bank to provide a filtering mechanism; Substantial exposure limit i.e. sum total of exposures assumed in respect of those single borrowers enjoying credit facilities in excess of a threshold limit, say 10% or 15% of capital funds. The substantial exposure limit may be fixed at 600% or 800% of capital funds, depending upon the degree of concentration risk the bank is exposed;

c)

d)

Maximum exposure limits to industry,

sector, etc. should be set up.

There must also be systems in place to evaluate the exposures at

41 reasonable intervals and the limits should be adjusted especially when a particular sector or industry faces slowdown or other sector/industry specific problems. The exposure limits to sensitive sectors, such as, advances against equity shares, real estate, etc., which are subject to a high degree of asset price volatility and to specific industries, which are subject to frequent business cycles, may necessarily be restricted. Similarly, high-risk industries, as perceived by the bank, should also be placed under lower portfolio limit. Any excess exposure should be fully backed by adequate collaterals or strategic considerations; and
e)

Banks may consider maturity profile of the loan book, keeping in view the market risks inherent in the balance sheet, risk evaluation capability, liquidity, etc.

Risk Rating Banks should have a comprehensive risk scoring / rating system that serves as a single point indicator of diverse risk factors of counterparty and for taking credit decisions in a consistent manner. To facilitate this, a substantial degree of standardisation is required in ratings across borrowers. The risk rating system should be designed to reveal the overall risk of lending, critical input for setting pricing and non-price terms of loans as also present meaningful information for review and management of loan portfolio. The risk rating, in short, should reflect the underlying credit risk of the loan book. The rating exercise should also facilitate the credit granting authorities some comfort in its knowledge of loan quality at any moment of time. The risk rating system should be drawn up in a structured manner, incorporating, inter alia, financial analysis, projections and sensitivity, industrial and management risks. The banks may use any number of financial ratios and operational parameters and collaterals as also qualitative aspects of management and industry characteristics that have bearings on the creditworthiness of borrowers. Banks can also weigh the ratios on the basis of the years to which they represent for giving importance to near term developments. Within the rating framework, banks can also prescribe certain level of standards or critical parameters, beyond which no proposals should be

42 entertained. Banks may also consider separate rating framework for large corporate / small borrowers, traders, etc. that exhibit varying nature and degree of risk. Forex exposures assumed by corporates who have no natural hedges have significantly altered the risk profile of banks. Banks should, therefore, factor the unhinged market risk exposures of borrowers also in the rating framework. The overall score for risk is to be placed on a numerical scale ranging between 1-6, 1-8, etc. on the basis of credit quality. For each numerical category, a quantitative definition of the borrower, the loans underlying quality, and an analytic representation of the underlying financials of the borrower should be presented. Further, as a prudent risk management policy, each bank should prescribe the minimum rating below which no exposures would be undertaken. Any flexibility in the minimum standards and conditions for relaxation and authority therefor should be clearly articulated in the Loan Policy. The credit risk assessment exercise should be repeated biannually (or even at shorter intervals for low quality customers) and should be delinked invariably from the regular renewal exercise. The updating of the credit ratings should be undertaken normally at quarterly intervals or at least at half-yearly intervals, in order to gauge the quality of the portfolio at periodic intervals. Variations in the ratings of borrowers over time indicate changes in credit quality and expected loan losses from the credit portfolio. Thus, if the rating system is to be meaningful, the credit quality reports should signal changes in expected loan losses. In order to ensure the consistency and accuracy of internal ratings, the responsibility for setting or confirming such ratings should vest with the Loan Review function and examined by an independent Loan Review Group. The banks should undertake comprehensive study on migration (upward lower to higher and downward higher to lower) of borrowers in the ratings to add accuracy in expected loan loss calculations. Risk Pricing Risk-return pricing is a fundamental tenet of risk management. In a risk-return setting, borrowers with weak financial position and hence placed in high credit

43 risk category should be priced high. Thus, banks should evolve scientific systems to price the credit risk, which should have a bearing on the expected probability of default. The pricing of loans normally should be linked to risk rating or credit quality. The probability of default could be derived from the past behaviour of the loan portfolio, which is the function of loan loss provision/charge offs for the last five years or so. Banks should build historical database on the portfolio quality and provisioning / charge off to equip themselves to price the risk. But value of collateral, market forces, perceived value of accounts, future business potential, portfolio/industry exposure and strategic reasons may also play important role in pricing. Flexibility should also be made for revising the price (risk premia) due to changes in rating / value of collaterals over time. Large sized banks across the world have already put in place Risk Adjusted Return on Capital (RAROC) framework for pricing of loans, which calls for data on portfolio behaviour and allocation of capital commensurate with credit risk inherent in loan proposals. Under RAROC framework, lender begins by charging an interest mark-up to cover the expected loss expected default rate of the rating category of the borrower. The lender then allocates enough capital to the prospective loan to cover some amount of unexpected loss- variability of default rates. Generally, international banks allocate enough capital so that the expected loan loss reserve or provision plus allocated capital covers 99% of the loan loss outcomes. There is, however, a need for comparing the prices quoted by competitors for borrowers perched on the same rating /quality. Thus, any attempt at pricecutting for market share would result in mispricing of risk and Adverse Selection. Portfolio Management The existing framework of tracking the Non Performing Loans around the balance sheet date does not signal the quality of the entire Loan Book. Banks should evolve proper systems for identification of credit weaknesses well in advance. Most of international banks have adopted various portfolio management techniques for gauging asset quality. The CRMD, set up at Head Office should be assigned the responsibility of periodic monitoring of the portfolio. The portfolio quality could be evaluated by tracking the migration

44 (upward or downward) of borrowers from one rating scale to another. This process would be meaningful only if the borrower-wise ratings are updated at quarterly / half-yearly intervals. Data on movements within grading categories provide a useful insight into the nature and composition of loan book. The banks could also consider the following measures to maintain the portfolio quality:
1)

Stipulate quantitative ceiling on aggregate exposure in specified rating categories, i.e. certain percentage of total advances should be in the rating category of 1 to 2 or 1 to 3, 2 to 4 or 4 to 5, etc.;

2)

Evaluate the rating-wise distribution of borrowers in various industry, business segments, etc.; Exposure to one industry/sector should be evaluated on the basis of overall rating distribution of borrowers in the sector/group. In this context, banks should weigh the pros and cons of specialisation and concentration by industry group. In cases where portfolio exposure to a single industry is badly performing, the banks may increase the quality standards for that specific industry;

3)

4)

Target rating-wise volume of loans, probable defaults and provisioning requirements as a prudent planning exercise. For any deviation/s from the expected parameters, an exercise for restructuring of the portfolio should immediately be undertaken and if necessary, the entry-level criteria could be enhanced to insulate the portfolio from further deterioration;

5)

Undertake rapid portfolio reviews, stress tests and scenario analysis when external environment undergoes rapid changes (e.g. volatility in the forex market, economic sanctions, changes in the fiscal/monetary policies, general slowdown of the economy, market risk events, extreme liquidity conditions, etc.). The stress tests would reveal undetected areas of potential credit risk exposure and linkages between different categories of risk. In adverse circumstances, there may be substantial correlation of various risks, especially credit and market risks. Stress testing can range from relatively simple alterations in assumptions about one or more financial, structural or economic variables to the use of highly sophisticated models. The output of such portfolio-wide stress tests should be reviewed by the Board and suitable changes may be made in prudential risk limits for

45 protecting the quality. Stress tests could also include contingency plans, detailing management responses to stressful situations.
6)

Introduce discriminatory time schedules for renewal of borrower limits. Lower rated borrowers whose financials show signs of problems should be subjected to renewal control twice/thrice a year.

Banks should evolve suitable framework for monitoring the market risks especially forex risk exposure of corporates who have no natural hedges on a regular basis. Banks should also appoint Portfolio Managers to watch the loan portfolios degree of concentrations and exposure to counterparties. For comprehensive evaluation of customer exposure, banks may consider appointing Relationship Managers to ensure that overall exposure to a single borrower is monitored, captured and controlled. The Relationship Managers have to work in coordination with the Treasury and Forex Departments. The Relationship Managers may service mainly high value loans so that a substantial share of the loan portfolio, which can alter the risk profile, would be under constant surveillance. Further, transactions with affiliated companies/groups need to be aggregated and maintained close to real time. The banks should also put in place formalised systems for identification of accounts showing pronounced credit weaknesses well in advance and also prepare internal guidelines for such an exercise and set time frame for deciding courses of action. Many of the international banks have adopted credit risk models for evaluation of credit portfolio. The credit risk models offer banks framework for examining credit risk exposures, across geographical locations and product lines in a timely manner, centralising data and analysing marginal and absolute contributions to risk. The models also provide estimates of credit risk (unexpected loss) which reflect individual portfolio composition. The Altmans Z score forecasts the probability of a company entering bankruptcy within a 12month period. The model combines five financial ratios using reported accounting information and equity values to produce an objective measure of borrowers financial health. J. P. Morgan has developed a portfolio model CreditMetrics for evaluating credit risk. The models basically focus on estimating the volatility in the value of assets caused by variations in the quality

46 of assets. The volatility is computed by tracking the probability that the

borrower might migrate from one rating category to another (downgrade or upgrade). Thus, the value of loans can change over time, reflecting migration of the borrowers to a different risk-rating grade. The model can be used for promoting transparency in credit risk, establishing benchmark for credit risk measurement and estimating economic capital for credit risk under RAROC framework. Credit Suisse developed a statistical method for measuring and accounting for credit risk which is known as CreditRisk+. The model is based on actuarial calculation of expected default rates and unexpected losses from default. The banks may evaluate the utility of these models with suitable modifications to Indian environment for fine-tuning the credit risk management. The success of credit risk models impinges on time series data on historical loan loss rates and other model variables, spanning multiple credit cycles. risk modeling after a specified period of time. Banks may, therefore, Endeavour building adequate database for switching over to credit

Loan Review Mechanism (LRM) LRM is an effective tool for constantly evaluating the quality of loan book and to bring about qualitative improvements in credit administration. Banks should, therefore, put in place proper Loan Review Mechanism for large value accounts with responsibilities assigned in various areas such as, evaluating the effectiveness of loan administration, maintaining the integrity of credit grading process, assessing the loan loss provision, portfolio quality, etc. The complexity and scope of LRM normally vary based on banks size, type of operations and management practices. It may be independent of the CRMD or even separate Department in large banks. The main objectives of LRM could be: to identify promptly loans which develop credit weaknesses and initiate timely corrective action; to evaluate portfolio quality and isolate potential problem areas; to provide information for determining adequacy of loan loss provision;

47 to assess the adequacy of and adherence to, loan policies and procedures, and to monitor compliance with relevant laws and regulations; and to provide top management with information on credit administration, including credit sanction process, risk evaluation and post-sanction followup. Accurate and timely credit grading is one of the basic components of an effective LRM. Credit grading involves assessment of credit quality, identification of problem loans, and assignment of risk ratings. A proper Credit Grading System should support evaluating the portfolio quality and establishing loan loss provisions. Given the importance and subjective nature of credit rating, the credit ratings awarded by Credit Administration Department should be subjected to review by Loan Review Officers who are independent of loan administration. Banks should formulate Loan Review Policy and it should be reviewed annually by the Board. The Policy should, inter alia, address: Qualification and Independence The Loan Review Officers should have sound knowledge in credit appraisal, lending practices and loan policies of the bank. They should also be well The versed in the relevant laws/regulations that affect lending activities.

independence of Loan Review Officers should be ensured and the findings of the reviews should also be reported directly to the Board or Committee of the Board. Frequency and Scope of Reviews The Loan Reviews are designed to provide feedback on effectiveness of credit sanction and to identify incipient deterioration in portfolio quality. Reviews of high value loans should be undertaken usually within three months of sanction/renewal or more frequently when factors indicate a potential for deterioration in the credit quality. The scope of the review should cover all loans above a cut-off limit. In addition, banks should also target other accounts that present elevated risk characteristics. At least 30-40% of the portfolio

48 should be subjected to LRM in a year to provide reasonable assurance that all the major credit risks embedded in the balance sheet have been tracked. Depth of Reviews The loan reviews should focus on: Approval process; Accuracy and timeliness of credit ratings assigned by loan officers; Adherence to internal policies and procedures, and applicable laws / regulations; Compliance with loan covenants; Post-sanction follow-up; Sufficiency of loan documentation; Portfolio quality; and Recommendations for improving portfolio quality

The findings of Reviews should be discussed with line Managers and the corrective actions should be elicited for all deficiencies. remain unresolved should be reported to top management. The Risk Management Group of the Basle Committee on Banking Supervision has released a consultative paper on Principles for the Management of Credit Risk. The Paper deals with various aspects relating to credit risk management. The Paper is enclosed for information of banks. Credit Risk and Investment Banking Significant magnitude of credit risk, in addition to market risk, is inherent in investment banking. The proposals for investments should also be subjected to the same degree of credit risk analysis, as any loan proposals. The proposals should be subjected to detailed appraisal and rating framework that factors in financial and non-financial parameters of issuers, sensitivity to external developments, etc. The maximum exposure to a customer should be bank-wide and include all exposures assumed by the Credit and Treasury Departments. The coupon on non-sovereign papers should be commensurate with their risk profile. The banks should exercise due caution, particularly in investment proposals, which are not rated and should ensure comprehensive Deficiencies that

49 risk evaluation. There should be greater interaction between Credit and

Treasury Departments and the portfolio analysis should also cover the total exposures, including investments. The rating migration of the issuers and the consequent diminution in the portfolio quality should also be tracked at periodic intervals. As a matter of prudence, banks should stipulate entry level minimum ratings/quality standards, industry, maturity, duration, issuer-wise, etc. limits in investment proposals as well to mitigate the adverse impacts of concentration and the risk of liquidity.

Credit Risk in Off-balance Sheet Exposure Banks should evolve adequate framework for managing their exposure in offbalance sheet products like forex forward contracts, swaps, options, etc. as a part of overall credit to individual customer relationship and subject to the same credit appraisal, limits and monitoring procedures. Banks should classify their off-balance sheet exposures into three broad categories - full risk (credit substitutes) - standby letters of credit, money guarantees, etc, medium risk (not direct credit substitutes, which do not support existing financial obligations) - bid bonds, letters of credit, indemnities and warranties and low risk - reverse repos, currency swaps, options, futures, etc. The trading credit exposure to counter parties can be measured on static (constant percentage of the notional principal over the life of the transaction) and on a dynamic basis. The total exposures to the counter parties on a dynamic basis should be the sum total of:
1) 2)

The current replacement cost (unrealized loss to the counter party); and The potential increase in replacement cost (estimated with the help of VaR or other methods to capture future volatilitys in the value of the outstanding contracts/ obligations).

The current and potential credit exposures may be measured on a daily basis to evaluate the impact of potential changes in market conditions on the value of counter party positions. The potential exposures also may be quantified by

50 subjecting the position to market movements involving normal and abnormal movements in interest rates, foreign exchange rates, equity prices, liquidity conditions, etc.

INTER-BANK EXPOSURE AND COUNTRY RISK

A suitable framework should be evolved to provide a centralised overview on the aggregate exposure on other banks. Bank-wise exposure limits could be set on the basis of assessment of financial performance, operating efficiency, management quality, past experience, etc. Like corporate clients, banks should also be rated and placed in range of 1-5, 1-8, as the case may be, on the basis of their credit quality. The limits so arrived at should be allocated to various operating centers and followed up and half-yearly/annual reviews undertaken at a single point. Regarding exposure on overseas banks, banks can use the country ratings of international rating agencies and classify the countries into low risk, moderate risk and high risk. Banks should Endeavour for developing an internal matrix that reckons the counter party and country risks. The maximum exposure should be subjected to adherence of country and bank exposure limits already in place. While the exposure should at least be monitored on a weekly basis till the banks are equipped to monitor exposures on a real time basis, all exposures to problem countries should be evaluated on a real time basis.

Market Risk Traditionally, credit risk management was the primary challenge for banks. With progressive deregulation, market risk arising from adverse changes in market variables, such as interest rate, foreign exchange rate, equity price and commodity price has become relatively more important. Even a small change in market variables causes substantial changes in income and economic value of banks. Market risk takes the form of: 1) Liquidity Risk 2) Interest Rate Risk

51 3) Foreign Exchange Rate (Forex) Risk 4) Commodity Price Risk and 5) Equity Price Risk

Market Risk Management

Management of market risk should be the major concern of top management of banks. The Boards should clearly articulate market risk management policies, procedures, prudential risk limits, review mechanisms and reporting and auditing systems. The policies should address the banks exposure on a consolidated basis and clearly articulate the risk measurement systems that capture all material sources of market risk and assess the effects on the bank. The operating prudential limits and the accountability of the line management should also be clearly defined. The Asset-Liability Management Committee (ALCO) should function as the top operational unit for managing the balance sheet within the performance/risk parameters laid down by the Board. The banks should also set up an independent Middle Office to track the magnitude of market risk on a real time basis. The Middle Office should comprise of experts in market risk management, economists, statisticians and general bankers and may be functionally placed directly under the ALCO. The Middle Office should also be separated from Treasury Department and should not be involved in the day to day management of Treasury. The Middle Office should apprise the top management / ALCO / Treasury about adherence to prudential / risk parameters and also aggregate the total market risk exposures assumed by the bank at any point of time.

Liquidity Risk Liquidity Planning is an important facet of risk management framework in banks. Liquidity is the ability to efficiently accommodate deposit and other liability decreases, as well as, fund loan portfolio growth and the possible funding of off-balance sheet claims. A bank has adequate liquidity when sufficient funds can be raised, either by increasing liabilities or converting

52 assets, promptly and at a reasonable cost. It encompasses the potential sale of liquid assets and borrowings from money, capital and forex markets. Thus, liquidity should be considered as a defense mechanism from losses on fire sale of assets. 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:

i)

Funding Risk need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);

ii)

Time Risk - need to compensate for non-receipt of expected inflows of funds, i.e. performing assets turning into non-performing assets; and

iii)

Call Risk - due to crystallization of contingent liabilities and unable to undertake profitable business opportunities when desirable.

The first step towards liquidity management is to put in place an effective liquidity management policy, which, inter alia, should spell out the funding strategies, liquidity planning under alternative scenarios, prudential limits, liquidity reporting / reviewing, etc. Liquidity measurement is quite a difficult task and can be measured through stock or cash flow approaches. The key ratios, adopted across the banking system are:

i) ii) iii)

Loans to Total Assets Loans to Core Deposits Large Liabilities (minus) Temporary Investments to Earning Assets (minus) Temporary Investments, where large liabilities represent wholesale deposits which are market sensitive and temporary Investments are those maturing within one year and those investments which are held in the trading book and are readily sold in the market;

53 iv) Purchased Funds to Total Assets, where purchased funds include the entire inter-bank and other money market borrowings, including Certificate of Deposits and institutional deposits; and v) Loan Losses/Net Loans.

While the liquidity ratios are the ideal indicator of liquidity of banks operating in developed financial markets, the ratios do not reveal the intrinsic liquidity profile of Indian banks which are operating generally in an illiquid market. Experiences show that assets commonly considered as liquid like Government securities, other money market instruments, etc. have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches. For measuring and managing net funding requirements, the use of maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is recommended as a standard tool. The format prescribed by RBI in this regard under ALM System should be adopted for measuring cash flow mismatches at different time bands. The cash flows should be placed in different time bands based on future behaviour of assets, liabilities and off-balance sheet items. In other words, banks should have to analyze the behavioural maturity profile of various components of on / off-balance sheet items on the basis of assumptions and trend analysis supported by time series analysis. Banks should also undertake variance The analysis, at least, once in six months to validate the assumptions.

assumptions should be fine-tuned over a period which facilitate near reality predictions about future behaviour of on / off-balance sheet items. Apart from the above cash flows, banks should also track the impact of prepayments of loans, premature closure of deposits and exercise of options built in certain instruments which offer put/call options after specified times. Thus, cash outflows can be ranked by the date on which liabilities fall due, the earliest date a liability holder could exercise an early repayment option or the earliest date contingencies could be crystallized.

The difference between cash inflows and outflows in each time period, the excess or deficit of funds, becomes a starting point for a measure of a banks

54 future liquidity surplus or deficit, at a series of points of time. The banks should also consider putting in place certain prudential limits to avoid liquidity crisis: 1. Cap on inter-bank borrowings, especially call borrowings; 2. Purchased funds vis--vis liquid assets; 3. Core deposits vis--vis Core Assets i.e. Cash Reserve Ratio, Liquidity Reserve Ratio and Loans; 4. Duration of liabilities and investment portfolio; 5. Maximum Cumulative Outflows. Banks should fix cumulative mismatches across all time bands; 6. Commitment Ratio track the total commitments given to corporate/banks and other financial institutions to limit the off-balance sheet exposure; 7. Swapped Funds Ratio, i.e. extent of Indian Rupees raised out of foreign currency sources.

Banks should also evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs.1 crore or more to track the volatile liabilities. Further the cash flows arising out of contingent liabilities in normal situation and the scope for an increase in cash flows during periods of stress should also be estimated. It is quite possible that market crisis can trigger substantial increase in the amount of draw downs from cash credit/overdraft accounts, contingent liabilities like letters of credit, etc. The liquidity profile of the banks could be analysed on a static basis, wherein the assets and liabilities and off-balance sheet items are pegged on a particular day and the behavioural pattern and the sensitivity of these items to changes in market interest rates and environment are duly accounted for. The banks can also estimate the liquidity profile on a dynamic way by giving due importance to: 1) Seasonal pattern of deposits/loans;

55 2) Potential liquidity needs for meeting new loan demands, unavailed credit limits, loan policy, potential deposit losses, investment obligations, statutory obligations, etc. ALTERNATIVE SCENARIOS The liquidity profile of banks depends on the market conditions, which influence the cash flow behaviour. Thus, banks should evaluate liquidity profile under different conditions, viz. normal situation, bank specific crisis and market crisis scenario. The banks should establish benchmark for normal situation; cash flow profile of on / off balance sheet items and manages net funding requirements.

Estimating liquidity under bank specific crisis should provide a worst-case benchmark. It should be assumed that the purchased funds could not be easily rolled over; some of the core deposits could be prematurely closed; a substantial share of assets have turned into non-performing and thus become totally illiquid. These developments would lead to rating down grades and high cost of liquidity. The banks should evolve contingency plans to overcome such situations. The market crisis scenario analyses cases of extreme tightening of liquidity conditions arising out of monetary policy stance of Reserve Bank, general perception about risk profile of the banking system, severe market disruptions, failure of one or more of major players in the market, financial crisis, contagion, etc. Under this scenario, the rollover of high value customer deposits and purchased funds could extremely be difficult besides flight of volatile deposits / liabilities. The banks could also sell their investment with huge discounts, entailing severe capital loss. Contingency Plan Banks should prepare Contingency Plans to measure their ability to withstand bank-specific or market crisis scenario. The blue-print for asset sales, market access, capacity to restructure the maturity and composition of assets and liabilities should be clearly documented and alternative options of funding in the

56 event of banks failure to raise liquidity from existing source/s could be clearly articulated. Liquidity from the Reserve Bank, arising out of its refinance window and interim liquidity adjustment facility or as lender of last resort should not be reckoned for contingency plans. Availability of back-up liquidity support in the form of committed lines of credit, reciprocal arrangements, liquidity support from other external sources, liquidity of assets, etc. should also be clearly established.

Interest Rate Risk (IRR) The management of Interest Rate Risk should be one of the critical components of market risk management in banks. The regulatory restrictions in the past had greatly reduced many of the risks in the banking system. Deregulation of interest rates has, however, exposed them to the adverse impacts of interest rate risk. The Net Interest Income (NII) or Net Interest Margin (NIM) of banks is dependent on the movements of interest rates. Any mismatches in the cash flows (fixed assets or liabilities) or reprising dates (floating assets or liabilities), expose banks NII or NIM to variations. interest rate volatility. The earning of assets and the cost of liabilities are now closely related to market

Interest Rate Risk (IRR) refers to potential impact on NII or NIM or Market Value of Equity (MVE), caused by unexpected changes in market interest rates. Interest Rate Risk can take different forms: Types of Interest Rate Risk Gap or Mismatch Risk: A gap or mismatch risk arises from holding assets and liabilities and offbalance sheet items with different principal amounts, maturity dates or reprising dates, thereby creating exposure to unexpected changes in the level of market interest rates.

57 Basis Risk Market interest rates of various instruments seldom change by the same degree during a given period of time. The risk that the interest rate of different assets, liabilities and off-balance sheet items may change in different magnitude is termed as basis risk. The degree of basis risk is fairly high in respect of banks that create composite assets out of composite liabilities. The Loan book in India is funded out of a composite liability portfolio and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile interest rate scenarios. When the variation in market interest rate causes the NII to expand, the banks have experienced favorable basis shifts and if the interest rate movement causes the NII to contract, the basis has moved against the banks. Embedded Option Risk Significant changes in market interest rates create another source of risk to banks profitability by encouraging prepayment of cash credit/demand loans/term loans and exercise of call/put options on bonds/debentures and/or premature withdrawal of term deposits before their stated maturities. The embedded option risk is becoming a reality in India and is experienced in volatile situations. The faster and higher the magnitude of changes in interest rate, the greater will be the embedded option risk to the banks NII. Thus, banks should evolve scientific techniques to estimate the probable embedded options and adjust the Gap statements (Liquidity and Interest Rate Sensitivity) to realistically estimate the risk profiles in their balance sheet. Banks should also endeavour for stipulating appropriate penalties based on opportunity costs to stem the exercise of options, which is always to the disadvantage of banks.

Yield Curve Risk In a floating interest rate scenario, banks may price their assets and liabilities based on different benchmarks, i.e. TBs yields, fixed deposit rates, call money rates, MIBOR, etc. In case the banks use two different instruments maturing at different time horizon for pricing their assets and liabilities, any non-parallel movements in yield curves would affect the NII. The movements in yield curve

58 are rather frequent when the economy moves through business cycles. Thus, banks should evaluate the movement in yield curves and the impact of that on the portfolio values and income. Price Risk Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The price risk is closely associated with the trading book, which is created for making profit out of short-term movements in interest rates. Banks which have an active trading book should, therefore, formulate policies to limit the portfolio size, holding period, duration, defeasance period, stop loss limits, marking to market, etc.0 Reinvestment Risk Uncertainty with regard to interest rate at which the future cash flows could be reinvested is called reinvestment risk. Any mismatches in cash flows would expose the banks to variations in NII as the market interest rates move in different directions. Net Interest Position Risk The size of nonpaying liabilities is one of the significant factors contributing towards profitability of banks. When banks have more earning assets than paying liabilities, interest rate risk arises when the market interest rates adjust downwards. Thus, banks with positive net interest positions will experience a reduction in NII as the market interest rate declines and increases when interest rate rises. Thus, large float is a natural hedge against the variations in interest rates. Measuring Interest Rate Risk Before interest rate risk could be managed, they should be identified and quantified. Unless the quantum of IRR inherent in the balance sheet is identified, it is impossible to measure the degree of risks to which banks are exposed. It is also equally impossible to develop effective risk management strategies/hedging techniques without being able to understand the correct risk position of banks. The IRR measurement system should address all material

59 sources of interest rate risk including gap or mismatch, basis, embedded option, yield curve, price, reinvestment and net interest position risks exposures. The IRR measurement system should also take into account the specific characteristics of each individual interest rate sensitive position and should capture in detail the full range of potential movements in interest rates. There are different techniques for measurement of interest rate risk, ranging from the traditional Maturity Gap Analysis (to measure the interest rate sensitivity of earnings), Duration (to measure interest rate sensitivity of capital), Simulation and Value at Risk. While these methods highlight different facets of interest rate risk, many banks use them in combination, or use hybrid methods that combine features of all the techniques. Generally, the approach towards measurement and hedging of IRR varies with the segmentation of the balance sheet. In a well functioning risk management system, banks broadly position their balance sheet into Trading and Investment or Banking Books. While the assets in the trading book are held primarily for generating profit on short-term differences in prices/yields, the banking book comprises assets and liabilities, which are contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity. Thus, while the price risk is the prime concern of banks in trading book, the earnings or economic value changes are the main focus of banking book.

Trading Book The top management of banks should lay down policies with regard to volume, maximum maturity, holding period, duration, stop loss, defeasance period, rating standards, etc. for classifying securities in the trading book. While the securities held in the trading book should ideally be marked to market on a daily basis, the potential price risk to changes in market risk factors should be estimated through internally developed Value at Risk (VaR) models. The VaR method is employed to assess potential loss that could crystalise on trading position or portfolio due to variations in market interest rates and prices, using a given confidence level, usually 95% to 99%, within a defined period of time.

60 The VaR method should incorporate the market factors against which the market value of the trading position is exposed. The top management should put in place bank-wide VaR exposure limits to the trading portfolio (including forex and gold positions, derivative products, etc.) which is then disaggregated across different desks and departments. The loss making tolerance level should also be stipulated to ensure that potential impact on earnings is managed within acceptable limits. The potential loss in Present Value Basis Points should be matched by the Middle Office on a daily basis vis--vis the prudential limits set by the Board. The advantage of using VaR is that it is comparable across products, desks and Departments and it can be validated through back testing. However, VaR models require the use of extensive historical data to estimate future volatility. VaR model also may not give good results in extreme volatile conditions or outlier events and stress test has to be employed to complement VaR. The stress tests provide management a view on the potential impact of large size market movements and also attempt to estimate the size of potential losses due to stress events, which occur in the tails of the loss distribution. Banks may also undertake scenario analysis with specific possible stress situations (recently experienced in some countries) by linking hypothetical, simultaneous and related changes in multiple risk factors present in the trading portfolio to determine the impact of moves on the rest of the portfolio. VaR models could also be modified to reflect liquidity risk differences observed across assets over time. International banks are now estimating Liquidity adjusted Value at Risk (LaVaR) by assuming variable time horizons based on position size and relative turnover. In an environment where VaR is difficult to estimate for lack of data, non-statistical concepts such as stop loss and gross/net positions can be used. Banking Book The changes in market interest rates have earnings and economic value impacts on the banks banking book. Thus, given the complexity and range of balance sheet products, banks should have IRR measurement systems that assess the effects of the rate changes on both earnings and economic value. The variety of techniques ranges from simple maturity (fixed rate) and reprising (floating rate) to static simulation, based on current on-and-off-balance sheet

61 positions, to highly sophisticated dynamic modeling techniques that incorporate assumptions on behavioural pattern of assets, liabilities and off-balance sheet items and can easily capture the full range of exposures against basis risk, embedded option risk, yield curve risk, etc. Maturity Gap Analysis The simplest analytical techniques for calculation of IRR exposure begins with maturity Gap analysis that distributes interest rate sensitive assets, liabilities and off-balance sheet positions into a certain number of pre-defined time-bands according to their maturity (fixed rate) or time remaining for their next reprising (floating rate). Those assets and liabilities lacking definite reprising intervals (savings bank, cash credit, overdraft, loans, export finance, refinance from RBI etc.) or actual maturities vary from contractual maturities (embedded option in bonds with put/call options, loans, cash credit/overdraft, time deposits, etc.) are assigned time-bands according to the judgement, empirical studies and past experiences of banks.

A number of time bands can be used while constructing a gap report. Generally, most of the banks focus their attention on near-term periods, viz. monthly, quarterly, half-yearly or one year. It is very difficult to take a view on interest rate movements beyond a year. Banks with large exposures in the short-term should test the sensitivity of their assets and liabilities even at shorter intervals like overnight, 1-7 days, 8-14 days, etc. In order to evaluate the earnings exposure, interest Rate Sensitive Assets (RSAs) in each time band are netted with the interest Rate Sensitive Liabilities (RSLs) to produce a reprising Gap for that time band. The positive Gap indicates that banks have more RSAs than RSLs. A positive or asset sensitive Gap means that an increase in market interest rates could cause an increase in NII. Conversely, a negative or liability sensitive Gap implies that the banks NII could decline as a result of increase in market interest rates. The negative gap indicates that banks have more RSLs than RSAs. The Gap is used as a measure of interest rate sensitivity. The Positive or Negative Gap is multiplied

62 by the assumed interest rate changes to derive the Earnings at Risk (EaR). The EaR method facilitates to estimate how much the earnings might be impacted by an adverse movement in interest rates. The changes in interest rate could be estimated on the basis of past trends, forecasting of interest rates, etc. The banks should fix EaR which could be based on last/current years income and a trigger point at which the line management should adopt on-or off-balance sheet hedging strategies may be clearly defined. The Gap calculations can be augmented by information on the average coupon on assets and liabilities in each time band and the same could be used to calculate estimates of the level of NII from positions maturing or due for reprising within a given time-band, which would then provide a scale to assess the changes in income implied by the gap analysis. The periodic gap analysis indicates the interest rate risk exposure of banks over distinct maturities and suggests magnitude of portfolio changes necessary to alter the risk profile. However, the Gap report quantifies only the time difference between reprising dates of assets and liabilities but fails to measure the impact of basis and embedded option risks. The Gap report also fails to measure the entire impact of a change in interest rate (Gap report assumes that all assets and liabilities are matured or reprised simultaneously) within a given time-band and effect of changes in interest rates on the economic or market value of assets, liabilities and off-balance sheet position. It also does not take into account any differences in the timing of payments that might occur as a result of changes in interest rate environment. Further, the assumption of parallel shift in yield curves seldom happen in the financial market. The Gap report also fails to capture variability in non-interest revenue and expenses, a potentially important source of risk to current income. In case banks could realistically estimate the magnitude of changes in market interest rates of various assets and liabilities (basis risk) and their past behavioural pattern (embedded option risk), they could standardize the gap by multiplying the individual assets and liabilities by how much they will change for a given change in interest rate. Thus, one or several assumptions of

63 standardized gap seem more consistent with real world than the simple gap method. With the Adjusted Gap, banks could realistically estimate the EaR. Duration Gap Analysis Matching the duration of assets and liabilities, instead of matching the maturity or repricing dates is the most effective way to protect the economic values of banks from exposure to IRR than the simple gap model. Duration gap model focuses on managing economic value of banks by recognising the change in the market value of assets, liabilities and off-balance sheet (OBS) items. When weighted assets and liabilities and OBS duration are matched, market interest rate movements would have almost same impact on assets, liabilities and OBS, thereby protecting the banks total equity or net worth. Duration is a measure of the percentage change in the economic value of a position that will occur given a small change in the level of interest rates. Measuring the duration gap is more complex than the simple gap model. For approximation of duration of assets and liabilities, the simple gap schedule can be used by applying weights to each time-band. The weights are based on estimates of the duration of assets and liabilities and OBS that fall into each time band. The weighted duration of assets and liabilities and OBS provide a rough estimation of the changes in banks economic value to a given change in market interest rates. It is also possible to give different weights and interest rates to assets, liabilities and OBS in different time buckets to capture differences in coupons and maturities and volatilities in interest rates along the yield curve. In a more scientific way, banks can precisely estimate the economic value changes to market interest rates by calculating the duration of each asset, liability and OBS position and weigh each of them to arrive at the weighted duration of assets, liabilities and OBS. Once the weighted duration of assets and liabilities are estimated, the duration gap can be worked out with the help of standard mathematical formulae. The Duration Gap measure can be used to estimate the expected change in Market Value of Equity (MVE) for a given change in market interest rate.

64

The difference between duration of assets (DA) and liabilities (DL) is banks net duration. If the net duration is positive (DA>DL), a decrease in market interest rates will increase the market value of equity of the bank. When the duration gap is negative (DL> DA), the MVE increases when the interest rate increases but decreases when the rate declines. Thus, the Duration Gap shows the impact of the movements in market interest rates on the MVE through influencing the market value of assets, liabilities and OBS. The attraction of duration analysis is that it provides a comprehensive measure of IRR for the total portfolio. The duration analysis also recognises the time value of money. Duration measure is additive so that banks can match total assets and liabilities rather than matching individual accounts. However, Duration Gap analysis assumes parallel shifts in yield curve. For this reason, it fails to recognise basis risk. Simulation Many of the international banks are now using balance sheet simulation models to gauge the effect of market interest rate variations on reported earnings/economic values over different time zones. Simulation technique attempts to overcome the limitations of Gap and Duration approaches by computer modeling the banks interest rate sensitivity. Such modeling involves making assumptions about future path of interest rates, shape of yield curve, changes in business activity, pricing and hedging strategies, etc. The simulation involves detailed assessment of the potential effects of changes in interest rate on earnings and economic value. on-and off-balance sheet positions. The simulation techniques involve detailed analysis of various components of Simulations can also incorporate more varied and refined changes in the interest rate environment, ranging from changes in the slope and shape of the yield curve and interest rate scenario derived from Monte Carlo simulations. The output of simulation can take a variety of forms, depending on users need. Simulation can provide current and expected periodic gaps, duration gaps,

65 balance sheet and income statements, performance measures, budget and financial reports. The simulation model provides an effective tool for understanding the risk exposure under variety of interest rate/balance sheet scenarios. This technique also plays an integral-planning role in evaluating the effect of alternative business strategies on risk exposures. The simulation can be carried out under static and dynamic environment. While the current on and off-balance sheet positions are evaluated under static environment, the dynamic simulation builds in more detailed assumptions about the future course of interest rates and the unexpected changes in banks business activity. The usefulness of the simulation technique depends on the structure of the model, validity of assumption, technology support and technical expertise of banks. The application of various techniques depends to a large extent on the quality of data and the degree of automated system of operations. Thus, banks may start with the gap or duration gap or simulation techniques on the basis of availability of data, information technology and technical expertise. In any case, as suggested by RBI in the guidelines on ALM System, banks should start estimating the interest rate risk exposure with the help of Maturity Gap approach. Once banks are comfortable with the Gap model, they can progressively graduate into the sophisticated approaches. Funds Transfer Pricing The Transfer Pricing mechanism being followed by many banks does not support good ALM Systems. Many international banks which have different products and operate in various geographic markets have been using internal Funds Transfer Pricing (FTP). FTP is an internal measurement designed to assess the financial impact of uses and sources of funds and can be used to evaluate the profitability. It can also be used to isolate returns for various risks assumed in the intermediation process. FTP also helps correctly identify the cost of opportunity value of funds. Although banks have adopted various FTP frameworks and techniques, Matched Funds Pricing (MFP) is the most efficient technique. Most of the international banks use MFP. The FTP envisages

66 assignment of specific assets and liabilities to various functional units (profit centers) lending, investment, deposit taking and funds management. Each unit attracts sources and uses of funds. The lending, investment and deposit taking profit centers sell their liabilities to and buys funds for financing their assets from the funds management profit centre at appropriate transfer prices. The transfer prices are fixed on the basis of a single curve (MIBOR or derived cash curve, etc) so that asset-liability transactions of identical attributes are assigned identical transfer prices. Transfer prices could, however, vary according to maturity, purpose, terms and other attributes. The FTP provides for allocation of margin (franchise and credit spreads) to profit centers on original transfer rates and any residual spread (mismatch spread) is credited to the funds management profit centre. This spread is the result of accumulated mismatches. The margins of various profit centers are: Deposit profit centre:

Transfer Price (TP) on deposits - cost of deposits deposit insuranceoverheads. Lending profit centre: Loan yields + TP on deposits TP on loan financing cost of deposits deposit insurance - overheads loan loss provisions.

Investment profit centre:

Security yields + TP on deposits TP on security financing cost of deposits deposit insurance - overheads provisions for depreciation in investments and loan loss. Funds Management profit centre:

TP on funds lent TP on funds borrowed Statutory Reserves cost overheads.

67

For illustration, let us assume that a banks Deposit profit centre has raised a 3 month deposit @ 6.5% p.a. and that the alternative funding cost i.e. MIBOR for 3 months and one year @ 8% and 10.5% p.a., respectively. Let us also assume that the banks Loan profit centre created a one year loan @ 13.5% p.a. The franchise (liability), credit and mismatch spreads of bank is as under: Deposit 8.0 6.5 1.5 0.1 0.6 0.8 Profit Centers Funds 10.5 8.0 2.5 1.0 0.5 1.0 Total Loan 13.5 10.5 3.0 1.0 0.6 1.4 13.5 6.5 7.0 1.0 0.1 1.0 1.7 3.2

Interest Income Interest Expenditure Margin Loan Loss Provision (expected) Deposit Insurance Reserve Cost (CRR/ SLR) Overheads

NII

Under the FTP mechanism, the profit centers (other than funds management) are precluded from assuming any funding mismatches and thereby exposing them to market risk. The credit or counterparty and price risks are, however, managed by these profit centers. The entire market risks, i.e. interest rate, liquidity and forex are assumed by the funds management profit centre. The FTP allows lending and deposit raising profit centers determine their expenses and price their products competitively. Lending profit centre which knows the carrying cost of the loans needs to focus on to price only the spread necessary to compensate the perceived credit risk and operating expenses. Thus, FTP system could effectively be used as a way to centralise the banks overall market risk at one place and would support an effective ALM modeling system. FTP also could be used to enhance corporate communication; greater line management control and solid base for rewarding line management.

FOREIGN EXCHANGE (FOREX) RISK

68 The risk inherent in running open foreign exchange positions have been heightened in recent years by the pronounced volatility in forex rates, thereby adding a new dimension to the risk profile of banks balance sheets. 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. The banks are also exposed to interest rate risk, which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premia/discounts of the currencies concerned. In the forex business, banks also face the risk of default of the counter parties or settlement risk. While such type of risk crystallisation does not cause Thus, banks may incur principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or Herstatt risk which arises out of time-lags in settlement of one currency in one centre and the settlement of another currency in another time-zone. The forex transactions with counter parties from another country also trigger sovereign or country risk. Forex Risk Management Measures 1. Set appropriate limits open positions and gaps. 2. Clear-cut and well-defined division of responsibility between front, middle and back offices. The top management should also adopt the VaR approach to measure the risk associated with exposures. Reserve Bank of India has recently introduced two statements viz. Maturity and Position (MAP) and Interest Rate Sensitivity (SIR) for measurement of forex risk exposures. Banks should use these statements for periodical monitoring of forex risk exposures.

69

Capital for Market Risk

The Basle Committee on Banking Supervision (BCBS) had issued comprehensive guidelines to provide an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities. The banks have been given flexibility to use in-house models based on VaR for measuring market risk as an alternative to a standardised measurement framework suggested by Basle Committee. The internal models should, however, comply with quantitative and qualitative criteria prescribed by Basle Committee. Reserve Bank of India has accepted the general framework suggested by the Basle Committee. RBI has also initiated various steps in moving towards prescribing capital for market risk. As an initial step, a risk weight of 2.5% has been prescribed for investments in Government and other approved securities, besides a risk weight each of 100% on the open position limits in forex and gold. RBI has also prescribed detailed operating guidelines for Asset-Liability Management System in banks. As the ability of banks to identify and measure market risk improves, it would be necessary to assign explicit capital charge for market risk. In the meanwhile, banks are advised to study the Basle Committees paper on Overview of the Amendment to the Capital Accord to Incorporate Market Risks January 1996 (copy enclosed). While the small banks operating predominantly in India could adopt the standardised methodology, large banks and those banks operating in international markets should develop expertise in evolving internal models for measurement of market risk. The Basle Committee on Banking Supervision proposes to develop capital charge for interest rate risk in the banking book as well for banks where the interest rate risks are significantly above average (outliers). The Committee is now exploring various methodologies for identifying outliers and how best to apply and calibrate a capital charge for interest rate risk for banks. Once the Committee finalises the modalities, it may be necessary, at least for banks

70 operating in the international markets to comply with the explicit capital charge requirements for interest rate risk in the banking book.

Operational Risk
Managing operational risk is becoming an important feature of sound risk management practices in modern financial markets in the wake of phenomenal increase in the volume of transactions, high degree of structural changes and complex support systems. The most important type of operational risk involves breakdowns in internal controls and corporate governance. Such breakdowns can lead to financial loss through error, fraud, or failure to perform in a timely manner or cause the interest of the bank to be compromised.

Generally, operational risk is defined as any risk, which is not categorized as market or credit risk, or the risk of loss arising from various types of human or technical error. It is also synonymous with settlement or payments risk and business interruption, administrative and legal risks. Operational risk has some form of link between credit and market risks. An operational problem with a business transaction could trigger a credit or market risk.

Measurement There is no uniformity of approach in measurement of operational risk in the banking system. Besides, the existing methods are relatively simple and experimental, although some of the international capital with regard to operational risk. Measuring operational risk requires both estimating the probability of an operational loss event and the potential size of the loss. It relies on risk factor that provides some indication of the likelihood of an operational loss event occurring. The process of operational risk assessment needs to address the likelihood (or frequency) of a particular operational risk occurring, the magnitude (or severity) of the effect of the operational risk on business objectives and the options available to manage and initiate actions to reduce/ banks have made considerable progress in developing more advanced techniques for allocating

71 mitigate operational risk. The set of risk factors that measure risk in each business unit such as audit ratings, operational data such as volume, turnover and complexity and data on quality of operations such as error rate or measure of business risks such as revenue volatility, could be related to historical loss experience. Banks can also use different analytical or judgmental techniques to arrive at an overall operational risk level. Some of the international banks have already developed operational risk rating matrix, similar to bond credit rating. The operational risk assessment should be bank-wide basis and it should be reviewed at regular intervals. Banks, over a period, should develop internal systems to evaluate the risk profile and assign economic capital within the RAROC framework. Indian banks have so far not evolved any scientific methods for quantifying operational risk. In the absence any sophisticated models, banks could evolve simple benchmark based on an aggregate measure of business activity such as gross revenue, fee income, operating costs, managed assets or total assets adjusted for off-balance sheet exposures or a combination of these variables.

Risk Monitoring The operational risk monitoring system focuses, inter alia, on operational performance measures such as volume, turnover, settlement facts, delays and errors. It could also be incumbent to monitor operational loss directly with an analysis of each occurrence and description of the nature and causes of the loss. Control of Operational Risk Internal controls and the internal audit are used as the primary means to mitigate operational risk. Banks could also explore setting up operational risk limits, based on the measures of operational risk. The contingent processing capabilities could also be used as a means to limit the adverse impacts of operational risk. Insurance is also an important mitigator of some forms of operational risk. Risk education for familiarising the complex operations at all levels of staff can also reduce operational risk.

72

Policies and Procedures Banks should have well defined policies on operational risk management. The policies and procedures should be based on common elements across business lines or risks. The policy should address product review process, involving business, risk management and internal control functions.

Internal Control One of the major tools for managing operational risk is the well-established internal control system, which includes segregation of duties, clear management reporting lines and adequate operating procedures. Most of the operational risk events are associated with weak links in internal control systems or laxity in complying with the existing internal control procedures.

The ideal method of identifying problem spots is the technique of selfassessment of internal control environment. used to evaluate operational risk along reports/ratings or RBI inspection findings. supervisors/internal or external auditors. Along with activating internal audit systems, the Audit Committees should play greater role to ensure independent financial and internal control functions. The Basle Committee on Banking Supervision proposes to develop an explicit capital charge for operational risk. Risk Aggregation and Capital Allocation Most of internally active banks have developed internal processes and techniques to assess and evaluate their own capital needs in the light of their risk profiles and business plans. Such banks take into account both qualitative and quantitative factors to assess economic capital. The Basle Committee now recognizes that capital adequacy in relation to economic risk is a necessary condition for the long-term soundness of banks. Thus, in addition to complying with the established minimum regulatory capital requirements, banks should The self-assessment could be with internal/external audit Banks should Endeavour for

detection of operational problem spots rather than their being pointed out by

73 critically assess their internal capital adequacy and future capital needs on the basis of risks assumed by individual lines of business, product, etc. As a part of the process for evaluating internal capital adequacy, a bank should be able to identify and evaluate its risks across all its activities to determine whether its capital levels are appropriate. Thus, at the banks Head Office level, aggregate risk exposure should receive increased scrutiny. To do so, however, it requires the summation of the different types of risks. Banks, across the world, use different ways to estimate the aggregate risk exposures. The most commonly used approach is the Risk Adjusted Return on Capital (RAROC). The RAROC is designed to allow all the business streams of a financial institution to be evaluated on an equal footing. Each type of risks is measured to determine both the expected and unexpected losses using VaR or worst-case type analytical model. Key to RAROC is the matching of revenues, costs and risks on transaction or portfolio basis over a defined time period. This begins with a clear differentiation between expected and unexpected losses. Expected losses are covered by reserves and provisions and unexpected losses require capital allocation which is determined on the principles of confidence levels, time horizon, diversification and correlation. In this approach, risk is measured in terms of variability of income. Under this framework, the frequency distribution of return, wherever possible is estimated and the Standard Deviation (SD) of this distribution is also estimated. Capital is thereafter allocated to activities as a function of this risk or volatility measure. Then, the risky position is required to carry an expected rate of return on allocated capital, which compensates the bank for the associated incremental risk. By dimensioning all risks in terms of loss distribution and allocating capital by the volatility of the new activity, risk is aggregated and priced. The second approach is similar to the RAROC, but depends less on capital allocation and more on cash flows or variability in earnings. This is referred to as EaR, when employed to analyze interest rate risk. Under this analytical framework also frequency distribution of returns for any one type of risk can be estimated from historical data. Extreme outcome can be estimated from the tail of the distribution. Either a worst case scenario could be used or Standard

74 Deviation 1/2/2.69 could also be considered. Accordingly, each bank can

restrict the maximum potential loss to certain percentage of past/current income or market value. Thereafter, rather than moving from volatility of value through capital, this approach goes directly to current earnings implications from a risky position. This approach, however, is based on cash flows and ignores the value changes in assets and liabilities due to changes in market interest rates. It also depends upon a subjectively specified range of the risky environments to drive the worst case scenario. Given the level of extant risk management practices, most of Indian banks may not be in a position to adopt RAROC framework and allocate capital to various businesses units on the basis of risk.

GUIDELINES FOR ASSET LIABILITY MANAGEMENT (ALM) SYSTEM IN FINANCIAL INSTITUTIONS (FIS)
In the normal course, FIs are exposed to credit and market risks in view of the asset-liability transformation. With liberalization in Indian financial markets over the last few years and growing integration of domestic markets with external markets, the risks, particularly the market risks, associated with FIs operations have become complex and large, requiring strategic management. FIs are operating in a fairly deregulated environment and are required to determine interest rates on various products in their liabilities and assets portfolios, both in domestic as well as foreign currencies, on a dynamic basis. Intense competition for business involving both the assets and liabilities, together with increasing volatility in the domestic interest rates as also in foreign exchange rates, has brought pressure on the management of FIs to maintain a good balance amongst spreads, profitability and long-term viability. These pressures call for structured and comprehensive measures for institutionalizing an integrated risk management system and not just ad hoc action. The FIs are exposed to several major risks in the course of their business generically classified as credit risk, market risk and operational risk which underlines the need for effective risk management systems in FIs. The FIs need to address these risks in a structured manner by upgrading the quality of their risk

75 management and adopting more comprehensive ALM practices than has been done hitherto. The envisaged ALM system seeks to introduce a formalized framework for management of market risks through measuring, monitoring and managing liquidity, exchange rate and interest rate risks of a FI that need to be closely integrated with the FIs business strategy. This note lays down broad guidelines for FIs in respect of liquidity, exchange rate and interest rate risk management systems which form part of the ALM function. The initial focus of the ALM function would be to enforce the discipline of market risk management viz. managing business after assessing the market risks involved. The objective of a good risk management system should be to evolve into a strategic tool for effective management of FIs. The ALM process rests on three pillars: ALM Information System

Management Information System Information availability, accuracy, adequacy and expediency

ALM Organization Structure and responsibilities Level of top management involvement

ALM Process Risk parameters Risk identification Risk measurement Risk management Risk policies and tolerance levels.

ALM Information System ALM has to be supported by a management philosophy which clearly specifies the risk policies and tolerance limits. This framework needs to be built on sound methodology with necessary supporting information system as the central element of the entire ALM exercise is the availability of adequate

76 and accurate information with expedience. Thus, information is the key to the ALM process. There are various methods prevalent world-wide for measuring risks. These range from the simple Gap Statement to extremely sophisticate and data intensive Risk Adjusted Profitability Measurement methods. The present guidelines would require comparatively simpler information system for generating liquidity gap and interest rate gap reports. ALM Organization Successful implementation of the risk management process would require strong commitment on the part of the senior management in the FI, to integrate basic operations and strategic decision making with risk management. The Board should have overall responsibility for management of market risks and should decide the risk management policy of the FI and set limits for liquidity, interest rate, exchange rate and equity price risks. The ALCO is a decision-making unit, consisting of the FI's senior management including CEO, responsible for integrated balance sheet management from risk-return perspective including the strategic management of interest rate and liquidity risks. While each FI will have to decide the role of its ALCO, its powers and responsibilities as also the decisions to be taken by it, its responsibilities would normally include:

Monitoring the market risk levels of the FI by ensuring adherence to the various risk-limits set by the Board; Articulating the current interest rate view and a view on future direction of interest rate movements and base its decisions for future business strategy on this view as also on other parameters considered relevant.

Deciding the business strategy of the FI, both - on the assets and liabilities sides, consistent with the FIs interest rate view, budget and pre-determined risk management objectives. This would, in turn, include:

Determining the desired maturity profile and mix of the assets and liabilities Product pricing for both - assets as well as liabilities side;

77

Deciding the funding strategy i.e. the source and mix of liabilities or sale of assets; the proportion of fixed vs floating rate funds, wholesale vs retail funds, money market currency funding, etc. vs capital market funding , domestic vs foreign

Reviewing the results of and progress in implementation of the decisions made in the previous meetings

The ALM Support Groups consisting of operating staff should be responsible for analyzing, monitoring and reporting the risk profiles to the ALCO. The staff should also prepare forecasts (simulations) reflecting the impact of various possible changes in market conditions on the balance sheet and recommend the action needed to adhere to FI's internal limits. Composition of ALCO The size (number of members) of ALCO would depend on the size of each institution, business mix and organizational complexity. To ensure commitment of the Top Management and timely response to market dynamics, the CEO/CMD/DMD or the ED should head the Committee. Though the composition of ALCO could vary across the FIs as per their respective set up and business profile, it would be useful to have the Chiefs of Investment, Credit, Resources Management or Planning, Funds Management / Treasury (forex and domestic), International Business and Economic Research as the members of the Committee. In addition, the Head of the Technology Division should also be an invitee for building up of MIS and related computerization. Some FIs may even have Sub-committees and Support Groups. Committee of Directors The Management Committee of the Board or any other Specific Committee constituted by the Board should oversee the implementation of the ALM system and review its functioning periodically. ALM PROCESS The scope of ALM function can be described as follows:

78 Liquidity risk management Management of market risks Trading risk management Funding and capital planning Profit planning and growth projection

The guidelines contained in this note mainly address Liquidity and Interest Rate risks. Liquidity Risk Management Measuring and managing liquidity needs are vital for effective operation of FIs. By assuring a FI's ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing. The importance of liquidity transcends individual institutions, as liquidity shortfall in one institution can have repercussions on the entire system. FIs management should measure not only the liquidity positions of FIs on an ongoing basis but also examine how liquidity requirements are likely to evolve under different assumptions. Experience shows that assets commonly considered being liquid, such as Government securities and other money market instruments, could also become illiquid when the market and players are unidirectional. Therefore liquidity has to be tracked through maturity or cash flow mismatches. For measuring and managing net funding requirements, the use of a maturity ladder and calculation of cumulative surplus or deficit of funds at selected maturity dates is adopted as a standard tool. The format of the Statement of Liquidity is furnished in Annexure I. The Maturity Profile, as detailed in Appendix I, could be used for measuring the future cash flows of FIs in different time buckets. The time buckets, may be distributed as under: i) 1 to 14 days ii) 15 to 28 days iii) 29 days and up to 3 months iv) Over 3 months and up to 6 months

79 v) Over 6 months and up to 1 year vi) Over 1 year and up to 3 years vii) Over 3 years and up to 5 years viii) Over 5 years and up to 7 years ix) Over 7 years and up to 10 years x) Over 10 years. The investments are assumed as illiquid due to lack of depth in the secondary market and are, therefore, generally shown, as per their residual maturity, under respective time buckets. However, some of the FIs may be maintaining securities in the Trading Book, which are kept distinct from other investments made for retaining relationship with customers. Securities held in the 'Trading Book should be subject to the following preconditions: i)The composition and volume of the Trading Book should be clearly defined; ii)Maximum maturity/duration of the trading portfolio should be restricted; iii)The holding period of the trading securities should not exceed 90 days; iv)Cut-loss limit(s) should be prescribed; v) vi) Product-wise defeasance periods (i.e. the time taken to liquidate the position on the basis of liquidity in the secondary market) should be prescribed; Such securities should be marked-to-market on a daily/weekly basis and the revaluation gain/loss should be charged to the profit and loss account; etc.

FIs which maintain such Trading Books consisting of securities that comply with the above standards, are permitted to show the trading securities under 114 days, 15-28 days and 29-90 days buckets on the basis of the defeasance periods. The Board/ALCO of the banks should approve the volume, composition, maximum maturity/duration, holding/defeasance period, cut loss limits, etc., of the Trading Book. FIs, which are better equipped, will have the option of evolving with the approval of the Board / ALCO, an integrated Value at Risk (VaR) limit for their entire balance sheet including the Banking Book and the Trading Book, for the rupee as well as foreign currency portfolio. A copy of the approved policy note in this regard, should be forwarded to the Department of Banking Supervision, FID, and RBI.

80

Within each time bucket there could be mismatches depending on cash inflows and outflows. While the mismatches up to one year would be relevant since these provide early warning signals of impending liquidity problems, the main focus should be on the short-term mismatches viz., 1-14 days and 15-28 days. FIs however, are expected to monitor their cumulative mismatches (running total) across all time buckets by establishing internal prudential limits with the approval of the Board / ALCO. The negative gap during 1-14 days and 15-28 days time-buckets, in normal course, should not exceed 10 per cent and 15 per cent respectively, of the cash outflows in each time bucket. If a FI in view of its current asset-liability profile and the consequential structural mismatches needs higher tolerance level, it could operate with higher limit sanctioned by its Board / ALCO giving specific reasons on the need for such higher limit. The discretion to allow a higher tolerance level is intended for a temporary period, i.e. till March 31, 2001. While determining the tolerance levels, the FIs may take into account all relevant factors based on their asset-liability base, nature of business, future strategy, etc. The RBI is interested in ensuring that the tolerance levels are determined keeping all necessary factors in view and further refined with experience gained in Liquidity Management. The Statement of Liquidity may be prepared by placing all cash inflows and outflows in the maturity ladder according to the expected timing of cash flows. A maturing liability will be a cash outflow while a maturing asset will be a cash inflow. It would also be necessary to take into account the rupee inflows and outflows on account of forex operations. Thus, the foreign currency resources raised abroad but swapped into rupees and deployed in rupee assets would be reflected in the rupee liquidity statement. Some of the FIs have the practice of disbursing rupee loans to their exporter clients but denominating such loans in foreign currency in their books which are extinguished by the export proceeds. Such foreign currency denominated loans too would be a part of rupee liquidity statement since such loans are created out of rupee resources. As regards the foreign currency loans granted out of foreign currency resources on a back-toback basis, a currency-wise liquidity statement for each of the foreign currencies in which liabilities and assets have been created.

81

Currency Risk Floating exchange rate arrangement has brought in its wake pronounced volatility adding a new dimension to the risk profile of FIs balance sheets. The increased capital flows across free economies following deregulation have contributed to increase in the volume of transactions. Large cross border flows together with the volatility has rendered the FIs' balance sheets vulnerable to exchange rate movements. Dealing in different currencies brings opportunities as also risks. If the liabilities in one currency exceed the level of assets in the same currency, then the currency mismatch can add value or erode value depending upon the currency movements. Mismatched currency position, besides exposing the balance sheet to movements in exchange rate, also exposes it to country risk and settlement risk. FIs undertake operations in foreign exchange such as borrowings and making loans in foreign currency, which exposes them to currency or exchange rate risk. The simplest way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or near zero. However, irrespective of the strategies adopted, it may not be possible to eliminate currency mismatches altogether. At present, only five FIs (viz. EXIM Bank, ICICI, IDBI, IFCI and IIBI) have been granted by RBI (ECD) restricted authorization to deal in foreign exchange under FERA 1973 while other FIs are not authorized to deal in foreign exchange. The FIs are, therefore, unlike banks, are not subject to the full rigour of the reporting requirements under Exchange Control regulations. Hence, the MAP and SIR statements prescribed for banks vide AD (MA Series) circular no. 52 dated 27 December 1997 issued by RBI (ECD), are not applicable to FIs. In order, however, to capture the liquidity and interest rate risk inherent in the foreign currency portfolio of the FIs, it would be necessary to compile, on an ongoing basis, currency-wise Statement of Liquidity and IRS Statement, separately for each of the currencies in which the FIs have an exposure. Interest Rate Risk (IRR)

82 Interest rate risk is the risk where changes in market interest rates might adversely affect a FI's financial condition. The immediate impact of changes in interest rates is on FI's earnings (i.e. reported profits) by changing its Net Interest Income (NII). A long-term impact of changing interest rates is on FI's Market Value of Equity (MVE) or Net Worth as the economic value of banks assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as earnings perspective and economic value perspective, respectively. The risk from the earnings perspective can be measured as changes in the Net Interest Income (NII) or Net Interest Margin (NIM). There are many analytical techniques for measurement and management of Interest Rate Risk. In the context of poor MIS, slow pace of computerization in FIs, the traditional Gap analysis is considered to be a suitable method to measure the Interest Rate Risk in the initial phase of the ALM system. However, the FIs, which are better equipped, would have the option of deploying Advanced IRR management techniques with the approval of their Board / ALCO, in addition to the Gap Analysis prescribed under the guidelines. It is the intention of RBI to move over to the modern techniques of Interest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk over time when FIs acquire sufficient expertise and sophistication in acquiring and handling MIS. The Gap or Mismatch risk can be measured by calculating Gaps over different time intervals as at a given date. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets (including off-balance sheet positions). An asset or liability is normally classified as rate sensitive if: i) Within the time interval under consideration, there is a cash flow; ii) The interest rate resets/reprices contractually during the interval; iii) It is contractually pre-payable or withdraw able before the stated maturities; iv) It is dependent on the changes in the Bank Rate by RBI.

83 The Gap Report should be generated by grouping rate sensitive liabilities, assets and off-balance sheet positions into time buckets according to residual maturity or next re-pricing period, whichever is earlier. All investments, advances, deposits, borrowings, purchased funds, etc. that mature/re-price within a specified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is also rate sensitive if the FI expects to receive it within the time horizon. This includes final principal repayment and interim installments. Certain assets and liabilities carry floating rates of interest that vary with a reference rate and hence, these items get re-priced at pre-determined intervals. Such assets and liabilities are rate sensitive at the time of re-pricing. While the interest rates on term deposits and bonds are generally fixed during their currency, the interest rates on advances could be re-priced any number of occasions, on the pre-determined reset / re-pricing dates and the new rate would normally correspond to the changes in PLR. The interest rate gaps may be identified in the following time buckets: i) 1-28 days ii) 29 days and upto 3 months iii) Over 3 months and upto 6 months iv) Over 6 months and upto 1 year v) Over 1 year and upto 3 years vi) Over 3 years and upto 5 years vii) viii) Over 5 years and upto 7 years Over 7 years and upto 10 years

ix) Over 10 years x) Non-sensitive The various items of rate sensitive assets and liabilities and off-balance sheet items may be classified into various time-buckets, The Gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive Liabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs than RSLs whereas the negative Gap indicates that it has

84 more RSLs. The Gap reports indicate whether the institution is in a position to benefit from rising interest rates by having a positive Gap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by a negative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest rate sensitivity. Each FI should set prudential limits on interest rate gaps in various time buckets with the approval of the Board/ALCO. Such prudential limits should have a relationship with the Total Assets, Earning Assets or Equity. In addition to the interest rate gap limits, the FIs which are better equipped would have the option of setting the prudential limits in terms of Earnings at Risk (EaR) or Net Interest Margin (NIM) based on their views on interest rate movements with the approval of the Board/ALCO.

The classification of various components of assets and liabilities into different time buckets for preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in Appendices I & II is the benchmark. FIs which are better equipped to reasonably estimate the behavioural pattern, embedded options, rolls-in and rolls-out, etc of various components of assets and liabilities on the basis of past data / empirical studies could classify them in the appropriate time buckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO / Board may be sent to the Department of Banking Supervision, Financial Institutions Division. The impact of embedded options (i.e. the customers exercising their options for premature closure of term deposits, premature encashment of bonds and prepayment of loans and advances) on the liquidity and interest rate risks profile of FIs and the magnitude of embedded option risk during the periods of volatility in market interest rates, is quite substantial. FIs should therefore evolve suitable mechanism, supported by empirical studies and behavioural analysis, to estimate the future behaviour of assets, liabilities and off-balance sheet items to changes in market variables and estimate the impact of embedded options. In the absence of adequate historical database, the entire amount payable

85 under the embedded options should be slotted as per the residual period to the earliest exercise date. A scientifically evolved internal transfer pricing model by assigning values on the basis of current market rates to funds provided and funds used is an important component for effective implementation of ALM System. The transfer price mechanism can enhance the management of margin i.e. lending or credit spread, the funding or liability spread and mismatch spread. It also helps centralizing interest rate risk at one place which facilitates effective control and management of interest rate risk. A well defined transfer pricing system also provides a rational framework for pricing of assets and liabilities.