Anda di halaman 1dari 22


Haldwani (Nainital) Uttarakhand


Mr. Vinay Kandpal Vivek
Singh Mewar

Lecturer of management Dept. MBA 3rd

UTU Roll 08020500087


This Project has Been Undertaken for Partial Full Fillment of The Requirement for The Award
of Degree of Master of Business Administration of Uttarakhand Technical University (UTU)
Dehradun .

This Project was Executed in III Semester Under The Guidance of Mr. Vinay Kandpal
Faculty (Management Department ) Further We Declare That This Project is Our Original
work and not Submitted for The Award of Any Another Degree or Diploma.

Vivek Singh Mewar

2nd year MBA


I express my deep sense of gratitude to our internal guide Mr. Vinay Kandpal (Lecturer of
management Dept.) for his valuable support and guidance given to me through out the project.
I consider myself lucky to have worked under his.

This project provided me a platform to increase my knowledge and empowered me with a better
understanding of concepts in the financial world scenario and the most special the Mr. Vinay
Kandpal who accepted me in spite of my inexperience in the field and gave me the opportunity
to work and learn with them.

Last but not the least I would like to thank my God and my ever loving and caring parents for
their ever encouraging words during my days of distress.

Vivek Singh Mewar

2nd year MBA

Risk Management introduces, illustrates, and analyzes the many aspects of modern risk
management in both financial institutions and nonbank corporations. It consolidates the entire
field of risk management from policies to methodologies as well as data and technological
infrastructure. It also covers investment, hedging, and management strategies.

The shift to flexible exchange rates in the late 1960s has led to more volatility in exchange rates.
As volatility increased, financial markets began to offer a new breed of securities, that is,
derivatives such as futures and options, to allow institutions to hedge their exposures to currency

The increase in inflation in the early 1970s and the advent of floating exchange rates soon began
to generate interest rate instability. Again, the market responded by offering new derivative
products to hedge and manage these new risks. Banks found themselves increasingly engaged
in risk intermediation and less in traditional maturity intermediation. Banks also started to
innovate and off new customized derivative instruments, known as over-the-counter (OTC)
products, that both compete with and complement traded derivatives.

The Need for Risk Management Systems


1.2Historical Evolution

1.3 The Regulatory Environment

The New Regulatory and Corporate Environment

2.1 Introduction

2.2 The Group of 30 (G-30) Policy Recommen

2.3 The 1988 BIS Accord: The "Accord"The Regulatory Environment

Structuring and Managing the Risk Management Function in a Bank


3.2 Organizing the Risk Management Function: Three-Pillar


Model Risk
4.1 Introduction

4.2 Valuation Models and Sources of Model Risk

4.3 Typology of Model Risks

Risk Management in the Future

5.1 The Total Risk-Enabled Bank

5.2 External Client Profitability . . . A Partner Plus TM Approach

5.3 Process for Reviewing Risk in Extreme Markets Will Become Standardized

6.1 Summary & conclusion

6.2 References
Chapter I
The Need for Risk Management Systems

The Financial Services Act of 1999 will lead to further far-reaching changes in the U.S. financial
system. It will repeal key provisions of the Glass–Steagall Act, passed during the Great
Depression, which prohibits commercial banks from underwriting insurance and most kinds of
securities. Most significantly, brokerage firms, banks, and insurers will be able to merge with
each other; this sort of alliance was prohibited by the Bank Holdings Act of 1956. The proposed
reform is intended to allow bank holding companies to expand their range of financial services
and to take advantage of new financial technologies such as web-based e-commerce.

The new legislation will also put brokerage firms and insurers on a par with banks by allowing
them to enter into the full range of financial activities and compete globally.

The expansion of the activities of bank holding companies will incur new market, credit and
operational risks. The consolidations will also precipitate a thorough revision of capital adequacy
requirements, which are currently tailored to the needs of traditional bank holding companies.

1.2Historical Evolution
Regulation strongly affects the attitude of financial institutions to risk taking, and often dictates
how they accommodate risk. Around the world, the banking industry is regulated in a variety of
ways, and through a multitude of governing bodies, laws, and bylaws. Two related observations
can be made: nowadays there is a world-wide recognition of the need to measure and control
risks in global and local banking activities, and regulation is converging and becoming more
consistent across countries.

But before we look at how this is happening, we need to understand some of the historical
foundations of the banking industry.

The crash of 1929 and the economic crisis that followed led to major changes in bank regulation
in the United States. The regulators focused on what is termed today "systemic risk," i.e., the risk
of a collapse of the banking industry at a regional, national, or international level. In particular,
regulators were concerned to prevent the "domino effect": the chance that a failure by one bank
might lead to failure in another, and then another. In a series of acts and laws, the government
tried to increase the stability of the banking system in order to avoid this and other types of
economic crisis. At the same time, the safety of bank deposits was enhanced by the
establishment in 1933 of the Federal Deposit

Insurance Corporation (FDIC). A third set of legislation defined the playing field for commercial
banks: crucially, they were barred from dealing in equity and from underwriting securities. The
famous Glass–Steagall Act of 1933 effectively separated commercial banking and investment
banking activities.

1.3The Regulatory Environment

So far in this chapter, we have explained how the global environment became riskier as the
financial markets were liberalized, and we have charted the consequent growth in risk
management products in terms of the types of instrument and the volumes traded. Now it is time
to turn our attention back to the regulatory environment.

In 1980 the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) marked
a major change in regulatory philosophy in the United States. This act was an important step in
the deregulation of the banking system, and the liberalization of the economic environment in
which banks operate. The act initiated a six-year phase-out period for Regulation Q, which had
placed a ceiling on the interest rates that banks could offer deposit accounts with check facilities
and savings deposits. The act allowed commercial banks to pay interest on accounts with
withdrawal rights (the so-called "NOW" accounts).

This trend continued with the 1982 Garn–St. Germain Depository Institution Act (DIA), which
allowed banks to offer money market deposit accounts, and the so-called "super-NOW" accounts
(i.e., accounts that paid interest but offered limited check-writing privileges). These regulatory
moves opened up the banking industry to further competition from federally chartered thrift
institutions, but they also allowed commercial banks to expand by buying failed savings banks.
By the late 1970s and early 1980s, the numbers of such failed institutions had increased
substantially. The main reason was an economic squeeze on banks that held sizable fixed-rate
loan portfolios and which had financed these portfolios by means of short-term instruments. The
inflationary environment of the 1970s left such institutions exposed to rising interest rates.

Chapter II
The New Regulatory and Corporate Environment
We discussed the importance of the regulatory environment to the development of risk
management in financial institutions. In this chapter, we take the story one step further by
explaining how sophisticated methodologies in risk management are starting to become part of
the new regulatory and corporate risk environment. First, though, we need to ask a fundamental
question. Regulators impose a unique set of minimum required regulatory capital rules on
commercial banks. Why do they do so? Prior to the implementation in 1992 of the 1988 Basle
Accord, bank capital was regulated by imposing uniform minimum capital standards. These were
applied to banks regardless of the individual risk profiles, and the off-balance-sheet positions and
commitments of each bank were simply ignored. The increased international competition among
banks during the 1980s emphasized how inconsistently banks were regulated with regard to
capital. Japanese bank regulations contained no formal capital adequacy requirements, while in
the United States and the United Kingdom banks were required to finance more than 5 percent of
their risky assets by means of equity.

The major increase in off-balance-sheet activity by banks that took place in the 1980s altered the
risk profile of banks, while the regulatory requirements concerning equity ratios remained the
same. The 1988 Basle Accord (known also as the 1988 BIS Accord, or the "Accord") established
international minimum capital guidelines that linked banks' capital requirements to their credit.

2.2Group of Thirty (G-30) Policy Recommendations

In 1993 the Group of Thirty (G-30) published a report that described 20 best-practice price risk
management recommendations for dealers and end-users of derivatives, and four
recommendations for legislators, regulators, and supervisors. The report was put together by a G
30 working group composed of a diverse cross-section of end-users, dealers, academics,
accountants, and lawyers involved in derivatives. Their work was based in part on a detailed
survey of industry practice among 80 dealers and 72 end-users worldwide, involving both
questionnaires and in-depth interviews. The policy recommendations in the G-30 report were the
first comprehensive industry-led effort to take stock of what the industry had learned, and to
broaden awareness of the more sucessful approaches to price risk management. The G-30
focusse on providing practical guidance in terms of managing derivatives business. The
recommendations also offered a benchmark against which participants could measure their own
price risk management practices.

2.3The 1988 BIS Accord: The "Accord"

International risk-based capital adequacy standards rely on principles that are laid out in the
"International Convergence of Capital Measurement and Capital Standards" document, published
in July 1988 (cf. Basle 1988), or the "Accord." This Accord was initially developed by the Basle
Committee on Banking Supervision, and later endorsed by the central bank governors of the
Group of Ten (G-10) countries. The approach is quite simple and somewhat arbitrary, and it has
been the subject of much criticism. In fact, it is really only a first step in establishing a level
playing field across member countries for internationally active banks.

It defined two minimum standards for meeting acceptable capital adequacy requirements: an
assets-to-capital multiple and a risk-based capital ratio. The first standard is an overall measure
of the bank's capital adequacy. The second measure focuses on the credit risk associated with
specific on- and off- balance-sheet asset categories. It takes the form of a solvency ratio, known
as the Cooke ratio, and is defined as the ratio of capital to risk-weighted on-balance-sheet assets
plus off-balance-sheet exposures, where the weights are assigned on the basis of counterparty
credit risk.

Chapter III
Structuring and Managing the Risk Management Function
in a Bank
If they are to measure, price, and control risk in a comprehensive manner, financial institutions
must establish appropriate firm-wide policies, and develop relevant firm-wide risk
methodologies that are coupled to a firm-wide risk management infrastructure. This chapter
provides an integrated framework for just such an approach to risk management, in the context of
best-practice risk management.

An important component of integrated risk management is the measurement and management of

all the firm's risk in terms of a common measurement unit and strategy. The risks that need to be
covered include trading market risk, corporate treasury gap market risk, liquidity risk, credit risk
in the trading book, credit risk in the banking book, and operational risk. (Section 5 of this
chapter offers a treatment of gap market risk and liquidity risk; other chapters of this book offer
in-depth discussions of credit, market, and operational risk.)

3.2Organizing the Risk Management Function:

Three-Pillar Framework
Today, it is relatively unusual to find sophisticated risk literate organizations with a decentralized
risk management structure, where risk is managed to a minimum standard and risk assessment
remains under the direct control of risk takers. Firms understand that they need to establish a risk
management function that is independent of direct risk takers. But at many firms senior
managers need to encourage risk takers and risk managers to accelerate their efforts toward
establishing a more uniform and sophisticated risk management framework.

Such a framework can be benchmarked in terms of policies, methodologies, and infrastructure

(Figure 3.2). The bank needs to develop best-practice policies (e.g., price risk authorities for the
trading book, credit risk authorities for the loan book), best-practice methodologies (e.g., market
and credit value-at-risk, stress testing) that protect against losses while supporting a profitable
business, and also a best-practice infrastructure.

The independent first-class active management of risk, as shown in the center of Figure 3.2,
includes the capability to attribute capital, to appropriately price risk, and to actively manage the
portfolio of residual risks.
3.2.1Best-Practice Policies
Risk tolerance must be expressed in terms that are consistent with the bank's business strategy
(Figure 3.3). The business strategy should express the objectives of the financial institution in
terms of risk/ return targets. This should lead to setting risk limits, or tolerances, for the
organization as a whole, and for its major activities.
3.2.2Market Risk Policy
Business and risk managers should establish a policy that explicitly states their risk policy in
terms of a statistically defined potential or "worst case" loss: dealers and loan officers require a

policy that states how much money can be put at risk. To this end, most major financial
institutions are moving toward a value-at-risk (VaR) framework, which calculates risk in terms
of a probabilistic worst-case loss.
A best-practice market risk policy should state the statistically defined worst-case loss in a way
that considers the probability of both parallel and nonparallel shifts in the yield

The policy should also define the worst-case loss in terms of a sufficiently low level of
probability, say, 1 percent. Management should decide how to allocate capital and risk units
across activities and divisions in the institution in order to achieve their goals, while controlling
exposure to market risk. The greater the market risk, the higher the expected rate of return that
the bank can expect. The question is, how much risk exposure can the bank afford? Management
should also set the authorities for assuming market risks, and specify the nature of the market
risks to which the institution should be exposed.

For example, a local or regional bank might decide to limit its exposure mainly to interest rate
and local credit risks, while minimizing its exposure to currency risks.
Chapter IV
Model Risk
At times we can lose sight of the ultimate purpose of the models when their
mathematics become too interesting. The mathematics of financial models can be
applied precisely, but the models are not at all precise in their application to the
complex real world. Their accuracy as a useful approximation to that world varies
significantly across time and place.

The models should be applied in practice only tentatively, with careful assessment
of their limitations in each application.

The special risk that arises when an institution uses mathematical models to value and hedge
securities has come to be known as ''model risk." For simple instruments, such as stocks and
straight bonds, model risk is relatively insignificant. It becomes a compelling issue, however, for
institutions that trade over-the-counter (OTC) derivative products and for institutions that
execute complex arbitrage strategies.

In relatively efficient and liquid securities markets, the market price is, on average, the best
indicator of the value of an asset. In the absence of liquid markets and price discovery
mechanisms, theoretical valuation models have to be used to mark-to-model the bank's position,
to assess the risk exposure in terms of the various risk factors, and to derive the appropriate
hedging strategy.

4.2Valuation Models and Sources of Model Risk

In financial markets two types of securities are traded: "fundamental" instruments such as stocks,
bonds, and loans; and the more complicated "derivatives" securities. Theoretical valuation
models for fundamental assets are derived from general equilibrium considerations in the
economy and the assumption that financial markets are perfect and efficient.

The key principles for the valuation of fundamental securities are well known and are generally
accepted: investors prefer high returns and dislike risk. Even so, the models are expected to
produce guidelines rather than very precise valuations. For example, a risky security should offer
a higher expected return than a risk-free security. But how much higher? Pricing theory cannot
give a specific value unless it is fed with "perfect" information. The dependence of models on
unobservable market factors—investor expectations and risk aversion—makes precise valuation
difficult, therefore, even in the case of fundamental securities. It also means that market
participants do not rely extensively on theoretical models when trading in these markets.

Pricing models for derivatives, on the other hand, value a derivative instrument relative to the
price of its underlying asset. A swaption, for example, is an option on an underlying swap.

The values of the derivative and the underlying are perfectly correlated over short time intervals.
It is not necessary that the underlying asset is priced correctly in the market in order to produce
the equilibrium value of the derivative. This is because the pricing model for the derivative
depends simply on considerations of no arbitrage between the derivative and its underlying asset.
If the derivatives market price differs from the value predicted by the model, then an arbitrage
strategy can be implemented that will earn a risk-adjusted return that is above normal. This is
true whether or not the underlying is accurately priced vis--vis other securities in the market.

At the risk of oversimplifying, we can classify all the models that prevail in finance into three
categories: structural models, statistical models, and models that are a mixture of structural and
statistical models. It is worth reviewing these different types of models before looking in more
detail at the kind of model risks that can occur.

(i) Structural models are based on a system of premises concerning how markets operate under
the assumption of rational behavior. They employ assumptions about the underlying asset price
process and market equilibrium conditions to allow the modeler to draw inferences about the
equilibrium prices. The celebrated Black-Schooles (1973) formula is the best-known example of
a structural model in the derivatives markets. It is derived from an arbitrage-based trading
strategy that combines the option and its underlying to create a delta-neutral portfolio which is
therefore unaffected by small changes in the underlying price over a short interval of time.

(ii) Statistical models rely on empirical observations that are formulated in terms of correlation
rather than causation. A classic example is the market model, which specifies the return
generating process for a stock

(iii)Mixture of structural and statistical models. For example, the GARCH option pricing model
combines features of both types of model.In the case of the GARCH option pricing model,
volatility is assumed to follow a GARCH process, calibrated on historical data, but the
equilibrium price of the option is based on a no-arbitrage argument that is conditional on
GARCH volatility.

4.3Typology ofModel Risks

As our discussion so far has indicated, there are many aspects to model risk, both practical as
well as philosophical. Figure 15.1 summarizes the stages of a transaction that are particularly
vulnerable to model risk. In this section we discuss the practical issues that often lead to
substantial trading losses, and which require considerable attention and monitoring from
management. The risks are not described in order of importance, or frequency of occurrence;
some model risks cross categories or belong to more than one category.

ErroneousModel and Model Misspecification

Errors in the Analytical Solution

Since most financial models rely on mathematical formulations, often using complex statistical
tools, there is always the danger of reaching the wrong solution. This problem is especially
serious when pricing new complex derivatives with special features that make them path
dependent, or dependent on more than one source of risk.

Chapter V
Risk Management in the Future

5.1The Total Risk-Enabled Bank

The bank of the future will be reorganized around a new vision. To succeed, it will have to be
able to respond to opportunities as they present themselves. And it will have to strive to improve
the portfolio management of its balance sheet and capital.

To manage conflicting objectives, it will need to determine a number of policy variables such as
a target risk-adjusted rate of return (RAROC), target regulatory return, target tier 1 ratio, target
liquidity, and so on in turn, this will mean transforming the risk management function. Risk
management will need to encompass limit management, risk analysis, RAROC, and active
portfolio management of risk (APMR).

In the first part of this chapter, we look at how these changes in risk management will be induced
— and facilitated—by advances in technology, the introduction of more sophisticated regulatory
measures, rapidly accelerating market forces, and an increasingly complex legal environment.

5.2External Client Profitability:

In the future, a select subset of leading-edge tools developed by banks to serve their internal
needs will be leveraged and redeployed to provide value-added services to bank clients. To try to
make clear what is meant by this, let us imagine a hypothetical bank called CGMthat leverages
its risk management policy, methodology, and infrastructure to offer a suite of services to clients.
We can call those services, for illustrative purposes, Partner Plus (Partner+TM). Our
hypothetical CGM bank might create revenue through establishing a service bureau, in joint
ownership with an external technology-enabled institution, to sell risk management services
through an independent legal entity. The service bureau might offer to run VaR calculations and
stress test certain risks for clients.

As with any step-change in how an industry is structured, banks may need to act quickly. ''The
easiest way is to be first: Yahoo was first, eBay was first, Amazon was first, etc. Being first helps
immensely to get that critical number of users necessary for the business to take on a life of its
own: critical mass."

5.3Process for Reviewing Risk in Extreme Markets Will Become

The industry will develop a standardized set of tools to review the performance of a portfolio or
business in extreme markets. The use of these tools will be encouraged by the regulators and will
prove to be quite useful in terms of examining potential future losses caused by extreme market

For example, over the last year banks have asked how they can avoid significant losses in market
conditions such as those of August–October 1998. Some market commentators have called
market conditions during these three months a "Series of Firsts." There is no easy answer to
this. Banks n to review continually their risk management performance, and ask themselves a
series of tough questions in terms of each element of the risk management framework introduced

They also need to ask how they can improve their risk management policies. It is not enough to
measure risks; banks need to ensure continually that in the future the risks in extreme markets
will properly disclosed, made transparent, and—most difficult of all—understood. of course, the
methodological perspective is vital too, and ever changing. Banks will need to ask themselves a
series of questions. How well will the bank's risk measurement models serve the organization in
the future? Will risk measurement models appropriately capture all the risk of future business
lines? How advanced is the bank's measurement of risk in comparison to its competitors?

Finally, a series of questions concerning infrastructure should be asked. Will the bank's risk
management infrastructure—staff, as well as its systems—serve it well in extreme markets? Let's
first analyze the policy component of the risk management framework. The tolerance for risk
should follow directly from the bank's business strategy. For example, the strategic plan at the
beginning of the year may call for the daily value at risk for credit spread risk to be set at a
certain level which is in excess of current trading limits in order to earn the income projected for
credit- intensive business, e.g., a high-yield business.

Chapter VI
Risk analysis and management is most effective when deployed early. A properly structured risk
identification, analysis, and mitigation process can moderate the risks associated with
international construction projects.
An organisation’s risk management policy should set out its approach and appetite for risk and
its approach to risk management. The policy should also set out responsibilities for risk
management throughout the organisation. Furthermore, it should refer to any legal requirements
for policy statements.
Different stake-holding body for the project play important role in successful management of
risk in organization. Bodies like project management unit and different business units when
proactive can do a great deal to identify risk and propose a mitigation plan. Project managers
today has to accept the fact that risk assessment and management is not a substitute for adequate
pre-project planning, project controls, or other management and technical requirements. The
most effective risk management process is coordinated with all aspects of project development
and management.
Project managers have to become more dynamic in terms of project management. They have to
have some idea about project portfolio management and program management. Because small
negligible risk in the project if not managed can cost very big deal in the program.
Project risk management is still a practice in present world. There is no set rule for the risk
management yet. Often organization manages their own risk in their own set way. And when
there is a change in the business rule or the project itself, it becomes really tough for the project
managers track the previous risk of the project. For this reason I believe there should be set
standards for project risk management as it is there for project management itself. Institutions
like PMI, RMI and AIRMIC should come forward to address the problem.





5) Economic Times
6) Financial Express