Description
This is a presentation that includes risk management in banks, different types of risks the banks are exposed to. The different risks covered include interest rate risk, liquidity risk etc.
?
?
Probability of loss in a specific environment over a stated period of time Involves the following elements
? Probability
? Loss amount
?
Why is ‘Risk’ so important for Banking?
GOVERNMENT Monetary/ Fiscal/industrial Trade policies
CREDIT RISK EXCHANGE RISK B A N K S
OTHER FIs/BANKS Lending/ investment Policies/dealing/ trading
INTEREST RISK
LIQUIDITY RISK COUNTRY RISK
CORPORATES Business/trade/ market
OTHER NONFINANCIAL RISKS
?
?
?
90% of a bank’s liabilities mature within the next 12 months. The bank has invested 80% of its liabilities in securities maturing after 5 years 80% of a bank’s liabilities mature within the next 12 months. The bank has lent 60% of liabilities to long term projects with a repayment holiday of 2 years 80% of a bank’s fixed rate liabilities mature after 3 years. The bank has lent 60% of its liabilities as short term loans to be repaid over the next 6 months. Interest rates are falling.
?
?
Risk management = Risk reduction? Multi step process for Risk Management
? Risk identification
? Quantification of level of exposures
? Policy and Strategy for risk mitigation ? Periodic monitoring of risk levels
ASSETS ? CASH ? SHORT TERM SECURITIES ? LONG TERM SECURITIES ? FIXED RATE LOANS ? FLOATING RATE LOANS ? OTHER ASSETS
LIABILITIES ? DEMAND DEPOSITS ? SHORT TERM DEPOSITS ? LONG TERM DEPOSITS ? BORROWINGS ? OTHER LIAB/PROVISIONS
?
?
?
?
Any risk impacts the ‘Net Interest Income’ of the Bank NII = Interest earned – Interest paid For inter bank comparisons, “Net Interest Margin” is used NIM = NII / earning assets
ALM aims at profitability through ‘price matching ‘Price matching’ attempts to maintain spreads by ensuring that deployment of liabilities will be at a rate higher than the costs ? ALM aims at liquidity through ‘maturity matching’ ? ‘Maturity matching’ groups assets and liabilities based on their maturity profiles. The gap is assessed to identify future financing requirements to ensure liquidity ? Not an easy task in practice
? ?
?
RESTS ON THREE PILLARS
? ALM INFORMATION SYSTEMS – includes MIS
and availability of accurate and timely data for decision making ? ALM ORGANIZATION – sets out structure and responsibilities; and the extent of top management involvement ? ALM PROCESS – risk parameters, risk identification, risk measurement, risk management and risk policies and tolerance levels
?
?
An effective ALM aims to manage volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities - to obtain an acceptable risk /reward ratio Process ? Review interest rate structure of both assets and
liabilities to highlight impending risks ? examine loan and investment portfolios – for liquidity and exchange rate risks. Match these to the cost and value of liabilities ? Probability of credit risk – due to rate fluctuations /default ? Review actual performance against estimates
?
? ?
Net Interest Income [NII] – what does this measure? Market value of Equity [MVE] – what does this signify? Which parameter should Banks target?
? ? ? ? ?
The gain / loss Arising due to sensitivity Of interest income / interest expenses Or values of assets / liabilities To fluctuations in interest rates
?
1] RATE LEVEL RISK
? Changes in interest rates either due to market
conditions or regulatory intervention ? Why is there an interest rate risk every time there is a change in PLR?
?
2] VOLATILITY RISK
? Interest rate changes – short and long term
fluctuations
?
3] PREPAYMENT RISK
? How does this arise?
? ?
4] REINVESTMENT RISK 5] BASIS RISK
? Arises when costs of liabilities and yields on assets
are linked to different benchmarks ? Changes in these benchmarks are not uniform
?
6] EMBEDDED OPTIONS RISK
? How does this arise?
?
Embedded options Risk [contd]
? For example, when funds are raised through issue of bonds ? ?
?
?
/securities, it may include options. Call option – exercised by issuer to redeem bonds before maturity Put option – exercised by investor to redeem bonds before maturity If call option exercised when interest rates are declining, the bank investing in these bonds would have a ‘reinvestment risk’ – intermediate cash flows would have to be reinvested at lower rate If put option exercised by investors when interest rates are rising, bank which has issued the bonds may face ‘prepayment risk’ – it would have to pay investors by borrowing at a higher rate
?
7] REAL INTEREST RATE RISK
? Changes in nominal interest rates may not
match with inflation rate changes ? Inflation factor to be considered to assess real interest costs / yields
?
The above factors, individually or collectively, result in interest rate risk – affect the assets / liability of bank through income / expenses – affect bank’s market value
?
LIABILITIES ? Capital ? Reserves ? Savings bank deposits ? Term deposits ? Borrowings ? Refinance ? Other liabilities and provisions ? Bills rediscounted/ swaps etc
?
ASSETS ? Cash ? Balances with RBI ? Balances with other banks ? Investments ? Advances ? NPAs ? Fixed assets ? Other assets
? ?
?
?
it matures during the time interval the interest rate applied to the outstanding advance changes contractually during the interval it represents an interim or partial principal payment the outstanding principal can be repriced when some base rate or index changes, and there is an expectation that the base rate or index may change during the interval
?
Should be a system that
?
? Quantifies risk ? Manages the risk ? Takes timely action Risk control – steps ? Fix the period for control [ forecasting period] ? Forecast interest rate fluctuations within this
period ? Classify assets / liabilities as rate sensitive within this period ? Identify suitable method to quantify the risk
?
‘Repricing’ of assets/ liabilities in the following situations
? At maturity ? For those with floating interest rate ? Stipulated by regulations
?
Total impact of rate fluctuations on Net Income [NI] = impact on non- interest income / expenses due to impact on assets/liabilities + impact on interest income due to pricing mismatch in assets/liabilities
?
15 PRINCIPLES UNDER THE FOLLOWING BROAD HEADS
? Board and senior management oversight ? Adequate risk management policies and procedures ? Risk measurement, monitoring and control functions
? Internal controls
? Information for supervisory authorities ? Capital adequacy ? Disclosure of interest rate risk
? Supervisory treatment of interest rate risk in the banking book
?
? ?
?
? ?
MATURITY GAP METHOD RATE ADJUSTED GAP DURATION ANALYSIS HEDGING SENSITIVITY ANALYSIS SIMULATION AND GAME THEORY
?
? ?
?
?
What is ‘liquidity’ in a Bank? How does one manage liquidity? How does ‘liquidity risk’ arise? What are the implications of a liquidity crisis in a bank? Which is more serious – Interest rate risk or Liquidity risk?
?
? ?
? ? ?
Liquidity risk is often related to bank’s inability to pay to its depositors. However, a bank’s inability to pay to its depositors is the ultimate manifestation of liquidity risk. Liquidity risk at initial stages may lead to distress pricing of assets and liabilities. A bank with high degree of liquidity risk may be forced to borrow funds from inter bank market at exorbitant rates or has to increase its deposit rates. As the bank may not be able to transfer these increased costs to borrowers, ultimately its net interest income shall be affected. Further, as bank’s cost of funds goes up, increasingly it looks for risky avenues to increase its earnings. The process may lead to wrong selection of borrowers as well as venturing into risky areas increasing overall risk profile of the bank. Therefore, liquidity risk has strong correlation with other risks such as interest rate risk and credit risk.
?
1] FUNDAMENTAL APPROACH
? Aims to ensure liquidity for long run sustenance
of the bank
?
?
2] TECHNICAL APPROACH
? Targets short run liquidity of bank
Hence in combo, both approaches should supplement each other
The bank has created long-term assets through shortterm liabilities as evident from negative mismatches in the near term buckets and positive mismatches in long-term buckets of 3-5 years and above 5 years. ? In the process, the bank has exposed its liquidity profile to a great degree of risk in two ways;
?
? its liquidity position will depend on the roll over of short term
?
In case, the long-term assets are in the form of investments, the bank will be forced to sale assets at loss to meet its liquidity requirements.
maturing liabilities and ? depending on adverse money market conditions as well as external liquidity, it may be forced to rollover maturing liabilities at a higher cost.
?
?
Liquidity sources for a Bank are ……. ASSET MANAGEMENT
? Rank banking assets in decreasing order of
liquidity ? What can you say about ‘asset management’ as a hedge against liquidity risk?
?
LIABILITY MANAGEMENT
? Focus on sources of funds ? What are the alternatives available to the Bank?
?
WHEN ASSET MANAGEMENT?
? Deposit rich banks ? Can easily borrow from market
? Have avenues for profitable deployment into
short term assets ? Aggressive short term investment strategies ? What about profitability?
?
?
?
?
Aggressive borrowings from market – both domestic and international Avenues for long term deployment of funds Which is more risky – asset or liability management? Which could be more profitable – asset or liability management?
?
? ?
Focus on liquidity position of bank in the short run Liquidity in the short run primarily linked to the cash flows from operations Liquidity risk tackled by adjusting cash inflows and outflows
?
Two approaches
? WORKING FUNDS APPROACH
? Liquidity assessed based on quantum of working funds available with the bank ? CASH FLOW APPROACH ? Forecasts cash flows impacting liquidity position
?
? ?
Working funds = total funds available for business operations = owned funds + deposits + float funds % of working funds – can be segment wise – to be maintained as liquid funds Bank will adjust liquidity by borrowing if in deficit or investing if in surplus
?
?
?
?
Assess liquidity requirements for each component of working funds Liquidity for ‘owned funds’ = Liquidity for ‘deposits’ based on ? Liquidity for ‘float funds’ – how much to be provided for?
?
Based on the liquidity requirements identified, bank can
? Stipulate average cash / bank balances to be
maintained as % of total working funds / in respect of every component ? Stipulate acceptable variance levels within which cash/ bank balances can fluctuate
?
?
Under this method, in which type of bank can a consolidated % on working funds be an adequate measure of liquidity requirements? In which type of bank should the cash balances be assessed and maintained on individual components?
?
Limitations of the approach
? Subjective – classification of deposits on
?
To avoid subjectivity – variations in deposit balances may be worked out on historical data – implicit assumption – history repeats itself!
withdrawal pattern ? Focus on existing funds – potential inflows ignored
?
? ?
Forecasts potential increase / decrease in deposits / credit Based on historical trends of changes in deposits / credit Two parameters to be established for this approach
? THE PLANNING HORIZON
? COSTS OF FORECASTING
?
STEPS ? Estimate anticipated changes in deposits [ in
the planning horizon] ? Estimate cash inflows [ loan recoveries] ? Estimate cash outflows [ credit disbursals, deposit withdrawals] ? Estimate liquidity needs over the planning horizon
?
? ?
?
Prudent decisions on investment of surplus/ borrowing in case of deficit liquidity Pecking order for liquidity deployment? Alternatives for deployment of surplus – long term investments / short term investments Alternatives for meeting deficits – disinvestment / market borrowings
?
?
Banks may use asset management or liability management in their investment decisions In an increasing interest rate scenario, which would be more prudent – asset or liability management?
?
? ?
?
?
Loans / total assets Loans / core deposits Large liabilities less temporary investments/earning assets less temporary investments Purchased funds / total assets Loan losses / net loans
?
? ? ?
?
Track cash flows - match inflows and outflows for each time period Cap on inter bank borrowings - especially call borrowings Purchased funds vis-à-vis liquid assets Core deposits vis-à-vis core assets Duration of liabilities and investment portfolio
? ?
?
?
Fix maximum cumulative cash outflows across all time bands Commitment ratio - total commitment given to corporates / banks - to limit off balance sheet exposures Swapped funds ratio - extent of Indian rupees raised out of foreign currency sources Prepare worst case scenario
doc_890411578.pptx
This is a presentation that includes risk management in banks, different types of risks the banks are exposed to. The different risks covered include interest rate risk, liquidity risk etc.
?
?
Probability of loss in a specific environment over a stated period of time Involves the following elements
? Probability
? Loss amount
?
Why is ‘Risk’ so important for Banking?
GOVERNMENT Monetary/ Fiscal/industrial Trade policies
CREDIT RISK EXCHANGE RISK B A N K S
OTHER FIs/BANKS Lending/ investment Policies/dealing/ trading
INTEREST RISK
LIQUIDITY RISK COUNTRY RISK
CORPORATES Business/trade/ market
OTHER NONFINANCIAL RISKS
?
?
?
90% of a bank’s liabilities mature within the next 12 months. The bank has invested 80% of its liabilities in securities maturing after 5 years 80% of a bank’s liabilities mature within the next 12 months. The bank has lent 60% of liabilities to long term projects with a repayment holiday of 2 years 80% of a bank’s fixed rate liabilities mature after 3 years. The bank has lent 60% of its liabilities as short term loans to be repaid over the next 6 months. Interest rates are falling.
?
?
Risk management = Risk reduction? Multi step process for Risk Management
? Risk identification
? Quantification of level of exposures
? Policy and Strategy for risk mitigation ? Periodic monitoring of risk levels
ASSETS ? CASH ? SHORT TERM SECURITIES ? LONG TERM SECURITIES ? FIXED RATE LOANS ? FLOATING RATE LOANS ? OTHER ASSETS
LIABILITIES ? DEMAND DEPOSITS ? SHORT TERM DEPOSITS ? LONG TERM DEPOSITS ? BORROWINGS ? OTHER LIAB/PROVISIONS
?
?
?
?
Any risk impacts the ‘Net Interest Income’ of the Bank NII = Interest earned – Interest paid For inter bank comparisons, “Net Interest Margin” is used NIM = NII / earning assets
ALM aims at profitability through ‘price matching ‘Price matching’ attempts to maintain spreads by ensuring that deployment of liabilities will be at a rate higher than the costs ? ALM aims at liquidity through ‘maturity matching’ ? ‘Maturity matching’ groups assets and liabilities based on their maturity profiles. The gap is assessed to identify future financing requirements to ensure liquidity ? Not an easy task in practice
? ?
?
RESTS ON THREE PILLARS
? ALM INFORMATION SYSTEMS – includes MIS
and availability of accurate and timely data for decision making ? ALM ORGANIZATION – sets out structure and responsibilities; and the extent of top management involvement ? ALM PROCESS – risk parameters, risk identification, risk measurement, risk management and risk policies and tolerance levels
?
?
An effective ALM aims to manage volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities - to obtain an acceptable risk /reward ratio Process ? Review interest rate structure of both assets and
liabilities to highlight impending risks ? examine loan and investment portfolios – for liquidity and exchange rate risks. Match these to the cost and value of liabilities ? Probability of credit risk – due to rate fluctuations /default ? Review actual performance against estimates
?
? ?
Net Interest Income [NII] – what does this measure? Market value of Equity [MVE] – what does this signify? Which parameter should Banks target?
? ? ? ? ?
The gain / loss Arising due to sensitivity Of interest income / interest expenses Or values of assets / liabilities To fluctuations in interest rates
?
1] RATE LEVEL RISK
? Changes in interest rates either due to market
conditions or regulatory intervention ? Why is there an interest rate risk every time there is a change in PLR?
?
2] VOLATILITY RISK
? Interest rate changes – short and long term
fluctuations
?
3] PREPAYMENT RISK
? How does this arise?
? ?
4] REINVESTMENT RISK 5] BASIS RISK
? Arises when costs of liabilities and yields on assets
are linked to different benchmarks ? Changes in these benchmarks are not uniform
?
6] EMBEDDED OPTIONS RISK
? How does this arise?
?
Embedded options Risk [contd]
? For example, when funds are raised through issue of bonds ? ?
?
?
/securities, it may include options. Call option – exercised by issuer to redeem bonds before maturity Put option – exercised by investor to redeem bonds before maturity If call option exercised when interest rates are declining, the bank investing in these bonds would have a ‘reinvestment risk’ – intermediate cash flows would have to be reinvested at lower rate If put option exercised by investors when interest rates are rising, bank which has issued the bonds may face ‘prepayment risk’ – it would have to pay investors by borrowing at a higher rate
?
7] REAL INTEREST RATE RISK
? Changes in nominal interest rates may not
match with inflation rate changes ? Inflation factor to be considered to assess real interest costs / yields
?
The above factors, individually or collectively, result in interest rate risk – affect the assets / liability of bank through income / expenses – affect bank’s market value
?
LIABILITIES ? Capital ? Reserves ? Savings bank deposits ? Term deposits ? Borrowings ? Refinance ? Other liabilities and provisions ? Bills rediscounted/ swaps etc
?
ASSETS ? Cash ? Balances with RBI ? Balances with other banks ? Investments ? Advances ? NPAs ? Fixed assets ? Other assets
? ?
?
?
it matures during the time interval the interest rate applied to the outstanding advance changes contractually during the interval it represents an interim or partial principal payment the outstanding principal can be repriced when some base rate or index changes, and there is an expectation that the base rate or index may change during the interval
?
Should be a system that
?
? Quantifies risk ? Manages the risk ? Takes timely action Risk control – steps ? Fix the period for control [ forecasting period] ? Forecast interest rate fluctuations within this
period ? Classify assets / liabilities as rate sensitive within this period ? Identify suitable method to quantify the risk
?
‘Repricing’ of assets/ liabilities in the following situations
? At maturity ? For those with floating interest rate ? Stipulated by regulations
?
Total impact of rate fluctuations on Net Income [NI] = impact on non- interest income / expenses due to impact on assets/liabilities + impact on interest income due to pricing mismatch in assets/liabilities
?
15 PRINCIPLES UNDER THE FOLLOWING BROAD HEADS
? Board and senior management oversight ? Adequate risk management policies and procedures ? Risk measurement, monitoring and control functions
? Internal controls
? Information for supervisory authorities ? Capital adequacy ? Disclosure of interest rate risk
? Supervisory treatment of interest rate risk in the banking book
?
? ?
?
? ?
MATURITY GAP METHOD RATE ADJUSTED GAP DURATION ANALYSIS HEDGING SENSITIVITY ANALYSIS SIMULATION AND GAME THEORY
?
? ?
?
?
What is ‘liquidity’ in a Bank? How does one manage liquidity? How does ‘liquidity risk’ arise? What are the implications of a liquidity crisis in a bank? Which is more serious – Interest rate risk or Liquidity risk?
?
? ?
? ? ?
Liquidity risk is often related to bank’s inability to pay to its depositors. However, a bank’s inability to pay to its depositors is the ultimate manifestation of liquidity risk. Liquidity risk at initial stages may lead to distress pricing of assets and liabilities. A bank with high degree of liquidity risk may be forced to borrow funds from inter bank market at exorbitant rates or has to increase its deposit rates. As the bank may not be able to transfer these increased costs to borrowers, ultimately its net interest income shall be affected. Further, as bank’s cost of funds goes up, increasingly it looks for risky avenues to increase its earnings. The process may lead to wrong selection of borrowers as well as venturing into risky areas increasing overall risk profile of the bank. Therefore, liquidity risk has strong correlation with other risks such as interest rate risk and credit risk.
?
1] FUNDAMENTAL APPROACH
? Aims to ensure liquidity for long run sustenance
of the bank
?
?
2] TECHNICAL APPROACH
? Targets short run liquidity of bank
Hence in combo, both approaches should supplement each other
The bank has created long-term assets through shortterm liabilities as evident from negative mismatches in the near term buckets and positive mismatches in long-term buckets of 3-5 years and above 5 years. ? In the process, the bank has exposed its liquidity profile to a great degree of risk in two ways;
?
? its liquidity position will depend on the roll over of short term
?
In case, the long-term assets are in the form of investments, the bank will be forced to sale assets at loss to meet its liquidity requirements.
maturing liabilities and ? depending on adverse money market conditions as well as external liquidity, it may be forced to rollover maturing liabilities at a higher cost.
?
?
Liquidity sources for a Bank are ……. ASSET MANAGEMENT
? Rank banking assets in decreasing order of
liquidity ? What can you say about ‘asset management’ as a hedge against liquidity risk?
?
LIABILITY MANAGEMENT
? Focus on sources of funds ? What are the alternatives available to the Bank?
?
WHEN ASSET MANAGEMENT?
? Deposit rich banks ? Can easily borrow from market
? Have avenues for profitable deployment into
short term assets ? Aggressive short term investment strategies ? What about profitability?
?
?
?
?
Aggressive borrowings from market – both domestic and international Avenues for long term deployment of funds Which is more risky – asset or liability management? Which could be more profitable – asset or liability management?
?
? ?
Focus on liquidity position of bank in the short run Liquidity in the short run primarily linked to the cash flows from operations Liquidity risk tackled by adjusting cash inflows and outflows
?
Two approaches
? WORKING FUNDS APPROACH
? Liquidity assessed based on quantum of working funds available with the bank ? CASH FLOW APPROACH ? Forecasts cash flows impacting liquidity position
?
? ?
Working funds = total funds available for business operations = owned funds + deposits + float funds % of working funds – can be segment wise – to be maintained as liquid funds Bank will adjust liquidity by borrowing if in deficit or investing if in surplus
?
?
?
?
Assess liquidity requirements for each component of working funds Liquidity for ‘owned funds’ = Liquidity for ‘deposits’ based on ? Liquidity for ‘float funds’ – how much to be provided for?
?
Based on the liquidity requirements identified, bank can
? Stipulate average cash / bank balances to be
maintained as % of total working funds / in respect of every component ? Stipulate acceptable variance levels within which cash/ bank balances can fluctuate
?
?
Under this method, in which type of bank can a consolidated % on working funds be an adequate measure of liquidity requirements? In which type of bank should the cash balances be assessed and maintained on individual components?
?
Limitations of the approach
? Subjective – classification of deposits on
?
To avoid subjectivity – variations in deposit balances may be worked out on historical data – implicit assumption – history repeats itself!
withdrawal pattern ? Focus on existing funds – potential inflows ignored
?
? ?
Forecasts potential increase / decrease in deposits / credit Based on historical trends of changes in deposits / credit Two parameters to be established for this approach
? THE PLANNING HORIZON
? COSTS OF FORECASTING
?
STEPS ? Estimate anticipated changes in deposits [ in
the planning horizon] ? Estimate cash inflows [ loan recoveries] ? Estimate cash outflows [ credit disbursals, deposit withdrawals] ? Estimate liquidity needs over the planning horizon
?
? ?
?
Prudent decisions on investment of surplus/ borrowing in case of deficit liquidity Pecking order for liquidity deployment? Alternatives for deployment of surplus – long term investments / short term investments Alternatives for meeting deficits – disinvestment / market borrowings
?
?
Banks may use asset management or liability management in their investment decisions In an increasing interest rate scenario, which would be more prudent – asset or liability management?
?
? ?
?
?
Loans / total assets Loans / core deposits Large liabilities less temporary investments/earning assets less temporary investments Purchased funds / total assets Loan losses / net loans
?
? ? ?
?
Track cash flows - match inflows and outflows for each time period Cap on inter bank borrowings - especially call borrowings Purchased funds vis-à-vis liquid assets Core deposits vis-à-vis core assets Duration of liabilities and investment portfolio
? ?
?
?
Fix maximum cumulative cash outflows across all time bands Commitment ratio - total commitment given to corporates / banks - to limit off balance sheet exposures Swapped funds ratio - extent of Indian rupees raised out of foreign currency sources Prepare worst case scenario
doc_890411578.pptx