Sr. No. TOPICS PAGE No. 1. INTRODUCTION Objective of the study Scope of the study Limitation of the study 2. DEFINITION OF RISK What is risk What is risk management? Does it eliminate risk? Risk in banking 3. TOPOLOGY OF RISK Market risk Credit risk Operational risk 4. AN IDEALISED BANK OF THE FUTURE 5. STUDY OF OPERATIONAL RISK AT PUNJAB NATIONAL BANK 6. REFERENCES
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Sr. No.
TOPICSPAGE No.
1. INTRODUCTION
Objective of the study
Scope of the study
Limitation of the study
2. DEFINITION OF RISK
What is risk
What is risk management? Does it eliminate risk?
Risk in banking
3. TOPOLOGY OF RISK
Market risk
Credit risk
Operational risk
4. AN IDEALISED BANK OF THE FUTURE
5.STUDY OF OPERATIONAL RISK AT PUNJAB NATIONAL BANK
6. REFERENCES
OBJECTIVES
To study broad outline of management of credit, market and operational risks
associated with banking sector .
Though the risk management area is very wide and elaborated, still the project
covers whole subject in concise manner.
The study aims at learning the techniques involved to manage the various types
of risks, various methodologies undertaken. The application of the techniques
involves us to gain an insight into the following aspects:
An overview of the risks in general.
An insight of the various credit, market and operational risks
attached to the banking sector
The methodology related to the management of operational risk
followed at PNB.
Tools applied in for measurement and management of various
types of risks.
Having an insight into the practical aspects of the working of
various departments.
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SCOPE OF THE STUDY
The report seeks to present a comprehensive picture of the various risks inherent
in the bank. The risks can be broadly classified into three categories:
Credit risk
Market risk
Operational risk
Within each of these broad groups, an attempt has been made to cover as
comprehensively as possible, the various sub-groups
The computation of capital charge for market risk will also be taken practically as
also the assigning the ratings for individual borrowers. PNB is also under the key
process of testing and implementation of Reuters "KONDOR" software for its
VaR calculations and other aspects of market risk.
LIMITATION OF THE STUDY
1. The major limitation of this study shall be data availability as the data is
proprietary and not readily shared for dissemination.
2. Due to the ongoing process of globalization and increasing competition, no
one model or method will suffice over a long period of time and constant up
gradation will be required. As such the project can be considered as an overview
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of the various risks prevailing in Punjab National Bank and in the Banking
Industry.
3. Each bank, in conforming to the RBI guidelines, may develop its own methods
for measuring and managing risk.
4. The concept of risk management implementation is relatively new and risk
management tools can prove to be costly.
5. Out of the various ways in which risks can be managed, none of the method is
perfect and may be very diverse even for the work in a similar situation for the
future.
6. Due to ever changing environment , many risks are unexpected and the
remedial measures available are based on general experience from the past.
7. Selection of methods depends on the firms expectations as well as the risk
appetite. Also risks can only be minimized not completely erased.
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INTRODUCTION
The significant transformation of the banking industry in India is clearly
evident from the changes that have occurred in the financial markets, institutions
and products. While deregulation has opened up new vistas for banks to
argument revenues, it has entailed greater competition and consequently greater
risks. Cross- border flows and entry of new products, particularly derivative
instruments, have impacted significantly on the domestic banking sector forcing
banks to adjust the product mix, as also to effect rapid changes in their
processes and operations in order to remain competitive to the globalized
environment. These developments have facilitated greater choice for consumers,
who have become more discerning and demanding compelling banks to offer a
broader range of products through diverse distribution channels. The traditional
face of banks as mere financial intermediaries has since altered and risk
management has emerged as their defining attribute.
Currently, the most important factor shaping the world is globalization. The
benefits of globalization have been well documented and are being increasingly
recognized. Integration of domestic markets with international financial markets
has been facilitated by tremendous advancement in information and
communications technology. But, such an environment has also meant that a
problem in one country can sometimes adversely impact one or more countries
instantaneously, even if they are fundamentally strong.
There is a growing realisation that the ability of countries to conduct
business across national borders and the ability to cope with the possible
downside risks would depend, interalia, on the soundness of the financial
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system. This has consequently meant the adoption of a strong and transparent,
prudential, regulatory, supervisory, technological and institutional framework in
the financial sector on par with international best practices. All this necessitates a
transformation: a transformation in the mindset, a transformation in the business
processes and finally, a transformation in knowledge management. This process
is not a one shot affair; it needs to be appropriately phased in the least disruptive
manner.
The banking and financial crises in recent years in emerging economies
have demonstrated that, when things go wrong with the financial system, they
can result in a severe economic downturn. Furthermore, banking crises often
impose substantial costs on the exchequer, the incidence of which is ultimately
borne by the taxpayer. The World Bank Annual Report (2002) has observed that
the loss of US $1 trillion in banking crisis in the 1980s and 1990s is equal to the
total flow of official development assistance to developing countries from 1950s
to the present date. As a consequence, the focus of financial market reform in
many emerging economies has been towards increasing efficiency while at the
same time ensuring stability in financial markets.
From this perspective, financial sector reforms are essential in order to
avoid such costs. It is, therefore, not surprising that financial market reform is at
the forefront of public policy debate in recent years. The crucial role of sound
financial markets in promoting rapid economic growth and ensuring financial
stability. Financial sector reform, through the development of an efficient financial
system, is thus perceived as a key element in raising countries out of their 'low
level equilibrium trap'. As the World Bank Annual Report (2002) observes, ‘ a
robust financial system is a precondition for a sound investment climate, growth
and the reduction of poverty ’.
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Financial sector reforms were initiated in India a decade ago with a view to
improving efficiency in the process of financial intermediation, enhancing the
effectiveness in the conduct of monetary policy and creating conditions for
integration of the domestic financial sector with the global system. The first phase
of reforms was guided by the recommendations of Narasimham Committee.
The approach was to ensure that ‘the financial services industry operates
on the basis of operational flexibility and functional autonomy with a view
to enhancing efficiency, productivity and profitability'.
The second phase, guided by Narasimham Committee II, focused on
strengthening the foundations of the banking system and bringing about
structural improvements. Further intensive discussions are held on
important issues related to corporate governance, reform of the capital
structure, (in the context of Basel II norms), retail banking, risk
management technology, and human resources development, among
others.
Since 1992, significant changes have been introduced in the Indian
financial system. These changes have infused an element of competition in the
financial system, marking the gradual end of financial repression characterized
by price and non-price controls in the process of financial intermediation. While
financial markets have been fairly developed, there still remains a large extent of
segmentation of markets and non-level playing field among participants, which
contribute to volatility in asset prices. This volatility is exacerbated by the lack of
liquidity in the secondary markets. The purpose of this paper is to highlight the
need for the regulator and market participants to recognize the risks in the
financial system, the products available to hedge risks and the instruments,
including derivatives that are required to be developed/introduced in the Indian
system.
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The financial sector serves the economic function of intermediation by
ensuring efficient allocation of resources in the economy. Financial
intermediation is enabled through a four-pronged transformation mechanism
consisting of liability-asset transformation, size transformation, maturity
transformation and risk transformation.
Risk is inherent in the very act of transformation. However, prior to reform
of 1991-92, banks were not exposed to diverse financial risks mainly because
interest rates were regulated, financial asset prices moved within a narrow band
and the roles of different categories of intermediaries were clearly defined. Credit
risk was the major risk for which banks adopted certain appraisal standards.
Several structural changes have taken place in the financial sector since
1992. The operating environment has undergone a vast change bringing to fore
the critical importance of managing a whole range of financial risks. The key
elements of this transformation process have been
1. The deregulation of coupon rate on Government securities.
2. Substantial liberalization of bank deposit and lending rates.
3. A gradual trend towards disintermediation in the financial system in the
wake of increased access of corporates to capital markets.
4. Blurring of distinction between activities of financial institutions.
5. Greater integration among the various segments of financial markets and
their increased order of globalisation, diversification of ownership of public
sector banks.
6. Emergence of new private sector banks and other financial institutions,
and,
7. The rapid advancement of technology in the financial system.
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DEFINITION OF RISK
What is Risk?
"What is risk?" And what is a pragmatic definition of risk? Risk means
different things to different people. For some it is "financial (exchange rate,
interest-call money rates), mergers of competitors globally to form more powerful
entities and not leveraging IT optimally" and for someone else "an event or
commitment which has the potential to generate commercial liability or damage
to the brand image". Since risk is accepted in business as a trade off between
reward and threat, it does mean that taking risk bring forth benefits as well. In
other words it is necessary to accept risks, if the desire is to reap the anticipated
benefits.
Risk in its pragmatic definition, therefore, includes both threats that can
materialize and opportunities, which can be exploited. This definition of risk is
very pertinent today as the current business environment offers both challenges
and opportunities to organizations, and it is up to an organization to manage
these to their competitive advantage.
What is Risk Management - Does it eliminate risk?
Risk management is a discipline for dealing with the possibility that some
future event will cause harm. It provides strategies, techniques, and an approach
to recognizing and confronting any threat faced by an organization in fulfilling its
mission. Risk management may be as uncomplicated as asking and answering
three basic questions:
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1. What can go wrong?
2. What will we do (both to prevent the harm from occurring and in the
aftermath of an "incident")?
3. If something happens, how will we pay for it?
Risk management does not aim at risk elimination, but enables the
organization to bring their risks to manageable proportions while not severely
affecting their income. This balancing act between the risk levels and profits
needs to be well-planned. Apart from bringing the risks to manageable
proportions, they should also ensure that one risk does not get transformed into
any other undesirable risk. This transformation takes place due to the inter-
linkage present among the various risks. The focal point in managing any risk will
be to understand the nature of the transaction in a way to unbundle the risks it is
exposed to.
Risk Management is a more mature subject in the western world. This is
largely a result of lessons from major corporate failures, most telling and visible
being the Barings collapse. In addition, regulatory requirements have been
introduced, which expect organizations to have effective risk management
practices. In India, whilst risk management is still in its infancy, there has been
considerable debate on the need to introduce comprehensive risk management
practices.
Objectives of Risk Management Function
Two distinct viewpoints emerge –
One which is about managing risks, maximizing profitability and creating
opportunity out of risks
And the other which is about minimising risks/loss and protecting
corporate assets.
The management of an organization needs to consciously decide on
whether they want their risk management function to 'manage' or 'mitigate' Risks.
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Managing risks essentially is about striking the right balance between risks
and controls and taking informed management decisions on opportunities
and threats facing an organization. Both situations, i.e. over or under
controlling risks are highly undesirable as the former means higher costs
and the latter means possible exposure to risk.
Mitigating or minimising risks, on the other hand, means mitigating all risks
even if the cost of minimising a risk may be excessive and outweighs the
cost-benefit analysis. Further, it may mean that the opportunities are not
adequately exploited.
In the context of the risk management function, identification and
management of Risk is more prominent for the financial services sector and less
so for consumer products industry. What are the primary objectives of your risk
management function? When specifically asked in a survey conducted, 33% of
respondents stated that their risk management function is indeed expressly
mandated to optimise risk.
Risks in Banking
Risks manifest themselves in many ways and the risks in banking are a
result of many diverse activities, executed from many locations and by numerous
people. As a financial intermediary, banks borrow funds and lend them as a part
of their primary activity. This intermediation activity, of banks exposes them to a
host of risks. The volatility in the operating environment of banks will aggravate
the effect of the various risks. The case discusses the various risks that arise due
to financial intermediation and by highlighting the need for asset-liability
management; it discusses the Gap Model for risk management.
Typology of Risk Exposure
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Based on the origin and their nature, risks are classified into various
categories. The most prominent financial risks to which the banks are exposed to
taking into consideration practical issues including the limitations of models and
theories, human factor, existence of frictions such as taxes and transaction cost
and limitations on quality and quantity of information, as well as the cost of
acquiring this information, and more.
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FINANCIAL RISKS
MARKETRISK
LIQUIDITY RISK
OPERATIONAL RISK
HUMAN FACTOR RISK
CREDIT RISK LEGAL & REGULATORY RISK
FUNDING LIQUIDITY RISK
TRADING LIQUIDITY RISK
TRANSACTION RISK
PORTFOLIO CONCENTRATION
ISSUE RISK ISSUER RISK COUNTERPARTY RISK
EQUITY RISK INEREST RATE RISK
CURRENCY RISK
COMMODITY RISK
1. MARKET RISK
Market risk is that risk that changes in financial market prices and rates
will reduce the value of the bank’s positions. Market risk for a fund is often
measured relative to a benchmark index or portfolio, is referred to as a “risk of
tracking error” market risk also includes “basis risk,” a term used in risk
management industry to describe the chance of a breakdown in the relationship
between price of a product, on the one hand, and the price of the instrument
used to hedge that price exposure on the other. The market-Var methodology
attempts to capture multiple component of market such as directional risk,
convexity risk, volatility risk, basis risk, etc.
2. CREDIT RISK
Credit risk is that risk that a change in the credit quality of a counterparty
will affect the value of a bank’s position. Default, whereby a counterparty is
unwilling or unable to fulfill its contractual obligations, is the extreme case;
however banks are also exposed to the risk that the counterparty might
downgraded by a rating agency.
Credit risk is only an issue when the position is an asset, i.e., when it
exhibits a positive replacement value. In that instance if the counterparty
defaults, the bank either loses all of the market value of the position or, more
commonly, the part of the value that it cannot recover following the credit event.
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TRADING RISK
GAP RISK
GENERAL MARKET RISK
SPECIFIC RISK
However, the credit exposure induced by the replacement values of derivative
instruments are dynamic: they can be negative at one point of time, and yet
become positive at a later point in time after market conditions have changed.
Therefore the banks must examine not only the current exposure, measured by
the current replacement value, but also the profile of future exposures up to the
termination of the deal.
3. LIQUIDITY RISK
Liquidity risk comprises both
Funding liquidity risk
Trading-related liquidity risk.
Funding liquidity risk relates to a financial institution’s ability to raise the
necessary cash to roll over its debt, to meet the cash, margin, and collateral
requirements of counterparties, and (in the case of funds) to satisfy capital
withdrawals. Funding liquidity risk is affected by various factors such as the
maturities of the liabilities, the extent of reliance of secured sources of funding,
the terms of financing, and the breadth of funding sources, including the ability to
access public market such as commercial paper market. Funding can also be
achieved through cash or cash equivalents, “buying power ,” and available credit
lines.
Trading-related liquidity risk, often simply called as liquidity risk, is the risk
that an institution will not be able to execute a transaction at the prevailing
market price because there is, temporarily, no appetite for the deal on the other
side of the market. If the transaction cannot be postponed its execution my lead
to substantial losses on position. This risk is generally very hard to quantify. It
may reduce an institution’s ability to manage and hedge market risk as well as its
capacity to satisfy any shortfall on the funding side through asset liquidation.
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4. OPERATIONAL RISK
It refers to potential losses resulting from inadequate systems,
management failure, faulty control, fraud and human error. Many of the recent
large losses related to derivatives are the direct consequences of operational
failure. Derivative trading is more prone to operational risk than cash transactions
because derivatives are, by heir nature, leveraged transactions. This means that
a trader can make very large commitment on behalf of the bank, and generate
huge exposure in to the future, using only small amount of cash. Very tight
controls are an absolute necessary if the bank is to avoid huge losses.
Operational risk includes” fraud,” for example when a trader or other
employee intentionally falsifies and misrepresents the risk incurred in a
transaction. Technology risk, and principally computer system risk also fall into
the operational risk category.
5. LEGAL RISK
Legal risk arises for a whole of variety of reasons. For example,
counterparty might lack the legal or regulatory authority to engage in a
transaction. Legal risks usually only become apparent when counterparty, or an
investor, lose money on a transaction and decided to sue the bank to avoid
meeting its obligations. Another aspect of regulatory risk is the potential impact of
a change in tax law on the market value of a position.
6. HUMAN FACTOR RISK
Human factor risk is really a special form of operational risk. It relates to
the losses that may result from human errors such as pushing the wrong button
on a computer, inadvertently destroying files, or entering wrong value for the
parameter input of a model.
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MARKET RISK
What is Market Risk?
Market Risk may be defined as the possibility of loss to a bank caused by
changes in the market variables. The Bank for International Settlements (BIS)
defines market risk as “the risk that the value of 'on' or 'off' balance sheet
positions will be adversely affected by movements in equity and interest rate
markets, currency exchange rates and commodity prices". Thus, Market Risk is
the risk to the bank's earnings and capital due to changes in the market level of
interest rates or prices of securities, foreign exchange and equities, as well as
the volatilities of those changes. Besides, it is equally concerned about the
bank's ability to meet its obligations as and when they fall due. In other words, it
should be ensured that the bank is not exposed to Liquidity Risk. Thus, focus on
the management of Liquidity Risk and Market Risk, further categorized into