FINANCIAL RISK MANAGEMENT

IN
SBI & ICICI

BY
AADITYA VIJAY WAJE

JANUARY 2012

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 ACKNOWLEDGEMENT

First I would like to thank “UNIVERSITY OF MUMBAI” for giving me an

opportunity to do a project work. Through the project work I got to know
how the banking sector works financially. Due to this project I could grab
lot of knowledge about financial operations of banks that was not of my
domain.

I would also like to thank my project guide Prof. kripa Shah to help me out
in doing this project because without her help & guidance I couldn’t have
been able to complete my project successfully. I am very thankful of Prof.
kripa Shah to give right path & suggestions for project to work upon.

Finally, I would like to thank the co-ordinator of BACHLOR OF

MANAGEMENT STUDIES Dr. Prakash Salvi, all professors for giving me
such a platform to do a project work which will definitely help me in my
near future& all my friends who assume major part in helping me out to
work upon the project.

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CONCEPTUAL FRAMEWORK 
The world of banking has assumed a new dimension at dawn of the 21 st century with
the advent of tech banking, thereby lending the industry a stamp of universality. In
general, banking may be classified as retail and corporate banking. Retail
banking, which is designed to meet the requirement of individual customers and
encourage their savings, includes payment of utility bills, consumer loans, credit cards,
checking account and the like. Corporate banking, on the other hand, caters to the need
of corporate customers like bills discounting, opening letters of credit, managing cash,
etc. Metamorphic changes took place in the Indian financial system during the eighties
and nineties consequent upon deregulation and liberalization of economic policies of
the government. India began shaping up its economy and earmarked ambitious plan for
economic growth.

consequently, a sea change in money and capital markets took place.

Application of marketing concept in the banking sector was introduced to
enhance the customer satisfaction t h e policy of privatization of banking services
aims at encouraging the competition in banking sector and introduction of financial
services. Consequently, services such as Demat, Internet banking, Portfolio
Management, Venture capital, etc, came into existence to cater to the needs of public.
An important agenda for every banker today is greater operational efficiency and
customer satisfaction.

The introduction to the marketing concept to banking sectors can be traced back to
American Banking Association Conference of 1958. Banks marketing can be defined as
the part of management activity, which seems to direct the flow of banking services
profitability to the customers. The marketing concept basically requires that there
should be thorough understanding of customer need and to learn about market it
operates in.

Further the market is segmented so as to understand the requirement of the customer at

a profit to the banks. The banking industry, one of the most important instruments of
the national development occupies a unique place in a nation’s economy. Profit is the
main reason for the continued existence of every commercial organization and
profitability depicts the relationship of the absolute amount of profit with various other

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factors. The main source of operating income of a commercial bank are- interest and
discount earned, commission, brokerage, income from non banking assets and profit
from sale of or dealing with such assets and other receipts. The expenditure broadly
consists of – interest paid on deposits and borrowings and non interest c o s t o r
charges incurred on staff salary, stationery, rent, law charges, postage, telegram,
telephone etc. In this context, some attempts have already been made at individual as
well as at the official level and various aspects of commercial banking profitability have
been discussed. Banks play an active role in the economic development of a country.
Their ability to make a positive contribution in igniting the process of growth depends
on the effective banking system.

These banks mostly deal with money collected in the form of deposits along with their
own funds in the form of share capital and resources constituting around 5% of the total
resources of the banks. So the banks have the obligation of meeting the demand of the
customers promptly, paying interest for the amount and meeting the expenses to carry
out its activities. This necessitates the banks to maintain adequate liquidity and earn
required profit from their activities.

Nationalized Banks

Nationalized banks dominate the banking system in India. The history of nationalized
banks in India dates back to mid-20th century, when Imperial Bank of India was
nationalized (under the SBI Act of 1955) and re-christened as State Bank of India (SBI) in
July 1955.

Private Banks in India

Initially all the banks in India were private banks, which were founded in the pre-
independence era to cater to the banking needs of the people. In 1921, three major banks
i.e. Banks of Bengal, Bank of Bombay, and Bank of Madras, merged to form Imperial
Bank of India

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LITERATURE REVIEW

1. Chidambram R. M and Alamelu (1994) in their study entitled, “Profitability in Banks,

a matter of survival”, pointed out the problem of declining profit
m a r g i n s i n t h e Indian Public Sector Banks as compared to their private
sector counterparts. It was observed that in spite of similar social
obligations; almost all the private sector banks have been registering both –high
profits and high growth rate with respect to deposits, advances and reserves as
compared to the public sector banks. Regional orientation,  better customer
services, proper monitoring of advances and appropriate marketing strategies
are the secrets behind the success of public of the private sector banks.

2. Das A.( 1997) in his paper on “Technical allocation and Scale Efficiency of
the Public Sector Banks in India” The study found that there is decline in
overall efficiency due to fall in technical efficiency which was not offset by
an improvement in allocative efficiency. However, it is pointed out that the
deterioration in technical efficiency was mainly on account of few nationalized banks.

3. Deb and Kalpada (1998) in their study entitled, “Indian Banking since
Independence”, s t u d i e d t h e g r o w t h o f b a n k i n g i n I n d i a c o v e r i n g t h e
p e r i o d f r o m 1 9 6 6 - 1 9 8 7 . T h e analysis revealed that the structure of the
banking system changed considerable over the years. It was further pointed
out that the quantitative growth of the public sector   banks was no doubt
significant in some of the areas, but qualitative improvement, by a n d l a r g e
lacked in desired standards. In spite of substantial increase in
deposit m o b i l i z a t i o n , t h e i r s h a r e i n n a t i o n a l i n c o m e c o n t i n u e d
t o b e v e r y l o w . I t w a s concluded that the public sector banks were
neither guided by the consideration of  returns nor were they very much
concerned with developmental strategies.

4. S. and Verma, S. (1999) determined the factors influencing the profitability

of public sector banks in India by making use of ratio of net profits as
percentage of working funds. They concluded that spread and burden play a
major role in determining the profitability of commercial banks.

5. Chandan, C.L. and Rajput, P.K.(2002) measured the performance of bank

on basis on the basis of profitability analysis.

6. Sangami M. (2002) in his study has suggested that the position of operating
cost can be improved with the introduction of high level technology as well as by
improvement the per employee productivity.

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7. Q a m a r , F ( 2 0 0 3 ) i n h i s p a p e r e x a m i n e d c o m m e r c i a l b a n k s i n t e r m s
o f e n d o w m e n t factors, risk factors, revenue diversification, profitability and
efficiency parameters.

8. Chawla, A.S.(2006) made an attempt to analyze the emerging trends in

profits and profitability of four banks, two each from public sector and private sector
banks.

9.Sanjay J. Bhayani(2006) in his study, “Performance of New India

P r i v a t e B a n k s : A Comparative Study”, analyzed the performance of new
private sector banks with the h e l p o f C A M E L m o d e l . T h e s t u d y c o v e r e d
4 l e a d i n g p r i v a t e s e c t o r b a n k s - I C I C I , HDFC, UTI and IDBI for a period
of 5 years from 2000-01 to 2004-05.It is revealed that the aggregate performance
of IDBI Bank is best among all the banks, followed by UTI.
 
10. Uppal, R.K. and Kaur, R. (2007) emphasized that cost should be properly managed
to improve the profitability of banks because the net profits were affected by the
increase or decrease in operating cost.11.Chowdari Prasad and K.S. Srinivasa Rao
(2004)in their paper, “Private Sector Banking in India- A SWOT Analysis” studied the
performance of all private sector  banks. As per the criteria selected like
efficiency, financial strength, profitability and size of scale, it is revealed that
the private sector banks are in position to offer cost-effective, efficient
products and services to their customers using technology, best utilization of
human resources along with professional management and corporate
governance principles.

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OBJECTIVES
1. To analyze the business model of State Bank of India.

2. To analyze the business model of ICICI bank.

3. To analyze the financial performance of State Bank of India.

4. To analyze the financial performance of ICICI bank.

5. To compare State Bank of India and ICICI bank on the basis of their
business model and financial performance.

RESEARCH METHODOLOGY

The study will be conducted with reference to the data related to

S t a t e B a n k o f I n d i a a n d ICICI bank. These banks have been studied with
the belief that they hold the largest market share of banking business in India, in
their respective sectors.

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WHAT IS FINANCIAL RISK MANAGEMENT?

FINANCIAL RISK MANAGEMENT

Financial risk management is the practice of creating economic value in a firm by using
financial instruments to manage exposure to risk, particularly credit risk and market
risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation
risks, etc. Similar to general risk management, financial risk management requires
identifying its sources, measuring it, and plans to address them.

Financial risk management can be qualitative and quantitative. As a specialization of

risk management, financial risk management focuses on when and how to hedge using
financial instruments to manage costly exposures to risk.

In the banking sector worldwide, the Basel Accords are generally adopted by
internationally active banks for tracking, reporting and exposing operational, credit and
market risks.

THE RISK

The word “Risk” can be traced to the Latin word “Rescum” meaning Risk at Sea or that
which cuts. Risk is associated with uncertainty and reflected by way of charge on the
fundamental/ basic i.e. in the case of business it is the Capital, which is the cushion that
protects the liability holders of an institution. These risks are inter-dependent and
events affecting one area of risk can have ramifications and penetrations for a range of
other categories of risks. Foremost thing is to understand the risks run by the bank and
to ensure that the risks are properly confronted, effectively controlled and rightly
managed.

Each transaction that the bank undertakes changes the risk profile of the bank. The
extent of calculations that need to be performed to understand the impact of each such
risk on the transactions of the bank makes it nearly impossible to continuously update
the risk calculations. Hence, providing real time risk information is one of the key
challenges of risk management exercise. Till recently all the activities of banks were
regulated and hence operational environment was not conducive to risk taking. Better
insight, sharp intuition and longer experience were adequate to manage the limited
risks. Business is the art of extracting money from other’s pocket, sans resorting to
violence. But profiting in business without exposing to risk is like trying to live without
being born. Everyone knows that risk taking is failure prone as otherwise it would be
treated as sure taking. Hence risk is inherent in any walk of life in general and in
financial sectors in particular.

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MANAGEMENT

In the process of financial intermediation, the gap of which becomes thinner and
thinner, banks are exposed to severe competition and hence are compelled to encounter
various types of financial and non-financial risks. Risks and uncertainties form an
integral part of banking which by nature entails taking risks. Business grows mainly by
taking risk. Greater the risk, higher the profit and hence the business unit must strike a
trade off between the two.

The essential functions of risk management are to identify, measure and more
importantly monitor the profile of the bank. While Non-Performing Assets are the
legacy of the past in the present, Risk Management system is the pro-active action in the
present for the future. Managing risk is nothing but managing the change before the
risk manages. While new avenues for the bank has opened up they have brought with
them new risks as well, which the banks will have to handle and overcome.

When to use financial risk management

Finance theory (i.e., financial economics) prescribes that a firm should take on a project
when it increases shareholder value. Finance theory also shows that firm managers
cannot create value for shareholders, also called its investors, by taking on projects that
shareholders could do for themselves at the same cost.

When applied to financial risk management, this implies that firm managers should not
hedge risks that investors can hedge for themselves at the same cost. This notion was
captured by the hedging irrelevance proposition: In a perfect market, the firm cannot
create value by hedging a risk when the price of bearing that risk within the firm is the
same as the price of bearing it outside of the firm. In practice, financial markets are not
likely to be perfect markets.

This suggests that firm managers likely have many opportunities to create value for
shareholders using financial risk management. The trick is to determine which risks are
cheaper for the firm to manage than the shareholders. A general rule of thumb,
however, is that market risks that result in unique risks for the firm are the best
candidates for financial risk management.

The concepts of financial risk management change dramatically in the international

realm. Multinational Corporations are faced with many different obstacles in
overcoming these challenges. There has been some research on the risks firms must

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consider when operating in many countries, such as the three kinds of foreign exchange
exposure for various future time horizons: transactions exposure, accounting exposure,
and economic exposure.

Megaprojects (sometimes also called "major programs") have been shown to be

particularly risky in terms of finance. Financial risk management is therefore
particularly pertinent for megaprojects and special methods have been developed for
such risk management.

RISK MANAGEMENT IN INDIAN BANKS

Risk is inherent in any walk of life in general and in financial sectors in particular. Till
recently, due to regulated environment, banks could not afford to take risks. But of late,
banks are exposed to same competition and hence are compelled to encounter various
types of financial and non-financial risks. Risks and uncertainties form an integral part
of banking which by nature entails taking risks. There are three main categories of risks;
Credit Risk, Market Risk & Operational Risk. Main features of these risks as well as
some other categories of risks such as Regulatory Risk and Environmental Risk. Various
tools and techniques to manage Credit Risk, Market Risk and Operational Risk and its
various components, are also discussed in detail. There are also mentioned relevant
points of Basel’s New Capital Accord’ and role of capital adequacy, Risk Aggregation &
Capital Allocation and Risk Based Supervision (RBS), in managing risks in banking
sector.

The fast changing financial environment exposes the banks to various types of risk. The
concept of risk and management are core of financial enterprise. The financial sector
especially the banking industry in most emerging economies including India is passing
through a process of change. Rising global competition, increasing deregulation,
introduction of innovative products and delivery channels have pushed risk
management to the forefront of today's financial landscape. Ability to gauge the risks
and take appropriate position will be the key to success.

Today, The Indian Economy is in the process of becoming a world class economy. The
Indian banking industry is making great advancement in terms of quality, quantity,
expansion and diversification and is keeping up with the updated technology, ability,
stability and thrust of a financial system, where the commercial banks play a very

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important role, emphasize the very special need of a strong and effective control system
with extra concern for the risk involved in the business.

Globalization, Liberalization and Privatization have opened up a new methods of

financial transaction where risk level is very high. In banks and financial institutions
risk is considered to be the most important factor of earnings. Therefore they have to
balance the relationship between risk and return. In reality we can say that management
of financial institution is nothing but a management of risk. Managing financial risk
systematically and professionally becomes an even more important task. Rising global
competition, increasing deregulation, introduction of innovative products and delivery
channels have pushed risk management to the forefront of today's financial landscape.
Ability to gauge the risks and take appropriate position will be the key to success. It can
be said that risk takers will survive, effective risk managers will proper and risk averse
are likely to perish.

The risk arises due to uncertainties, which in turn arise due to changes taking place in
prevailing economic, social and political environment and lack of non-availability of
information concerning such changes. Risk is an exposure to a transaction with loss,
which occurs with some probability and which can be expected, measured and
minimized. In financial institutions risk result from variations and fluctuations in assets
or liability or both in incomes from assets or payments and on liabilities or in outflows
and inflows of cash. Today, banks are facing various types of risks that financial
intermediaries are exposed to, in the course of their business

TYPES OF RISKS IN BANKS

When we use the term “Risk”, we all mean financial risk or uncertainty of financial loss.
If we consider risk in terms of probability of occurrence frequently, we measure risk on

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a scale, with certainty of occurrence at one end and certainty of non-occurrence at the
other end. Risk is the greatest where the probability of occurrence or non-occurrence is
equal. As per the Reserve Bank of India guidelines issued in Oct. 1999, there are three
major types of risks encountered by the banks and these are Credit Risk, Market Risk &
Operational Risk. As we go along the article, we will see what are the components of
these three major risks. In August 2001, a discussion paper on move towards Risk Based
Supervision was published.

Further after eliciting views of banks on the draft guidance note on Credit Risk
Management and market risk management, the RBI has issued the final guidelines and
advised some of the large PSU banks to implement so as to guage the impact. A
discussion paper on Country Risk was also released in May 02. Risk is the potentiality
that both the expected and unexpected events may have an adverse impact on the
bank’s capital or earnings. The expected loss is to be borne by the borrower and hence is
taken care of by adequately pricing the products through risk premium and reserves
created out of the earnings. It is the amount expected to be lost due to changes in credit
quality resulting in default. Where as, the unexpected loss on account of the individual
exposure and the whole portfolio in entirely is to be borne by the bank itself and hence
is to be taken care of by the capital.

Thus, the expected losses are covered by reserves/provisions and the unexpected
losses require capital allocation. Hence the need for sufficient Capital Adequacy Ratio is
felt. Each type of risks is measured to determine both the expected and unexpected
losses using VAR (Value at Risk) or worst-case type analytical model.

A) Financial Risks
1) Credit Risk: Credit risk is defined as the possibility of losses associated with decrease
in the credit quality of the borrower or the counter parties. In the bank's portfolio, losses
stem from outside default due to inability or unwillingness of the customer or the
counter party to meet the commitments, losses may also result from reduction in the
portfolio value arising from actual or perceived deterioration in credit quality.

Credit Risk is the potential that a bank borrower/counter party fails to meet the
obligations on agreed terms. There is always scope for the borrower to default from his
commitments for one or the other reason resulting in crystalisation of credit risk to the
bank. These losses could take the form outright default or alternatively, losses from
changes in portfolio value arising from actual or perceived deterioration in credit
quality that is short of default. Credit risk is inherent to the business of lending funds to
the operations linked closely to market risk variables.

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The objective of credit risk management is to minimize the risk and maximize bank’s
risk adjusted rate of return by assuming and maintaining credit exposure within the
acceptable parameters. Credit risk consists of primarily two components, viz Quantity
of risk, which is nothing but the outstanding loan balance as on the date of default and
the quality of risk, viz, the severity of loss defined by both Probability of Default as
reduced by the recoveries that could be made in the event of default. Thus credit risk is
a combined outcome of Default Risk and Exposure Risk. The elements of Credit Risk is
Portfolio risk comprising Concentration Risk as well as Intrinsic Risk and Transaction
Risk comprising migration/down gradation risk as well as Default Risk.

At the transaction level, credit ratings are useful measures of evaluating credit risk that
is prevalent across the entire organization where treasury and credit functions are
handled. Portfolio analysis help in identifying concentration of credit risk,
default/migration statistics, recovery data, etc. In general, Default is not an abrupt
process to happen suddenly and past experience dictates that, more often than not,
borrower’s credit worthiness and asset quality declines gradually, which is otherwise
known as migration. Default is an extreme event of credit migration. Off balance sheet
exposures such as foreign exchange forward cantracks, swaps options etc are classified
in to three broad categories such as full Risk, Medium Risk and Low risk and then
translated into risk Neighted assets.

Tools of Credit Risk Management.

The instruments and tools, through which credit risk management is carried out, are
detailed below:
a) Exposure Ceilings: Prudential Limit is linked to Capital Funds – say 15% for
individual borrower entity, 40% for a group with additional 10% for infrastructure
projects undertaken by the group, Threshold limit is fixed at a level lower than
Prudential Exposure; Substantial Exposure, which is the sum total of the exposures
beyond threshold limit should not exceed 600% to 800% of the Capital Funds of the
bank (i.e. six to eight times).
b) Review/Renewal: Multi-tier Credit Approving Authority, constitution wise
delegation of powers, Higher delegated powers for better-rated customers;
discriminatory time schedule for review/renewal, Hurdle rates and Bench marks for
fresh exposures and periodicity for renewal based on risk rating, etc are formulated.

c) Risk Rating Model: Set up comprehensive risk scoring system on a six to nine point
scale. Clearly define rating thresholds and review the ratings periodically preferably at
half yearly intervals. Rating migration is to be mapped to estimate the expected loss.

d) Risk based scientific pricing: Link loan pricing to expected loss. High-risk category
borrowers are to be priced high. Build historical data on default losses. Allocate capital
to absorb the unexpected loss. Adopt the RAROC framework.

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e) Portfolio Management: The need for credit portfolio management emanates from the
necessity to optimize the benefits associated with diversification and to reduce the
potential adverse impact of concentration of exposures to a particular borrower, sector
or industry. Stipulate quantitative ceiling on aggregate exposure on specific rating
categories, distribution of borrowers in various industry, business group and conduct
rapid portfolio reviews. The existing framework of tracking the non-performing loans
around the balance sheet date does not signal the quality of the entire loan book. There
should be a proper & regular on-going system for identification of credit weaknesses
well in advance. Initiate steps to preserve the desired portfolio quality and integrate
portfolio reviews with credit decision-making process.

f) Loan Review Mechanism: This should be done independent of credit operations. It is

also referred as Credit Audit covering review of sanction process, compliance status,
review of risk rating, pick up of warning signals and recommendation of corrective
action with the objective of improving credit quality. It should target all loans above
certain cut-off limit ensuring that at least 30% to 40% of the portfolio is subjected to
LRM in a year so as to ensure that all major credit risks embedded in the balance sheet
have been tracked. This is done to bring about qualitative improvement in credit
administration. Identify loans with credit weakness. Determine adequacy of loan loss
provisions. Ensure adherence to lending policies and procedures. The focus of the credit
audit needs to be broadened from account level to overall portfolio level. Regular,
proper & prompt reporting to Top Management should be ensured. Credit Audit is
conducted on site, i.e. at the branch that has appraised the advance and where the main
operative limits are made available. However, it is not required to visit borrowers
factory/office premises.

2) Market Risk: Market risk is the risk of incurring losses on account of movements in
market prices on all positions held by the banks. Liquidity risk of banks arises from
funding of long term assets (advances) by short term sources (deposits) changes in
interest rate can significantly affect the Net Interest Income (NII). The risk of an adverse
impact on NII due to variations of interest rate may be called interest rate risk. Forex
risk is the risk of loss that bank may suffer on account of adverse exchange rate
movements against uncovered position in foreign currency.

Market Risk may be defined as the possibility of loss to bank caused by the changes in
the market variables. It is the risk that the value of on-/off-balance sheet positions
will be adversely affected by movements in equity and interest rate markets, currency
exchange rates and commodity prices. 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 prices.

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Market Risk Management provides a comprehensive and dynamic frame work for
measuring, monitoring and managing liquidity, interest rate, foreign exchange and
equity as well as commodity price risk of a bank that needs to be closely integrated with
the bank’s business strategy. Scenario analysis and stress testing is yet another tool used
to assess areas of potential problems in a given portfolio. Identification of future
changes in economic conditions like – economic/industry overturns, market risk events,
liquidity conditions etc that could have unfavourable effect on bank’s portfolio is a
condition precedent for carrying out stress testing. As the underlying assumption keep
changing from time to time, output of the test should be reviewed periodically as
market risk management system should be responsive and sensitive to the happenings
in the market.

a) Liquidity Risk:

Bank Deposits generally have a much shorter contractual maturity than loans and
liquidity management needs to provide a cushion to cover anticipated deposit
withdrawals. Liquidity is the ability to efficiently accommodate deposit as also
reduction in liabilities and to fund the loan growth and possible funding of the off-
balance sheet claims. The cash flows are placed in different time buckets based on
future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk
consists of Funding Risk, Time Risk & Call Risk.

Funding Risk : It is the need to replace net out flows due to unanticipated
withdrawal/nonrenewal of deposit.

Time risk : It is the need to compensate for nonreceipt of expected inflows of funds, i.e.
performing assets turning into nonperforming assets.

Call risk : It happens on account of crystalisation of contingent liabilities and inability

to undertake profitable business opportunities when desired.

The Asset Liability Management (ALM) is a part of the overall risk management
system in the banks. It implies examination of all the assets and liabilities
simultaneously on a continuous basis with a view to ensuring a proper balance between
funds mobilization and their deployment with respect to their a) maturity profiles, b)
cost, c) yield, d) risk exposure, etc. It includes product pricing for deposits as well as
advances, and the desired maturity profile of assets and liabilities.
Tolerance levels on mismatches should be fixed for various maturities depending upon
the asset liability profile, deposit mix, nature of cash flow etc

b) Interest Rate Risk

Interest Rate Risk is the potential negative impact on the Net Interest Income and it
refers to the vulnerability of an institution’s financial condition to the movement in

15
interest rates. Changes in interest rate affect earnings, value of assets, liability off-
balance sheet items and cash flow. Hence, the objective of interest rate risk management
is to maintain earnings, improve the capability, ability to absorb potential loss and to
ensue the adequacy of the compensation received for the risk taken and effect risk
return trade-off.

Management of interest rate risk aims at capturing the risks arising from the maturity
and re-pricing mismatches and is measured both from the earnings and economic value
perspective. Earnings perspective involves analyzing the impact of changes in interest
rates on accrual or reported earnings in the near term. This is measured by measuring
the changes in the Net Interest Income (NII) equivalent to the difference between total
interest income and total interest expense.

In order to manage interest rate risk, banks should begin evaluating the vulnerability of
their portfolios to the risk of fluctuations in market interest rates. One such measure is
Duration of market value of a bank asset or liabilities to a percentage change in the
market interest rate. The difference between the average duration for bank assets and
the average duration for bank liabilities is known as the duration gap which assess the
bank’s exposure to interest rate risk. The Asset Liability Committee (ALCO) of a bank
uses the information contained in the duration gap analysis to guide and frame
strategies. By reducing the size of the duration gap, banks can minimize the interest rate
risk. Economic Value perspective involves analyzing the expected cash in flows on
assets minus expected cash out flows on liabilities plus the net cash flows on off-balance
sheet items. The economic value perspective identifies risk arising from long-term
interest rate gaps.

The various types of interest rate risks are detailed below:

Gap/Mismatch risk: It arises from holding assets and liabilities and off balance sheet
items with different principal amounts, maturity dates & re-pricing dates thereby
creating exposure to unexpected changes in the level of market interest rates.

Basis Risk: It is the risk that the Interest rat of different Assets/liabilities and off
balance items may change in different magnitude. The degree of basis risk is fairly high
in respect of banks that create composite assets out of composite liabilities.

Embedded option Risk: Option of pre-payment of loan and Fore- closure of deposits
before their stated maturities constitute embedded option risk Yield curve risk:
Movement in yield curve and the impact of that on portfolio values and income.

Reprice risk: When assets are sold before maturities.

Reinvestment risk: Uncertainty with regard to interest rate at which the future cash
flows could be reinvested.

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Net interest position risk: When banks have more earning assets than paying liabilities,
net interest position risk arises in case market interest rates adjust downwards.

There are different techniques such as a) the traditional Maturity Gap Analysis to
measure the interest rate sensitivity, b) Duration Gap Analysis to measure interest rate
sensitivity of capital, c) simulation and d) Value at Risk for measurement of interest rate
risk.

The approach towards measurement and hedging interest rate risk varies with
segmentation of bank’s balance sheet. Banks broadly bifurcate the asset into Trading
Book and Banking Book. While trading book comprises of assets held primarily for
generating profits on short term differences in prices/yields, the banking book consists
of assets and liabilities contracted basically on account of relationship or for steady
income and statutory obligations and are generally held till maturity/payment by
counter party.

Thus, while price risk is the prime concern of banks in trading book, the earnings or
changes in the economic value are the main focus in banking book. Value at Risk (VaR)
is a method of assessing the market risk using standard statistical techniques. It is a
statistical measure of risk exposure and measures the worst expected loss over a given
time interval under normal market conditions at a given confidence level of say 95% or
99%.

Thus VaR is simply a distribution of probable outcome of future losses that may occur
on a portfolio. The actual result will not be known until the event takes place. Till then it
is a random variable whose outcome has been estimated. As far as Trading Book is
concerned, bank should be able to adopt standardized method or internal models for
providing explicit capital charge for market risk.

c) Forex Risk
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse
exchange rate movement during a period in which it has an open position, either spot
or forward or both in same foreign currency. Even in case where spot or forward
positions in individual currencies are balanced the maturity pattern of forward
transactions may produce mismatches. There is also a settlement risk arising out of
default of the counter party and out of time lag in settlement of one currency in one
center and the settlement of another currency in another time zone.

Banks are also exposed to interest rate risk, which arises from the maturity mismatch of
foreign currency position. The Value at Risk (VaR) indicates the risk that the bank is
exposed due to uncovered position of mismatch and these gap positions are to be
valued on daily basis at the prevalent forward market rates announced by FEDAI for

17
the remaining maturities. Currency Risk is the possibility that exchange rate changes
will alter the expected amount of principal and return of the lending or investment.

At times, banks may try to cope with this specific risk on the lending side by shifting
the risk associated with exchange rate fluctuations to the borrowers. However the risk
does not get extinguished, but only gets converted in to credit risk. By setting
appropriates limits-open position and gaps, stop-loss limits, Day Light as well as
overnight limits for each currency, Individual Gap Limits and Aggregate Gap Limits,
clear cut and well defined division of responsibilities between front, middle and back
office the risk element in foreign exchange risk can be managed/monitored.

d) Country Risk

This is the risk that arises due to cross border transactions that are growing dramatically
in the recent years owing to economic liberalization and globalization. It is the
possibility that a country will be unable to service or repay debts to foreign lenders in
time.

It comprises of Transfer Risk arising on account of possibility of losses due to

restrictions on external remittances; Sovereign Risk associated with lending to
government of a sovereign nation or taking government guarantees; Political Risk when
political environment or legislative process of country leads to government taking over
the assets of the financial entity (like nationalization, etc) and preventing discharge of
liabilities in a manner that had been agreed to earlier; Cross border risk arising on
account of the borrower being a resident of a country other than the country where the
cross border asset is booked; Currency Risk, a possibility that exchange rate change, will
alter the expected amount of principal and return on the lending or investment.

In the process there can be a situation in which seller (exporter) may deliver the goods,
but may not be paid or the buyer (importer) might have paid the money in advance but
was not delivered the goods for one or the other reasons. As per the RBI guidance note
on Country Risk Management published recently, banks should reckon both fund and
non-fund exposures from their domestic as well as foreign branches, if any, while
identifying, measuring, monitoring and controlling country risk.

It advocates that bank should also take into account indirect country risk exposure. For
example, exposures to a domestic commercial borrower with large economic
dependence on a certain country may be considered as subject to indirect country risk.
The exposures should be computed on a net basis, i.e. gross exposure minus collaterals,
guarantees etc. Netting may be considered for collaterals in/guarantees issued by
countries in a lower risk category and may be permitted for bank’s dues payable to the
respective countries.

18
RBI further suggests that banks should eventually put in place appropriate systems to
move over to internal assessment of country risk within a prescribed period say by
31.3.2004, by which time the new capital accord would be implemented. The system
should be able to identify the full dimensions of country risk as well as incorporate
features that acknowledge the links between credit and market risks. Banks should not
rely solely on rating agencies or other external sources as their only country risk-
monitoring tool.

With regard to inter-bank exposures, the guidelines suggests that banks should use the
country ratings of international rating agencies and broadly classify the country risk
rating into six categories such as insignificant, low, moderate, high, very high & off-
credit. However, banks may be allowed to adopt a more conservative categorization of
the countries. Banks may set country exposure limits in relation to the bank’s regulatory
capital (Tier I & II) with suitable sub limits, if necessary, for products, branches,
maturity etc.

Banks were also advised to set country exposure limits and monitor such exposure on
weekly basis before eventually switching over to real tie monitoring. Banks should use
variety of internal and external sources as a means to measure country risk and should
not rely solely on rating agencies or other external sources as their only tool for
monitoring country risk. Banks are expected to disclose the “Country Risk
Management” policies in their Annual Report by way of notes.

B) Non-Financial Risk

Non-financial risk refers to those risks that may affect a bank's business growth,
marketability of its product and services, likely failure of its strategies aimed at business
growth etc. These risks may arise on account of management failures, competition, non-
availability of suitable products/services, external factors etc. In these risk operational
and strategic risk have a great need of consideration.

1) Operational Risk: It may be defined as the risk of loss resulting from inadequate or
failed internal process people and systems or because of external events. Always banks
live with the risks arising out of human error, financial fraud and natural disasters. The
recent happenings such as WTC tragedy, Barings debacle etc. has highlighted the
potential losses on account of operational risk. Exponential growth in the use of

19
technology and increase in global financial inter-linkages are the two primary changes
that contributed to such risks.

Operational risk, though defined as any risk that is not categorized as market or credit
risk, is the risk of loss arising from inadequate or failed internal processes, people and
systems or from external events. In order to mitigate this, internal control and internal
audit systems are used as the primary means. Risk education for familiarizing the
complex operations at all levels of staff can also reduce operational risk. Insurance cover
is one of the important mitigators of operational risk.

Operational risk events are associated with weak links in internal control procedures.
The key to management of operational risk lies in the bank’s ability to assess its process
for vulnerability and establish controls as well as safeguards while providing for
unanticipated worst-case scenarios.

Operational risk involves breakdown in internal controls and corporate governance

leading to error, fraud, performance failure, compromise on the interest of the bank
resulting in financial loss. Putting in place proper corporate governance practices by
itself would serve as an effective risk management tool. Bank should strive to promote a
shared understanding of operational risk within the organization, especially since
operational risk is often interwined with market or credit risk and it is difficult to
isolate.

Over a period of time, management of credit and market risks has evolved a more
sophisticated fashion than operational risk, as the former can be more easily measured,
monitored and analysed. And yet the root causes of all the financial scams and losses
are the result of operational risk caused by breakdowns in internal control mechanism
and staff lapses. So far, scientific measurement of operational risk has not been evolved.
Hence 20% charge on the Capital Funds is earmarked for operational risk and based on
subsequent data/feedback, it was reduced to 12%.

While measurement of operational risk and computing capital charges as envisaged in

the Basel proposals are to be the ultimate goals, what is to be done at present is start
implementing the Basel proposal in a phased manner and carefully plan in that
direction. The incentive for banks to move the measurement chain is not just to reduce
regulatory capital but more importantly to provide assurance to the top management
that the bank holds the required capital.

2) Strategic Risk: Strategic risk is the risk that arises from the inability to implement
appropriate business plans and strategies, decisions with regard to allocation of
resources or adaptability to dynamic changes in the business/operating environment.
These are a number of other risk factor through which operations risk, credit risk and
market risk may manifest. It should be recognized that many of these risk factors are
interrelated, one results to other.

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Process of Risk Management:

To overcome the risk and to make banking function well, there is a need to manage all
kinds of risks associated with the banking. Risk management becomes one of the main
functions of any banking services risk management consists of identifying the risk and
controlling them, means keeping the risk at acceptable level. These levels differ from
institution to institution and country to country. The basic objective of risk management
is to stakeholders; value by maximizing the profit and optimizing the capital funds for
ensuring long term solvency of the banking organization. In the process of risk
management following functions comprises:
• Risk identification
• Risk measurement or quantification
• Risk control
• Monitoring and reviewing

Risk Identification: The risk identification involves 1. the understanding the nature of
various kinds of risks. 2. the circumstances which lead a situation to become a risk
situation and 3. causes due to which the risk can arise.

Risk Quantification: Risk quantification is an assessment of the degree of the risk

which a particular transaction or an activity is exposed to. Though the exact
measurement of risk is not possible but the level of risk can be determined with the help
of risk rating models.

Risk Control: Risk control is the stage where the bank or institutions take steps to
control the risk with the help of various tools.

Tools for Risk Control

• Diversification of the business
• Insurance and hedging
• Fixation of exposure ceiling

21
• Transfer the risk to another party at right time
• Securitization and reconstruction.

Risk Monitoring: In risk monitoring the bankers have to fix up the parameters on
which the transaction is to be tested to be sure that there is no risk to viable existence of
the financial unit or investment of the bank.

Risk Management in Bank: Basel Committee Approach

In order to help the banks to recognise the different kinds of risks and to take adequate
steps to overcome the under capitalisation of banks assets and lessen the credit and
operational risks faced by banks. Banks of International Settlement (BIS) set up Basel
Committee on banking supervision in 1988, which issued guidelines for updating risk
management in banks. These guidelines brought about standardization and
universalization among the global banking committee for risk management and seek to
protect the interest of the depositors/shareholders of the bank. As per the guidelines
issued, capital adequacy was considered panacea for risk management and all banks
were advised to have Capital Adequacy Ratio (CAR) at at least 8%. CAR is the ratio of
capital to risk weighted assets and it provides the cushion to the depositors in case of
bankruptcy. In January 1999, the Basel Committee proposed a new capital accord,
which is known as Basel II.

A sound framework for measuring and quantifying the risk associated with banking
operations put by it. The emphasis of New Basel Accord is on flexibility, efficient

22
operations and higher revenues for banks with full acknowledgement of risks. The New
Accord makes clear distinction between the credit risk, market risk and operational risk
stipulating assessment of risk weightage covering all the three categories separately.
Also it provides a range of options for determining the capital requirements for credit
risk and operational risk. Banks are required to select approaches that are most
appropriate for their operations and financial markets.

The finalized Basel II Accord was released in June 2004. The midterm review of annual
policy for the year 2006-07 from the Reserve Bank of India (RBI) revealed that the
intended date for adoption of Basel II, i.e. March 2007, had to be postponed by two
years, taking into consideration the stake of preparedness of the banking system in the
country. This accord is based on three pillars, viz.

Pillar I: Minimum Capital Requirement

Pillar II: Supervisory Review
Pillar III: Market Discipline

Minimum Capital Requirement (Pillar I)

The Minimum Capital Requirement (MCR) is set by the capital ratio which is defined as
(Total Capital - Tier I + Tier II + Tier III) / credit risk + market risk + operational risk).
Basel I provided for only a credit risk charge. A market risk was implemented in 1996
amendments. In the initial stage, all banks are required to follow standardized
approach in credit risk, basic indicator approach in operational risk and standardized
duration approach in market risk. Migration to higher approaches will require RBI
permission. Higher approaches are more risk sensitive and may reduce capital
requirement for banks following sound risk management.

Supervisory Review Process (Pillar II)

The supervisory review process is required to ensure adequacy as well as to ensure
integrity by the risk management processes. The Basel Committee has started four key
principles of supervisory review as under:
• Bank should have a process for accessing its overall capital adequacy in relation to its
risk profile, as well as, a strategy for maintaining its capital levels.
• Supervisors expect banks to operate above the minimum regulatory capital ratios and
ensure banks hold capital in excess of the minimum.
• Supervisory shall review bank, internal capital adequacy assessment and strategy, as
well as compliance with regulatory capital ratios.
• Supervisors shall seek to intervene at an early stage to prevent capital from falling
below prudent levels.

The Reserve Bank of India being the supervisor of the banking operation in India is
expected to evaluate how well banks are assessing their capital needs relative to their
risks. When deficiencies are identified, prompt and decisive actions are expected to be
taken by the supervisors to reduce the risk.
23
Market Discipline (Pillar III) Effective market discipline requires retable and timely
information that enables counter parties to make well established risk assessment. Pillar
III relates to periodical disclosures to regulator, Board of Bank and market about
various parameters which indicates the risk profile of the bank. Reserve Bank of India
has stipulated that banks should provide all Pillar III disclosures, both quantitative and
qualitative as at the end March each year along with the annual financial statement. The
banks are required to put such disclosures on its websites. Market discipline promotes
safety and soundness in banks and financial system and facilitates banks conducting
their business in a safe, sound and efficient manner.

Challenges in the Indian context

Basel II is intended to improve safely and soundness of the financial system by placing
increased emphasis on bank's own internal control and risk management processes and
models, the supervisory review process and market discipline. Indeed, to enable the
calculation of capital requirements under the new accord requires a bank to implement
a comprehensive risk management framework. However, these changes will also have
wide ranging effects on bank's information technology systems, processes, people and
business, beyond the regulatory compliance, risk management and finance functions.
Though every bank has to invest lot of time, manpower and energy in the
implementations of Basel II, yet it helps the banks to assess the risks associated with the
business effectively. More so, it facilitates the banks to produce quantified and more
realistic measure of the risk. Basel II enables the banks to handle business with more
confidence and make better business decisions. But the techniques and the methods
suggested in the new accord would pose considerable implementation challenges for
the banks especially in a developing country like India; some of them are described as
under:

• Implementation of the new framework will require substantial resources and

commitment on the part of both banks and supervisors. Banks are required to make

24
enormous improvements in the areas of policies, organisational structure, MIS, tools for
analysis, process, specified training of staff etc. It will involve huge cost both for the
banks as well as for supervisors.

• The new norms will increase the capital requirements in all the banks due to
introduction in multiple risk weights with preferential treatment for high rated assets.
Although the capital requirement for credit risk may go down due to adoption of more
risk sensitive techniques such as securitization, derivatives, melting services, equity
holdings, venture capital and guarantees etc.

• Risk management is extremely data-intensive. Accurate, reliable and timely

availability of data is crucial for proper risk management. Banks need to implement
substantial changes to their internal systems to prepare for appropriate data collection
and revised reporting requirements. These changes may require systems integration,
modification and introduction of new software. Banks need to assess the capabilities of
their present systems and review the necessary system changes required.

• To provide the basis for forecasting and building of models in respect of various
activities, such as loaning, security and foreign exchange transactions, a lot of historical
data is required. In the Indian context major handicap is the absence of data series,
particularly, related to the transactions in individual loan accounts.

• The new capital accord assigns risk-weight of sovereign at 0-50%. These 13 also a
higher risk weight to the small and medium enterprises. In India, the PSBs have more
than 40 percent of their lending to priority sector. The implementation of Basel II can
adversely affect the priority sector lending.

• Even the G-10 countries are finding it difficult to implement the Basel II accord in all
the banks. Therefore, longer time may be required for its implementation in some or all
the banks in India.

• In India, credit rating is restricted to issues and not to the issuers. While Basel II gives
some scope to extend the rating of issues to issuers. This would be an approximation
and it would be necessary for the system to move to the rating of issuers. Encouraging
rating of issuers would be a challenge.

• Yet another requirement for establishing risk management system is trained and
skilled manpower. The managers should understand both the theory and practice of
risk. To reach such on understanding undoubtedly involves a continuous learning
process in the new technologies. Inducting a continuous learning process in the line
managers and educating them in risk management is a task to be addressed on priority
by the banks for the smooth adoption of the risk management principles and practices
and Basel-II recommendations across the banks. Skill development for risk management

25
approaches, both at the bank level and at supervisors’ level, would be a tough task
ahead.

Top six liquidity risk management challenges for global banks

The credit crisis has placed liquidity risk management front and center in the global banking
industry, presenting some weighty challenges that global banks must address. Liquidity risk
management is now a major focus for regulators, and global banks must navigate a range of
regulatory requirements and guidance that is not always clear or well-aligned.

What is clear is that liquidity risk must be owned from the top of the organization
down. Without maintaining a constant pulse on their liquidity position, banks can
quickly face serious reputational damage or, worse, insolvency. From our perspective,
there are six key challenges in effectively managing liquidity risk:

1. Moving from tactical stop-gap solutions to a long-term strategic model for risk
management, and cascading the new governance structure through all levels of
management.

2. Having clear guidance and requirements when global regulators are lacking
alignment.

3. Committing huge resources to implement needed changes in liquidity risk

management and regulatory compliance.

26
4. Re-thinking the viability of a business operating model that has traditionally relied on
the wholesale funding markets to fund business growth.

5. Integrating stress-testing (vs. using a siloed stress-test approach) when complications

arise between intra-day, short-term scenarios vs. longer term scenarios.

6. Projecting contractual cash flows for underlying transactions when some institutions
manage millions of transactions.

Asset - Liability Management System in banks – Guidelines

Over the last few years the Indian financial markets have witnessed wide ranging
changes at fast pace. Intense competition for business involving both the assets and
liabilities, together with increasing volatility in the domestic interest rates as well as
foreign exchange rates, has brought pressure on the management of banks to maintain a
good balance among spreads, profitability and long-term viability. These pressures call
for structured and comprehensive measures and not just adhoc action. The
Management of banks has to base their business decisions on a dynamic and integrated
risk management system and process, driven by corporate strategy. Banks are exposed
to several major risks in the course of their business - credit risk, interest rate risk,
foreign exchange risk, equity / commodity price risk, liquidity risk and operational
risks.

This note lays down broad guidelines in respect of interest rate and liquidity risks
management systems in banks which form part of the Asset-Liability Management
(ALM) function. The initial focus of the ALM function would be to enforce the risk
management discipline viz. managing business after assessing the risks involved. The
objective of good risk management programmes should be that these programmes will
evolve into a strategic tool for bank management.

27
The ALM process rests on three pillars:
1. ALM information system.
Management Information System
Information availability, accuracy, adequacy and expediency
2. ALM organization
Structure and responsibilities
Level of top management involvement
3. ALM process
Risk parameters
Risk identification
Risk measurement
Risk management
Risk policies and tolerance levels.

1. ALM information systems

Information is the key to the ALM process. Considering the large network of branches
and the lack of an adequate system to collect information required for ALM which
analyses information on the basis of residual maturity and behavioral pattern it will
take time for banks in the present state to get the requisite information. The problem of
ALM needs to be addressed by following an ABC approach i.e. analyzing the behavior
of asset and liability products in the top branches accounting for significant business
and then making rational assumptions about the way in which assets and liabilities
would behave in other branches.

In respect of foreign exchange, investment portfolio and money market operations, in

view of the centralized nature of the functions, it would be much easier to collect
reliable information. The data and assumptions can then be refined over time as the
bank management gain experience of conducting business within an ALM framework.
The spread of computerization will also help banks in accessing data.

2. ALM organization
a) The Board should have overall responsibility for management of risks and should
decide the risk management policy of the bank and set limits for liquidity, interest rate,
foreign exchange and equity price risks.

b) The Asset - Liability Committee (ALCO) consisting of the bank's senior management
including CEO should be responsible for ensuring adherence to the limits set by the
Board as wellas for deciding the business strategy of the bank (on the assets and
liabilities sides) in line with the bank's budget and decided risk management objectives.

c) The ALM desk consisting of operating staff should be responsible for analyzing,
28
monitoring and reporting the risk profiles to the ALCO. The staff should also prepare
forecasts (simulations) showing the effects of various possible changes in market
conditions related to the balance sheet and recommend the action needed to adhere to
bank's internal limits.

The ALCO is a decision making unit responsible for balance sheet planning from risk -
return perspective including the strategic management of interest rate and liquidity
risks. Each bank will have to decide on the role of its ALCO, its responsibility as also the
decisions to be taken by it. The business and risk management strategy of the bank
should ensure that the bank operates within the limits / parameters set by the Board.

The business issues that an ALCO would consider, inter alia, will include product
pricing for both deposits and advances, desired maturity profile of the incremental
assets and liabilities, etc. In addition to monitoring the risk levels of the bank, the ALCO
should review the results of and progress in implementation of the decisions made in
the previous meetings. The ALCO would also articulate the current interest rate view of
the bank and base its decisions for future business strategy on this view.

In respect of the funding policy, for instance, its responsibility would be to decide on
source and mix of liabilities or sale of assets. Towards this end, it will have to develop a
view on future direction of interest rate movements and decide on a funding mix
between fixed vs. floating rate funds, wholesale vs. retail deposits, money market vs.
capital market funding, domestic vs. foreign currency funding, etc. Individual banks
will have to decide the frequency for holding their ALCO meetings.

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, the CEO/CMD or ED should head the Committee. The Chiefs of
Investment, Credit, Funds Management / Treasury (forex and domestic), International
Banking and Economic Research can be members of the Committee. In addition the
Head of the Information Technology Division should also be an invitee for building up
of MIS and related computerization. Some banks may even have sub-committees.

Committee of Directors
Banks should also constitute a professional Managerial and Supervisory Committee
consisting of three to four directors which will oversee the implementation of the
system and review its functioning periodically.

3. ALM process:
The scope of ALM function can be described as follows:

29
1. Liquidity risk management
2. Management of market risks
(Including Interest Rate Risk)
3. Funding and capital planning
4. Profit planning and growth projection
5. Trading risk management
The guidelines given in this note mainly address Liquidity and Interest Rate risks.

Liquidity Risk Management

Measuring and managing liquidity needs are vital activities of commercial banks. By
Assuring a bank'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. Bank management should
measure not only the liquidity positions of banks on an ongoing basis but also examine
how liquidity requirements are likely to evolve under crisis scenarios.

Experience shows that assets commonly considered as liquid like 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 Structural Liquidity is given in Annexure I.

The Maturity Profile as given in Appendix I could be used for measuring the future
cash flows of banks in different time buckets. The time buckets given the Statutory
Reserve cycle of 14 days 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
v) Over 6 months and up to 12 months

30
vi) Over 1 year and up to 2 years
vii) Over 2 years and up to 5 years
viii) Over 5 years

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. Banks, 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 / Management
Committee. The mismatch during 1-14 days and 15-28 days should not in any case
exceed 20% of the cash outflows in each time bucket.

If a bank in view of its asset -liability profile needs higher tolerance level, it could
operate with higher limit sanctioned by its Board / Management Committee giving
reasons on the need for such higher limit. A copy of the note approved by Board /
Management Committee may be forwarded to the Department of Banking Supervision,
RBI. The discretion to allow a higher tolerance level is intended for a temporary period,
till the system stabilizes and the bank are able to restructure its asset -liability pattern.

The Statement of Structural Liquidity ( Annexure I ) 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 be necessary to take into account the rupee inflows and outflows
on account of forex operations including the readily available forex resources ( FCNR
(B) funds, etc) which can be deployed for augmenting rupee resources.

While determining the likely cash inflows / outflows, banks have to make a number of
assumptions according to their asset - liability profiles. For instance, Indian banks with
large branch network can (on the stability of their deposit base as most deposits are
Renewed) afford to have larger tolerance levels in mismatches if their term deposit base
is quite high. While determining the tolerance levels the banks 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.

In order to enable the banks to monitor their short-term liquidity on a dynamic basis
over a time horizon spanning from 1-90 days, banks may estimate their short-term
liquidity profiles on the basis of business projections and other commitments. An
indicative format ( Annexure III ) for estimating Short-term Dynamic Liquidity is
enclosed.

31
Currency Risk
Floating exchange rate arrangement has brought in its wake pronounced volatility
adding a new dimension to the risk profile of banks' 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 banks' 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. The simplest
way to avoid currency risk is to ensure that mismatches, if any, are reduced to zero or
near zero. Banks undertake operations in foreign exchange like accepting deposits,
making loans and advances and quoting prices for foreign exchange transactions.
Irrespective of the strategies adopted, it may not be possible to eliminate currency
mismatches altogether. Besides, some of the institutions may take proprietary trading
positions as a conscious business strategy.

Managing Currency Risk is one more dimension of Asset- Liability Management.

Mismatched currency position besides exposing the balance sheet to movements in
exchange rate also exposes it to country risk and settlement risk. Ever since the RBI
(Exchange Control Department) introduced the concept of end of the day near square
position in 1978, banks have been setting up overnight limits and selectively
undertaking active day time trading. Following the introduction of "Guidelines for
Internal Control over Foreign Exchange Business" in 1981, maturity mismatches (gaps)
are also subject to control.

Following the recommendations of Expert Group on Foreign Exchange Markets in

India (Sodhani Committee) the calculation of exchange position has been redefined and
banks have been given the discretion to set up overnight limits linked to maintenance of
additional Tier I capital to the extent of 5 per cent of open position limit.

Presently, the banks are also free to set gap limits with RBI's approval but are required
to adopt Value at Risk (VAR) approach to measure the risk associated with forward
exposures. Thus the open position limits together with the gap limits form the risk
management approach to forex operations. For monitoring such risks banks should
follow the instructions contained in Circular A.D (M. A. Series) No.52 dated December
27, 1997 issued by the Exchange Control Department.

Interest Rate Risk (IRR)

32
The phased deregulation of interest rates and the operational flexibility given to banks
in pricing most of the assets and liabilities have exposed the banking system to Interest
Rate Risk. Interest rate risk is the risk where changes in market interest rates might
adversely affect a bank's financial condition. Changes in interest rates affect both the
current earnings (earnings perspective) as also the net worth of the bank (economic
value perspective). The risk from the earnings' perspective can be measured as changes
in the Net Interest Income (Nil) or Net Interest Margin (NIM). In the context of poor
MIS, slow pace of computerization in banks and the absence of total deregulation, the
traditional Gap analysis is considered as a suitable method to measure the Interest Rate
Risk.

It is the intention of RBI to move over to modern techniques of Interest Rate Risk
measurement like Duration Gap Analysis, Simulation and Value at Risk at a later date
when banks acquire sufficient expertise and sophistication in 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/reprises contractually during the interval;
iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances
up to Rs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases
where interest rates are administered ; and
iv) it is contractually pre-payable or withdrawable before the stated maturities.

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
reprising period, whichever is earlier. The difficult task in Gap analysis is determining
rate sensitivity. All investments, advances, deposits, borrowings, purchased funds etc.
that mature/reprise within a specified timeframe are interest rate sensitive.

Similarly, any principal repayment of loan is also rate sensitive if the bank expects to
receive it within the time horizon. This includes final principal payment and interim
installments. Certain assets and liabilities receive/pay rates that vary with a reference
rate. These assets and liabilities are reprised at pre-determined intervals and are rate
sensitive at the time of reprising. While the interest rates on term deposits are fixed
during their currency, the advances portfolio of the banking system is basically floating.
The interest rates on advances could be reprised any number of occasions,
corresponding to the changes in PLR. The Gaps may be identified in the following time
buckets:

i) Up to 1 month
ii) Over one month and up to 3 months

33
iii) Over 3 months and up to 6 months
iv) Over 6 months and up to 12 months
v) Over 1 year and up to 3 years
vi) Over 3 years and up to 5 years
vii) Over 5 years
viii) Non-sensitive

The various items of rate sensitive assets and liabilities in the Balance Sheet may be
classified as explained in Appendix - II and the Reporting Format for interest rate
sensitive assets and liabilities is given in Annexure II.

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 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 bank should set prudential limits on individual Gaps with the approval of the
Board/Management Committee. The prudential limits should have a bearing on the
total assets, earning assets or equity. The banks may work out earnings at risk, based on
their views on interest rate movements and fix a prudent level with the approval of the
Board/Management Committee. RBI will also introduce capital adequacy for market
risks in due course.

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. Banks which are better equipped to
reasonably estimate the behavioral 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.

34
State Bank of India
The State Bank of India, the country’s oldest Bank and a premier in terms of
balance sheet size, number of branches, market capitalization and profits is today going
through a momentous phase of Change and Transformation – the two
hundred year old Public sector behemoth is today stirring out of its Public
Sector legacy and moving with an ability to give the Private and Foreign Banks a
run for their money.

The bank is entering into many new businesses with strategic tie ups – Pension Funds,
General Insurance, Custodial Services, Private Equity, Mobile Banking, Point of Sale
Merchant Acquisition, Advisory Services, structured products etc – each one of these
initiatives having a huge potential for growth. The Bank is forging ahead with cutting
edge technology and innovative new banking models, to expand its Rural Banking
base, looking at the vast untapped potential in the hinterland and  proposes to
cover 100,000 villages in the next two years.

It is also focusing at the top end of the market, on whole sale banking capabilities to
provide India’s growing mid / large Corporate with a complete array of products and
services. It is consolidating its global treasury operations and entering into structured
products and derivative instruments. Today, the Bank is the largest provider of
infrastructure debt and the largest arranger of external commercial borrowings in the
country. It is the only Indian bank to feature in the Fortune 500 list.

35
The Bank’s Operations and Performance
Business Turnover

The gross business turnover of the Bank crossed the major milestone of Rs. One lakh
crore in December 2010. The total business of the Bank stood at Rs.104,202 crore on 31st
March 2011, registering a growth of 16.63% from the level of Rs.89,345 crore as on 31st
March 2010. 2.2 Working Results and Operating Profit Operating profit (after staff
provisions) of the Bank for 2010-11 went up by 21% to Rs.1,175.97 crore from Rs. 972.27
crore for the previous year. Net Profit for the year stood at Rs.727.73 crore as compared
to Rs.684.27 crore in 2009-10. The Earnings per share (of Rs.10 face value) stood at Rs.
145.55 compared to Rs.136.85 at the end of the previous year. The Net Interest Income
increased by 21% from Rs.1,400 crore in FY 09-10 to Rs. 1696 crore in FY 10-11. Net
Interest Margin stood at 2.87%.

Dividend

The Bank declared a higher dividend of Rs. 18 per share (180%) for the year to the
shareholders, entailing a total payout of Rs. 90 crore. Of this, an interim Dividend of Rs.
8 per share (80%) was paid out in October 2010. The Pay-out ratio works out to 12.41%
of the distributable profit (excluding dividend tax).

Capital Augmentation & Capital Adequacy The Bank’s capital funds improved from
Rs.4397 crore as at the end of March 2010 to Rs.4881 crore as at the end of March 2011.
The capital adequacy Ratio under Basel II stood at 12.54% in March 11 as compared to
13.74% in March 10 against a minimum of 9% stipulated by RBI. The Tier-I CRAR on
this date is 9% as against 9.24% as at the end of the previous year. The Bank’s Board of
Directors had approved a Rights Issue of shares to the shareholders for an amount of

36
Rs. 500 crore. The approvals from the RBI and State Bank of India for the issue have
been received. The capital augmentation will serve to improve the Capital adequacy
ratio of the Bank in 2011-12.

Deposits

Aggregate Deposits of the Bank registered a growth of 15.49%, reaching the level of
Rs.57,599 crore as on 31st March 2011 as against Rs. 49,874 crore as on 31st March 2010.
Personal Deposits, which contribute the bulk of the resources, grew by Rs.3,618 crore to
reach Rs. 36,096 crore. NRI Deposits recorded improved performance State Bank of
Travancore Annual Report 2010-2011 -7- compared to the previous year, grew by Rs.
725 crore and stood at Rs.11,562 crore. NRI Deposits constituted 20.07% of the
Aggregate Deposits of the Bank as on 31st March 2011. Total Deposits of the Bank
[including Inter Bank Deposits] moved up to Rs. 58,158 crore as on 31st March 2011
from Rs. 50,883 crore as on 31st March 2010.

Advances

Advances of the Bank registered a growth of 19.72%during the year and reached a level
of Rs. 46,044 crore ason 31st March 2011 as against Rs. 38,461 crore as on 31st March
2010. The main contributions came from the C&I segment [growth of Rs.4,637 crore]
and Agriculture segment [growth of Rs.2,280 crore]. The Bank’s Retail lending stood at
Rs.23,055 crore and constituted 50% of Total Advances as at the end of March 2011. The
Credit Deposit Ratio of the Bank stood at 79.17% as on 31st March 2011 as against
75.59% as on 31st March 2010.

Market Share

Bank’s All India market share in Deposits has improved from 1.09% on 31st March 2010
to 1.10% on 26th March 2011. The market share in Advances has been static at 1.16% in
the same period. However, the market share would be 1.17% if the Rs.1,000 crore of
Inter Bank Participation Certificate (IBPC) issued by the Bank during the year is
included. The Bank continued to maintain its position as the premier bank in Kerala
with a market share in business of 22.13% as at September 2010 [the latest date up to
which data has been released by RBI] with 14% of the total branch network in the state.

Priority Sector lendings

The Bank continued to give special emphasis on lendingto the Priority Sector in
conformity with the national policies, expectations and fulfilment of social objectives.
Bank’s gross Advances to the Priority Sector increased from Rs. 14,260 crore as at the

37
end of March 2010 to Rs.17,353 crore as at the end of March 2011, and constituted
44.07% of the Adjusted Net Bank Credit against the benchmark of 40%.

Agricultural and Rural Finance & Self HelpGroups

Agriculture segment was the standout performer during the year under review. Bank
has disbursed an amount of Rs. 5,716 crore under Agriculture segment as at the end of
March 2011 against the Special Agricultural Credit Plan target of Rs.4,000 crore. The
level of lending to agriculture sector stood at Rs. 5,580 crore as on 31st March 2011. Agri
segment showed a positive growth of Rs. 2,280 crore as at the end of financial year 2010-
11 compared to a growth of Rs.449 crore during the same period last year. The share of
Agriculture Advances to Adjusted Net Bank Credit [ANBC] improved sharply to
14.17% from 10.33% at the end of the previous year. During the current fiscal 16,677
Kisan Credit Cards (Working capital facility to farmers) and 4,519 Kisan Gold Cards
(Investment credit to farmers) were issued with an outlay of funds of Rs. 146 crore and
Rs. 182 crore respectively. During the current year, the level of Kissan Credit Card loans
increased by 29% and 79% in number and amount respectively against the RBI
stipulation of 20%. The growth in Agriculture lending was driven by an intensive
agriculture lending campaign called “SBT- Haritotsavam- 2010” during the period June
to September 2010. Against a lending target of Rs.1,000 crore, the amount disbursed
during the period was Rs.1,424.25 crore, benefiting 2,04,082 farmers. Bank continued to
be active in assisting Self Help Groups and financing them through MFIs and NGOs.
84,787 groups were assisted so far with a financial outlay of Rs.656 crore. Bank has
entered into an MOU with Kudumbasree (State mission for poverty alleviation) for
giving loans to SHGs at low rate of interest. The notable feature of the programme is
community farming by women neighbourhood groups with bank assistance. 600
women who are active in Self Help Groups were honoured with SBT Kudumbasree
Award. Farmers meetings were conducted at various centres to give wide publicity for
schemes available to farmers. A special brochure on agricultural schemes in local
languages was printed and supplied to the branches for the benefit of farmers. The
Bank stands in the first position in terms of number of Farmers Clubs among
Commercial banks in Kerala. The farmers Clubs sponsored by Pattanakkad and
Bharananganam branches were awarded merit certificates by NABARD for their farmer
friendly performance.

Lending to Micro, Small and Medium Enterprises(MSMEs)

The Bank continued to extend support to Micro, Small and Medium Enterprises, in
conformity with national objectives. The total lending to MSME sector recorded a
growth of 14.49% over previous year to touch Rs. 8,487 crore. The lending to Micro &

38
Small Enterprises [MSEs] stood at Rs. 5,061 crore which is 18.69% higher over the
previous year level. The Small Scale Industries and Small -8- State Bank of Travancore
Annual Report 2010-2011 Business segment recorded a growth of Rs.214 crore during
the year, reaching a level of Rs.3906 crore as on 31st March 2011. The growth in this
sector was fuelled by an intensive MSMElending campaign conducted from 01st
October 2010 to31st January 2011. Against a target of Rs. 500 crore under MSME
segment [including Rs.150 crore under micro segment, Rs. 150 crore under small
segment and Rs. 200 crore under medium segment], the total lending during the
campaign period was Rs.628 crore. 1% reduction in interest and waiver of processing
charges were offered during the campaign period. Road Transport Operators (RTO)
segment has recorded steady progress after liberalization of collateral security norms
and interest rate concession. The lending to the sector grew by 43.98% to reach Rs. 514
crore as at March 31, 2011.Tie up arrangements with various manufacturers / dealers of
commercial vehicles served to increase the presence in the market. The Bank is a
Member Lending Institution under the Credit Guarantee Fund Trust for Micro and
Small Enterprises (CGTMSE) scheme for providing collateral free loans. Awareness
programmes / workshops /seminars were conducted in all Regional Offices of the
Bank / Training sessions and other important centres for operating staff about the
scheme. Meetings of entrepreneurs were also conducted to educate them about the
scheme. 10,350 loans amounting to Rs. 316 crore have been extended under the scheme
so far. The Bank’s Technical Consultancy Cell carried out three project appraisals, four
rehabilitation studies and two general studies during the year. The cell also involved in
the three Entrepreneurship Development Programmes (EDPs) conducted by the Bank
during the year.

Commercial & Institutional Finance

The Bank performed well under the segment by tapping the potential in market and
C&I advance of the Bank reached Rs. 23,835 Crore as on 31st March 2011. This segment
contributes more than 50 % of Bank’s total advances, which comprises financing Trade
and Services, Industry, Infrastructure, financing Corporate customers and other
institutions. The 4 Industrial Finance Branches at New Delhi, Bangalore, Chennai and
Ernakulam were redesignated as Commercial Branches, to sharpen their focus and
broad base their portfolio. The 5 Commercial Network branches (including the
Corporate Finance Branch at Mumbai) contribute 40% of the Credit growth. These
branches’ share of the Credit of the Bank has moved up from 22% to 25% during the
year. Their share of the Nonfund based income of the Bank improved from 19% to 23%
in the same period. Account Planning Initiative was rolled out at these branches during
the year to improve the share of income of the Bank from major accounts.

39
Personal Finance

The Bank continued to be active in extending finance to Personal Segment, mainly by

way of Housing Loans, CarLoans and Educational Loans. The Personal
segmentAdvances went up to Rs. 13,345 crore as at March 2011 from Rs. 12,696 crore as
at the end of the previous year, recording a growth of 5.11%. As many as 20,646
Housing Loans aggregating Rs. 2,363 crore were extended during the period under
review, taking the outstanding Housing Loan level to Rs. 6,714 crore as at 31 Mar 2011,
an improvement of 20.34% over March 2010 level of Rs. 6144 crore. Similarly 17,215 Car
Loans aggregating Rs. 590 crore were extended during the same period, taking the
outstanding Car Loan level to Rs. 1,420 crore as at 31 Mar 2011, which is higher by Rs.
96 crore over March 2010 level of Rs. 1,324 crore. As in the previous years, the Bank
continued to support the growing generation to prosecute higher studies by extending
Educational Loans under Gyan Jyothi Schemes. The Bank has granted the maximum
number of education loans in the State of Kerala. During the year under report, Bank
sanctioned 19,782 Educational loans amounting to Rs. 565 crore. The total amount
outstanding under this head stood at Rs. 1,713 crore. The Bank also extended the
subsidy assistance provided by the Government for Housing Loans and Educational
Loans. These included the 1% interest Subvention for Home Loan borrowers up to a
limit of Rs.10 lac where the estimate/cost of construction should not exceed Rs.20 lac,
(applicable to the loans disbursed from 01st October 2009 to 31st March 2011), Interest
Subsidy for Housing Urban Poor (ISHUP) Scheme to provide home loans with interest
subsidy to Economically Weaker Sections (EWS) / Low Income Groups (LIG) for
acquisition/construction of house and Central Scheme to provide Interest Subsidy on
Education Loan borrowers. Maximum permissible loan amount under ISHUP is Rs.1 lac
for EWS and Rs.1.60 lac for LIG category of borrowers (maximum amount eligible for
subsidy is Rs.1 lac). The subsidy scheme for education loans is available to students
belonging to Economically Weaker Sections whose State Bank of Travancore Annual
Report 2010-2011 -9- parental annual income does not exceed Rs.4.5 lac. Interest Subsidy
will be provided by the Government during the moratorium period for the
disbursements made on or after 01st April 2009.

Policies and Guidelines

A comprehensive Policy for lending to Micro Finance Institutions (MFIs)/Non

Governmental Organizations(NGOs) has been formulated for regulating and
standardizing the Advances to the sector. The policy gives detailed guidelines to enable
the Bank to increase the outreach by financing large number of SHGs/JLGs in a cost
effective manner and supplement the efforts of the branches in financing SHGs/JLGs
and enabling financial inclusion. The policy will also act as a precaution to pursue

40
caution while funding micro finance institution (MFIs/NGOs) by adhering to the norms
for funding. Interest rate and charges on Bill Discounting under Inland Letter of Credit
Scheme have been revised in line with the market condition to make the products the
best in the market and to maintain the profitability. The Policy on valuation of
properties and empanelment of values has been revised comprehensively in order to
improve smooth and quick delivery of credit and also to ensure speedy recovery of
NPAs.

Introduction of Base Rate

The Bank has introduced Base Rate System effective on July 1, 2010, in conformity with
RBI guidelines. Base rate was set at 7.75% on date, which has since been increased three
times in tune with the market conditions. The Base rate of the Bank stands at 9% as at
31st March 2011.

Internal Control Systems & Supervision (SBI)

Integrated Risk Management

The Bank’s risk management philosophy is based on a clear and timely identification of
various types of risks, accurate risk assessment and measurement procedures and
continuous monitoring. The risk management architecture of the Bank consists of the
Board of Directors at the top having overall responsibility to implement Risk
Management System in the Bank. Subordinate to the Board, Risk Management
Committee of the Board has been constituted to have an oversight on all the risks
assumed by the Bank and to decide appropriate policy and strategy for risk
management.

In order to have focused attention on various risks, Credit Risk Management

Committee (CRMC), Market Risk Management Committee (MRMC) and Operational
Risk Management Committee (ORMC) are in place to manage Credit Risk, Market Risk
and Operational Risk respectively at the granular level. The General Manager (P&D) is
designated as the Chief Risk Officer (CRO). The Integrated Risk Management
Department headed by Deputy General Manager is responsible for the overall daily
management of risks at micro level. Management of all the risks is governed by various
policies such as Credit Risk Management Policy, Loan Policy, Market Risk Management
Policy, Investment Policy, Operational Risk Management Policy, etc.

As part of credit risk management, the Bank has a structured and standardized credit
approval process, which includes comprehensive credit rating of proposals. The market
risk is largely managed through adherence to various position limits, stop loss limits,

41
Value at Risk [VaR] limits etc. The operational risk management framework comprises
risk and controls selfassessment (RCSA) and identification, measurement and
monitoring of various losses experienced by the Bank and mitigation of risks. The risk
management objectives will be accomplished by leveraging technology. The Bank is
closely monitoring the roadmap for migration to advanced approaches of Basel-II with
respect to all risks by striving to create sufficient and accurate database and ensuring
involvement and awareness among all the staff members of the Bank.

During the financial year 2010-11, the following major risk management initiatives
were taken:

 New Credit Rating models were introduced for NBFCs (Non Banking Financial
Companies) and infrastructure projects.
 Retail Pool Scoring Models were introduced for personal loans, housing loans,
education loans, car loans and two wheeler loans.
 Credit Rating models for trading and manufacturing sector were modified.
 The Bank started computing Value at Risk for all investments in trading book as
part of risk management.
 As part of spreading awareness and risk management culture all over the Bank,
during the quarter October- December 2010, officials from risk management
department conducted daylong workshops for the Controllers and the AGMs
and Chief Managers heading branches in Thiruvananthapuram, Ernakulum and
Kottayam zones and all Branch Managers and Controllers in Mumbai and Delhi
regions.

Asset Liability Management

The Asset Liability Management System implemented effective from 1st April 1999 is
functioning as per the guidelines prescribed by Reserve Bank of India. The Asset
Liability Management Committee (ALCO), headed by Managing Director, meets
regularly. Liquidity and Interest Rate Risks are identified, measured and monitored by
ALM Section through Duration Gap Analysis, Stress Testing on Liquidity and Interest
Rate Risks etc. and put up to ALCO for discussion and decision making. ALCO also
discusses in detail other statements of Structural Liquidity & Interest Rate Sensitivity,
Short Term Dynamic Liquidity, Quarterly Review of Contingency Funding Plan, etc.
The ALM Section prepares the statements of Structural Liquidity & Interest Rate
Sensitivity and Short Term Dynamic Liquidity which helps to monitor the liquidity
levels vis-à-vis the benchmark levels fixed by RBI / as per Bank’s ALM Policy and
proposes corrective action wherever found necessary. Various interest rate revisions
including the revisions of the Benchmark Prime Lending Rate (BPLR) and Base Rate

42
(BR) of the Bank are discussed and decided by the ALCO. The ALCO also discusses the
current financial position of the country on an ongoing basis. The changes in the market
are monitored continuously and decision support papers on the current economic
developments are up to the Top Management.

Inspection and Supervision

The Bank has put in place an effective institutional mechanism for Risk Based
Supervision through RBS Cell in Inspection Department. As envisaged by the regulator,
the Bank introduced Risk Focused Internal Audit (RFIA) under RBS w.e.f 1st April 2003,
where business parameters have been de-linked from the Risk Parameters. With effect
from 1st April 2010, score for Business Parameters has been taken out of RFIA In
addition to the regular internal inspection, IS Audit, Compliance Audit, Surprise
Inspection, System Audit of Zonal Offices and Head Office departments, etc. are
conducted by the Inspection Department. Following the migration to the Core Banking
System, RFIA was revamped by way of revision in Audit Report Formats, rating
mechanism, grouping of branches, sampling norms and periodicity of Inspection. The
Information System Audit (IS Audit) cell was formed within the Inspection Department

Credit Audit

The audit of high value credit accounts is undertaken by the Credit Audit Department,
with the aim of improving the asset quality of the Bank. Accounts with total exposure of
Rs. 2 crore and above are covered under Credit Audit. The Department conducted audit
of 1,077 accounts during the year, covering the pre-sanction and post sanction aspects.
This includes 14 AUC accounts and 73 accounts with exposure below Rs. 2 crore and
above Rs.1 crore on a random basis during the year. With the integration of Credit
Audit with Risk Focused Internal Audit (RFIA), the marks awarded by the credit
auditor are normalized by the internal auditors under Credit Risk Management,
wherever necessary. Monthly performance reports of the department are regularly
submitted to the Audit Committee of the Executives and the review reports are being
submitted to the Audit Committee of the Board at its next meeting for information.

Inter-Office Reconciliation

As per RBI guidelines, all high value debit entries of value Rs.1 lac and above and
99.99% of debit amount need to be reconciled within a period of six months from the
date of their origin. The Bank has completed reconciliation of Inter-branch accounts up
to 30th September 2010 achieving 100% reconciliation of debit entries. The Bank is

43
committed to perform better than the target set by RBI and shall aim at reconciling all
entries within three months of their origin.

Compliance

The Bank ensures that GOI and RBI directives/instructions received are being complied
with promptly. Quarterly review reports on the compliance status and performance of
the department are regularly submitted to the Audit Committee of the Board for
information.

KYC norms & AML/CFT measures

The Bank has put in place a Board approved revised policy and procedural guidelines
on Know Your Customer (KYC)/ Anti Money Laundering (AML) /Combating of
Financial Terrorism (CFT) measures in line with the master policy and subsequent
guidelines issued by Reserve Bank of India. A dedicated KYC-AML Cell is functioning
in the Head Office to oversee the compliance of KYC/AML/CFT measures. Deputy
General Manager (Compliance) is the designated Principal Officer for KYC/AML in the
Bank.

Monitoring of transactions is carried out to submit the required reports to Financial

Intelligence Unit-India, (FIUIND), as mandated by Prevention of Money Laundering
Act 2002. With a view to implementing and supporting monitoring of transactions, the
Bank has acquired appropriate software, which is processing all transactions handled
by all branches of the Bank, on a day-to-day basis. Monthly Cash Transaction Reports
(CTRs) are being generated by the system along with Suspicious Transaction alerts
daily, for analysis by the KYC-AML Cell.

After due analysis, suspicious transactions are reported to FIU-IND through STRs
where ever necessary. Counterfeit Currency Reports (CCRs) are also being submitted to
FIU-IND as and when detected. Data cleansing of the existing database of customers is
now under progress to update in the Core Banking System [CBS] all relevant customer
data. The progress in the implementation is being reported to the Board periodically.
KYC/AML Cell is publishing a quarterly newsletter and maintaining a web site to
provide relevant and up to date information for Branches / Administrative Offices.
Training on KYC / AML is being imparted on an ongoing basis in the Bank. Staff
awareness programmes are conducted regularly through seminars on Zonal/ Regional
Office levels, Learning Centers and branch visits.

44
RISK MANAGEMENT & INTERNAL CONTROLS Risk Management
(SBI)

Risk Management Structure

- An independent Risk Governance Structure is in place for Integrated Risk

Management covering Credit, Market, Operational and Group Risks. This framework
visualizes empowerment of Business Units at the operating level, with technology being
the key driver, enabling identification and management of risk at the place of
origination.

- The Risk Management Committee of the Board (RMCB) has the overall responsibility
to monitor and manage Enterprise Wide Risk. The Credit Risk Management Committee
(CRMC), Market Risk Management Committee (MRMC), Operational Risk
Management Committee (ORMC), Group Risk Management Committee (GRMC) and
Asset Liability Management Committee (ALCO) support RMCB.

- MD & Group Executive (Associates & Subsidiaries) and MD & Group Executive
(International Banking) are the members of RMCB, while MD & Group Executive
(National Banking) and MD & Chief Financial Officer are invited to attend all the
meetings of the Committee. The Deputy Managing Director & Chief Credit and Risk
Officer head CRMC, MRMC, ORM and GRMC. ALCO is headed by the Managing
Director & Chief Financial Officer.

- Risk Management is perceived as an enabler for business growth and in strategic

business planning, by aligning business strategy to the underlying risks. This is
achieved by constantly re-assessing the inter-dependencies / interfaces amongst each
silo of Risk and business functions.

- Bank is in the process of implementing Enterprise Risk Management (ERM) that will
integrate all the Risk Management functions of the Bank, explore inter-dependencies
amongst various risk types and act as a support system to strategic decision-making
process.

45
Basel II Implementation

- In accordance with RBI guidelines, the Bank has migrated to the Basel II framework,
with the Standardized Approach for Credit Risk and Basis Indicator approach for
Operational Risk w.e.f. March 31, 2008, having already implemented the Standardized
Duration Method for Market Risk w.e.f. March 31, 2006.

- Simultaneously, the Bank is updating and fine- tuning its Systems and Procedures,
Information Technology (IT) capabilities, Risk Assessment and Risk Governance
structure to meet the requirements of the Advanced Approaches under Basel II.

- Various initiatives such as new Credit Risk Assessment Models, independent

validation of Internal Ratings, loss data collection and computation of market risk Value
at Risk (VaR) and improvement in Loan Data Quality would facilitate efficient use of
Capital as well as smooth transition to Advanced Approaches.

- Risk Awareness exercises are being conducted across the Bank to enhance the degree
of awareness at the Operating levels, in alignment with better risk management
practices, Basel II requirements and over-arching aim of conservation and optimum use
of capital.

- Keeping in view the changes that the Banks portfolios may undergo in stressed
situations, the Bank has in place a policy, which provides a framework for conducting
the Stress Tests at periodic intervals an initiating remedial measures wherever
warranted. The scope of the test is constantly reviewed to include more stringent and
new scenarios.

Credit Risk Management

- Credit Risk Management process encompasses identification, assessment,

measurement, monitoring and control of the Credit Exposures. Well-defined basic risk
measures such as CRA (Credit Risk Assessment) models, Industry Exposure norms,
Counter-party Exposure limits, Substantial Exposure limits, etc., have been put in place.

- Credit Risk components such as Probability of Default (PD), Loss Given Default
(LGD) and Exposure at Default (EAD) are being computed.

46
- Frequency of Stress Tests in respect of Credit Risk has been increased from Annual to
Half-yearly, to identify Credit Risk at an early stage and to initiate appropriate
measures to contain/ mitigate Credit Risk.

Market Risk Management

- Market Risk Management is governed by the Board approved policies for

investment, Private Equity & Venture Capital, trading in Bonds, Equities, Foreign
Exchange and Derivatives.

- Exposure, Stop Loss, Modified Duration, PV01 and Value at Risk (VaR) limits have
been prescribed. These limits, along with other Management Action Triggers, are
tracked daily and necessary action initiated, as required, to keep Market Risk within
approved limits.

Operational Risk Management

- The Bank manages operational risks by having in place and maintaining a

comprehensive system of internal controls and policies.

- The main objectives of the Banks Operational Risk Management are to continuously
review systems and control mechanisms, create awareness of operational risk
throughout the Bank, assign risk ownership, alignment of risk management activities
with business strategy and ensuring compliance with regulatory requirements.

- The Operational Risk Management policy of the Bank establishes consistent

framework for systematic and pro-active identification assessment, measurement,
monitoring and mitigation of operational risk. The Policy applies to all business and
functional areas within the Bank, and is supplemented by operational systems,
procedures an guidelines which are periodically updated.

Group Risk Management

- The State Bank Group is recognized as a major Financial Conglomerate and as a

systemically important financial intermediary, with significant presence in various
financial markets.

47
 - Accordingly, it is imperative, both from the regulatory point of view as well as from
the Groups own internal control and risk management point of view, to oversee the
functioning of individual entities in the Group and periodically assess the overall level
of risk in the Group. This facilitates optimal utilization of capital resources and
adoption of a uniform set of risk practices across the Group Entities.

- The Group Risk Management Policy applies to all Associate Banks Banking and Non-
banking Subsidiaries and Joint Ventures of the State Bank Group under the jurisdiction
of specified regulators and complying with the relevant Accounting Standards, where
the SBI has investment in equity shares of 30% and more with control over
management.

- With a view to enabling the Group Entities to assess their material risks and adequacy
of the risk management processes and capital, all Group members, including Non-
banking Subsidiaries are encouraged to align their policies and practices with the
Group, follow Basel prescriptions and international best practices.

Asset Liability Management

- The Asset Liability Management Committee (ALCO) of the Bank is entrusted with
the evolvement of appropriate systems and procedures in order to identify and analyse
balance sheet risks and setting of benchmark parameters for efficient management of
these risks.

- ALM Department, being the support group to ALCO, monitors the Banks market risk
such as liquidity risk, interest rate risk etc., by analysing various ALM reports / returns.
The ALM department reviews the ALM Policy and complies with the Banks / RBIs
policy guidelines on an ongoing basis.

- The Market Related Fund Transfer Pricing Mechanism has been implemented for
evaluating the business performance of the branches of the Bank.

48
Internal Controls

The Bank has in-built internal control systems with well-defined responsibilities at each
level. The Bank carries out mainly two streams of audits - Inspection & Audit and
Management Audit covering different facets of Internal Audit requirement. Apart from
these, Credit Audit is conducted for units with large credit limits and Concurrent Audit
is carried out at branches having large deposits, advances and other risk exposures and
selected BPR Outfits. Expenditure Audit, involving scrutiny of accounts and
correctness of expenditure incurred, is conducted at Corporate Centre Establishments,
Local Head Offices, Zonal Offices, On Locale Regional Offices, Regional Business
Offices, Lead Bank Offices, etc. To verify the level of rectification of irregularities by
branches, audit of compliance at select branches is also undertaken. The Information
System Audit (IS Audit) of the centralised IT establishments is being conducted.

Risk Focussed Internal Audit (RFIA)

The inspection system plays an important and critical role of introducing international
best practices in the internal audit function which is regarded as a critical component of
Corporate Governance. Inspection & Management Audit Department undertakes a
critical review of the entire working of audit units. Risk Focused Internal Audit, an
adjunct to risk based supervision as per RBI directives, is in vogue in the Banks audit
system.

Inspection & Audit of branches

All domestic branches have been segregated into 3 groups on the basis of business
profile and risk exposures. While audit of Group I branches and credit oriented BPR
entities (excepting SARC) is administered by Central Audit Unit (CAU) at Inspection &
Management Audit Department headed by a General Manager (CAU), audit of
branches in Group II Group III category and other BPR entities are conducted by ten
Zonal Inspection Offices, located at various Centres, each of which is headed by a
General Manager (I&A). The audit of branches and BPR entities is conducted as per the
periodicity approved by Audit Committee of the Board (ACB) which is well within RBI
norms. During the period from

49
 01.04.2010 to 31.03.2011, 7,871 domestic branches (Group I: 86 Group II: 1,421; & Group
III: 6,364) were audited.

Cluster Audit

A number of Centres have been brought under the gamut of BPR and several branches
are linked with BPR entities. To be able to identify and mitigate the risk at such
branches, where the process is still underway, the department has introduced an
initiative called ‘Cluster Audit wherein a simultaneous audit of BPR entities and
identified branches linked to the BPR in a particular centre is taken up. During the
period from 01.04.2010 to 31.03.2011, Cluster Audit was conducted in 46 Centres
covering 1,188 Branches & 125 BPR entities. This brought to light the audit health of the
centre.

Management Audit

With the introduction of Risk Focussed Internal Audit, Management Audit has been
reoriented to focus on the effectiveness of risk management in the processes and the
procedures followed in the Bank. Management Audit universe comprises of Corporate
Centre Establishments; Circles / Ape Training Institutions, Associate Banks;
Subsidiaries (Domestic / Foreign); Joint Ventures (Domestic / Foreign), Regional Rural
Banks sponsored by the Bank (RRBs). During the period from 01.04.2010 to 31.03.2011,
Management Audit of 45 domestic offices/establishments was carried out.

Credit Audit

Credit Audit aims at achieving continuous improvement in the quality of Commercial

Credit portfolio of the Bank through critically examining individual large commercial
loans with exposures of Rs. 5 crores and above. Credit Audit System (CAS), which has
been aligned with Risk Focused Internal Audit, assesses whether the Banks laid down
policies in the area of credit appraisal, sanction of loans and credit administration are
meticulously complied with. CAS also provides feedback to the business unit by way of
warning signals about th equality of advance portfolio in the unit and suggests
remedial measures. It also comments on the risk rating awarded and whether it is in
order. Credit Audit carries out a review of all individual advances above the cut off

50
limit within 6 months of sanction/enhancement/ renewal as off-site audit and a post
sanction audit once in 12 months

as on-site. During the period 01.04.2010 to 31.03.2011, Credit Audit (on-site) was
conducted in 456 Branches, covering 5,733 accounts with aggregate exposures of Rs.
5,72,958 crores. Credit Audit (Off-site) was conducted in 14 Circles (including
MCROs/CAG functioning in the geographical area of the respective Circles) during the
same period, covering 6,875 proposals (domestic) with aggregate exposure of
Rs.8,43,864 crores.

Foreign Offices Audit:

Home Office Audit was carried out at 40 Branches / offices during 01.04.2010 to
31.03.2011, which included Inspection and Audit of 31 Branches, Management Audit of
4 Representative offices, 1 Subsidiary and 4 Regional Offices.

CONCURRENT AUDIT SYSTEM:

Concurrent Audit system is essentially a control process integral to the establishment

of sound internal accounting functions, effective controls and overseeing of operations.
It works as a tool for the Controllers of operations for scrutiny of day-to-day operations.
Concurrent Audit System is reviewed on an on-going basis as per the RBI directives so
as to cover 30-40% of the Banks Deposits and 60-70% of the Banks Advances and other
risk exposures. Inspection & Audit department prescribes the processes, guidelines and
formats for the conduct of concurrent audit at branches and BPR entities. As o
31.03.2011, the system covers 30.15 % of deposits and 75.21 % of advances and other risk
exposures of the Bank.

Vigilance

The main objective of vigilance activity in the Bank is not to reduc but enhance the
level of managerial efficiency and effectiveness in the organization. Risk taking is
integral part of the banking business. Therefore, every loss does not necessarily become
subject matter of vigilance enquiry. Motivated or reckless decisions that cause damage
to the Bank are essentially dealt as vigilance ones. While vigilance aims at punishing the
delinquent employees, it also protects the legitimate and bonafide business decisions
taken by them and any other action devoid of malafides. The Vigilance Department in

51
the Bank functions on these principles. Based on the principle Prevention is Better Than
Cure, the Vigilance Department is actively involved in the preventive measures, which
aim at taking steps, which are essential for avoiding recurrence of similar nature of
frauds in the Bank. At the same time, Vigilance department is taking proactive
measures to prevent the incidences of frauds arising in CBS environment. Considering
the size of the Organization, we have set up vigilance departments at each of the 14
Circles, headed by Deputy General Managers. At Corporate Centre, Vigilance set up is
headed by Chief Vigilance Officer of the rank of Chief General Manager. The
department reports to the Chairman directly and conducts its affairs independently.
The guidelines of the Central Vigilance Commission (CVC) are followed in letter and
spirit in its functioning.

52
ICICI Bank 
ICICI Bank is India’s second-largest bank and the largest private bank in the country,
having more than US$50 billion in assets. The Bank has a network of 2,044 branches and
about5, 546 ATMs in India and presence in 18 countries. ICICI Bank provides a wide
range of banking products and financial services — investment  banking, life
and non-life insurance, venture capital and asset management to corporate
and r e t a i l c u s t o m e r s t h r o u g h a v a r i e t y o f d e l i v e r y c h a n n e l s a n d
s p e c i a l i z e d s u b s i d i a r i e s a n d affiliates. Customers of all the groups under
the ICICI umbrella are served through roughly 6 1 4 b r a n c h e s a n d g l o b a l
services provided through 14 international offices. ICICI has
incubated Financial Information Network & Operations Pvt. Ltd. (FINO).

RISK MANAGEMENT FRAMEWORK (ICICI)

The Bank's risk management strategy is based on a clear understanding of

various risks, disciplined risk assessment and measurement procedures and
continuous monitoring. The policies and procedures established for this
purpose are continuously benchmarked with international best practices. The
Board of Directors has oversight on all the risks assumed by the Bank.
Specific Committees have been constituted to facilitate focused oversight
of various risks, as follows:

The Risk Committee of the Board reviews risk management policies of the
Bank in relation to various risks. The Risk Committee reviews various risk
policies pertaining to credit, market, liquidity, operational and
outsourcing risks, review of the Bank's stress testing framework and group
risk management framework. The Committee reviews the risk profile of the
Bank through periodic review of the key risk indicators and risk profile
templates and annual review of the Internal Capital Adequacy Assessment
Process. The Committee also reviews the risk profile of its overseas
banking subsidiaries annually. The Risk Committee reviews the Bank's
compliance with risk management guidelines stipulated by the Reserve Bank
of India and of the status of implementation of the advanced approaches
under the Basel framework. The Risk Committee also reviews the stress-
testing framework as part of the Internal Capital Adequacy Assessment
Process (ICAAP). The stress testing frame work included a wide range of
Bank-specific and market (systemic) scenarios. Linkage of macroeconomic
53
factors to stress test scenarios was documented as a part of ICAAP. The
ICAAP exercise covers the domestic and overseas operations of the Bank, the
banking subsidiaries and the material nonbanking subsidiaries. The Risk
Committee also reviews the Liquidity Contingency Plan (LCP) for the Bank
and the threshold limits.

Apart from sanctioning credit proposals, the Credit Committee of the

Board reviews developments in key industrial sectors and the Bank's
exposure to these sectors as well as to large borrower accounts. The Credit
Committee also reviews the non-performing loans, accounts under watch,
overdues and incremental sanctions.

The Audit Committee of the Board provides direction to and also monitors
the quality of the internal audit function and also monitors compliance
with inspection and audit reports of RBI and statutory auditors.

The Asset Liability Management Committee is responsible for managing

liquidity and interest rate risk and reviewing the asset-liability position
of the Bank.

A summary of reviews conducted by these committees are reported to the

Board on a regular basis.

Policies approved from time to time by the Board of Directors/Committees of

the Board form the governing framework for each type of risk. The business
activities are undertaken within this policy framework. Independent groups
and sub-groups have been constituted across the Bank to facilitate
independent evaluation, monitoring and reporting of various risks. These
groups function independently of the business groups/sub-groups.

The Bank has dedicated groups namely the Risk Management Group (RMG),
Compliance Group, Corporate Legal Group, Internal Audit Group and the
Financial Crime Prevention and Reputation Risk Management Group (FCPRRMG),
with a mandate to identify, assess and monitor all of the Bank's principal
risks in accordance with well-defined policies and procedures. RMG is
further organized into Credit Risk Management Group, Market Risk Management
Group and Operational Risk Management Group. These groups are completely
independent of all business operations and coordinate with representatives

54
of the business units to implement ICICI Bank's risk management policies
and methodologies. The internal audit and compliance groups are responsible
to the Audit Committee of the Board.

RISK MANAGEMENT (ICICI)

Risk is an integral part of the banking business and ICICI aim at delivering superior
shareholder value by achieving an appropriate trade-off between risk and returns. The
key risks are credit risk, market risk and operational risk. Our risk management
strategy is based on a clear understanding of various risks, disciplined risk assessment
and measurement procedures and continuous monitoring.

The key principles underlying risk management framework of ICICI are as follows:

The Board of Directors has oversight on all the risks assumed by the Bank. Specific
Committees have been constituted to facilitate focused oversight of various risks. Our
Risk Committee reviews our risk management policies in relation to various risks and
regulatory compliance issues relating thereto. It reviews key risk indicators covering
areas such as credit risk, interest rate risk, liquidity risk and foreign exchange risk and
the limits framework, including stress test limits for various risks. It also carries out an
assessment of the capital adequacy based on the risk profile of our balance sheet and
reviews the status with respect to implementation of Basel norms. Our Credit
Committee reviews developments in key industrial sectors and our exposure to these
sectors and reviews major portfolios on a periodic basis. Our Audit Committee
provides direction to and also monitors the quality of the internal audit function. Our
Asset Liability Management Committee is responsible for managing the balance sheet
within the risk parameters laid down by the Board/Risk Committee and reviewing our
asset- liability position.

Policies approved from time to time by the Board of Directors/Committees of the

Board form the governing framework for each type of risk. The business activities are
undertaken within this policy framework. Independent groups and sub-groups have
been constituted across the Bank to facilitate independent evaluation, monitoring and
reporting of various risks. These groups function independently of the business
groups/sub- groups.

ICICI has dedicated groups namely the Risk Management Group, Compliance Group,

55
Corporate Legal Group, Internal Audit Group and the Financial Crime Prevention &
Reputation Risk Management Group, with a mandate to identify, assess and monitor
all of the Bank's principal risks in accordance with well-defined policies and
procedures. These groups are completely independent of all business operations and
coordinate with representatives of the business units to implement ICICI Bank's risk
management methodologies. The Internal Audit Group and Compliance Group are
responsible to the Audit Committee of the Board.

Credit Risk

Credit risk is the risk that a borrower is unable to meet its financial obligations to the
lender. All credit risk related aspects are governed by a credit and recovery policy
which outlines the type of products that can be offered, customer categories, targeted
customer profile and the credit approval process and limits. The credit and recovery
policy is approved by our Board of Directors.

In order to assess the credit risk associated with any corporate financing proposal, we
assess a variety of risks relating to the borrower and the relevant industry. We have a
structured and standardised credit approval process which includes a well established
procedure of comprehensive credit appraisal and credit rating. We have developed
internal credit rating methodologies for rating obligors. The rating factors in
quantitative and qualitative issues and credit enhancement features specific to the
transaction. The rating serves as a key input in the approval as well as post-approval
credit processes. A risk based asset review framework has also been put in place
wherein the frequency of asset review would be higher for cases with higher exposure
and/or lower credit rating. Industry knowledge is constantly updated through field
visits and interactions with clients, regulatory bodies and industry experts.

The Bank has a strong framework for the appraisal and execution of project finance
transactions that involves a detailed evaluation of technical, commercial, financial,
marketing and management factors and the sponsor's financial strength and
experience. The Bank identifies the project risks, mitigating factors and residual risks
associated with the project. As a part of the due diligence process, the Bank appoints
consultants, including technical advisors, business analysts, legal counsel and
insurance consultants, wherever considered necessary, to advise the lenders. Risk
mitigating factors in these financings include creation of debt service reserves and
channelling project revenues through a trust and retention account. The Bank's project
finance loans are generally fully secured and have full recourse to the borrower. In
some cases, the Bank also takes additional credit comforts such as corporate or personal

56
guarantees from one or more sponsors of the project or a pledge of the sponsors' equity

holding in the project company. The Bank's practice is to normally disburse funds after
the entire project funding is committed and all necessary contractual arrangements
have been entered into.

In case of retail loans, sourcing and approval are segregated to achieve independence.
The Credit Risk Management Group has oversight on the credit risk issues for retail
assets including vetting of all credit policies/operating notes proposed for approval by
the Board of Directors or forums authorised by the Board of Directors. The Credit Risk
Management Group is also involved in portfolio monitoring for all retail assets and
suggesting/implementing policy changes. The Retail Credit and Policy Group is an
independent unit which focuses on policy formulation and portfolio tracking and
monitoring. In addition, we also have a Business Intelligence Unit to provide support
for analytics, score card development and database management. Our Credit
Administration Unit services various retail business units.

Its credit officers evaluate retail credit proposals on the basis of the product policy
approved by the Committee of Executive Directors and the risk assessment criteria
defined by the Credit Risk Management Group. These criteria vary across product
segments but typically include factors like the borrower's income, the loan-to-value
ratio and demographic parameters. The technical valuations in case of residential
mortgages are carried out by empanelled valuers or technical teams. External agencies
such as field investigation agencies and credit processing agencies are used to
facilitate a comprehensive due diligence process including visits to offices and homes
in the case of loans to individual borrowers. Before disbursements are made, the credit
officer checks a centralised delinquent database and reviews the borrower's profile. In
making our credit decisions, we also draw upon reports from credit information
bureaus. It also uses the services of certain fraud control agencies operating in India to
check applications before disbursement.

In addition, the Credit and Treasury Middle Office Groups and the Operations Group
monitor operational adherence to regulations, policies and internal approvals. We have
centralized operations to manage operational risk in most back office processes of the
Bank's retail loan business. The Fraud Prevention Group manages fraud related risks
through forensic audits and recovery of fraud losses. The segregation of responsibilities
and oversight by groups external to the business groups ensure adequate checks and
balances.

57
Its credit approval authorization framework is laid down by our Board of Directors.
We have established several levels of credit approval authorities for our corporate
banking activities like the Credit Committee of the Board of Directors, the Committee
of Executive Directors, the Committee of Senior Management, the Committee of
Executives (Credit) and the Regional Committee (Credit). Retail Credit Forums, Small
Enterprise Group Forums and Corporate Agriculture Group Forums have been created
for approval of retail loans and credit facilities to small enterprises and agri based
enterprises respectively. Individual executives have been delegated with powers in
case of policy based retail products to approve financial assistance within the exposure
limits set by our Board of Directors.

Market Risk

Market risk is the possibility of loss arising from changes in the value of a financial
instrument as a result of changes in market variables such as interest rates, exchange
rates and other asset prices. The prime source of market risk for the Bank is the interest
rate risk we are exposed to as a financial intermediary. In addition to interest rate risk,
we are exposed to other elements of market risk such as liquidity or funding risk, price
risk on trading portfolios, exchange rate risk on foreign currency positions and credit
spread risk. These risks are controlled through limits such as duration of equity,
earnings at risk, value-at-risk, stop loss and liquidity gap limits. The limits are
stipulated in our Investment Policy, ALM Policy and Derivatives Policy which are
reviewed and approved by our Board of Directors.

The Asset Liability Management Committee, which comprises wholetime Directors

and senior executives meets on a regular basis and reviews the trading positions,
monitors interest rate and liquidity gap positions, formulates views on interest rates,
sets benchmark lending and base rates and determines the asset liability management
strategy in light of the current and expected business environment. The Market Risk
Management Group recommends changes in risk policies and controls and the
processes and methodologies for quantifying and assessing market risks. Risk limits
including position limits and stop loss limits for the trading book are monitored on a
daily basis by the Treasury Middle Office Group and reviewed periodically.

Foreign exchange risk is monitored through the net overnight open foreign exchange
limit. Interest rate risk of the overall balance sheet is measured through the use of re-
pricing gap analysis and duration analysis. Interest rate gap sensitivity gap limits have

58
been set up in addition to limits on the duration of equity and earnings at risk. Risks on
trading positions are monitored and managed by setting VaR limits and stipulating
daily and cumulative stop-loss limits.

The Bank uses various tools for measurement of liquidity risk including the statement
of structural liquidity, dynamic liquidity gap statements, liquidity ratios and stress
testing. We maintain diverse sources of liquidity to facilitate flexibility in meeting
funding requirements. Incremental operations in the domestic market are principally
funded by accepting deposits from retail and corporate depositors. The deposits are
augmented by borrowings in the short-term inter-bank market and through the
issuance of bonds. Loan maturities and sale of investments also provide liquidity. Our
international branches are primarily funded by debt capital market issuances,
syndicated loans, bilateral loans and bank lines, while our international subsidiaries
raise deposits in their local markets.

Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. It includes legal risk but
excludes strategic and reputation risks. Operational risks in the Bank are managed
through a comprehensive system of internal controls, systems and procedures to
monitor transactions, key back-up procedures and undertaking regular contingency
planning. The control framework is designed based on categorisation of all functions
into front- office, comprising business groups; mid-office, comprising credit and
treasury mid-offices; back-office, comprising operations; and corporate and support
functions. ICICI Bank's operational risk management governance and framework is
defined in the Operational Risk Management Policy, approved by the Board of
Directors. While the policy provides a broad framework, detailed standard operating
procedures for operational risk management processes are established. The policy is
applicable across the Bank including overseas branches and aims to ensure clear
accountability, responsibility and mitigation of operational risk. We have constituted
an Operational Risk Management Committee (ORMC) to oversee the operational risk
management in the Bank. The policy specifies the composition, roles and
responsibilities of the ORMC. The framework comprises identification and assessment
of risks and controls, new products and processes approval framework, measurement
through incidents and exposure reporting, monitoring through key risk indicators and
mitigation through process and control enhancement and insurance. We have formed
an independent Operational Risk Management Group for design, implementation and

59
enhancement of the operational risk framework and to support business and operation
groups in the operational risk management on an on-going basis.

Risk management is a key focus area at ICICI Bank

Risk management is a key focus area at ICICI Bank and viewed as a strategic tool for
competitive advantage. In the Indian context ICICI Bank has been doing pioneering
work in this area since 1996, when a specailized risk management group was set up
within the Bank.

RCAG is a centralized group based at Mumbai with the responsibility of enterprise

wide risk management. RCAG is headed by a senior executive of the rank of General
Manager who reports to the Executive Director (Corporate Center). The philosophy at
ICICI Bank is to have a separate risk management group (independent of the business
group) whose mandate is to analyse, measure, monitor and manage risks. Risk
management is done under the overall supervision of the Board of Directors and sub
committees of the Board - Risk Committee, Credit Committee and Audit Committee.

RCAG is comprised of six groups - Corporate Credit Risk, Retail Risk, Market Risk,
Credit Policies & Compliance, Risk Analytics and Internal Audit.

Corporate Credit Risk Group carries out analysis of various industries and does a credit

60
rating of each borrower/ transaction in the portfolio. The group has evolved risk
analysis and rating methodologies suitable for various industries/ products, including
structured finance products. These methodologies have been developed through a
combination of rigorous internal analysis and extensive interaction with domestic and
international rating agencies. Each analyst in the group tracks a few industries and the
prospects of the companies within that industry. Every proposal has to be rated by the
Credit Risk Group prior to sanction. The Bank's portfolio is fully rated internally and
risk based pricing methodology for credit products has been implemented, which is a
significant achievement in the emerging markets context.

The retail portfolio of the Bank comprises a wide range of products including auto
loans, housing loans, construction equipment, commercial vehicles, two wheelers,
credit cards etc. Retail Risk Group is responsible for approving all product policies and
monitoring the performance of the retail portfolio. Approval of this group is mandatory
before any product policy is referred to the management. Analysis of the portfolio is
done on a regular basis across products, geographic locations etc.

Market risk group analyses the interest rate risk, liquidity risk, foreign exchange risk
and commodity risk. Contemporary tools such as gap analysis, duration, convexity and
Value at Risk (VaR) are used to manage market risks. This group also works on limit
setting and monitoring adherence to the limits.

Credit Policies & Compliance Group is responsible for design and review of all credit
policies, ensuring regulatory compliance in all activities of the Bank and coordinating
the inspections of Reserve Bank of India.

Risk Analytics Group provides the quantitative analysis and modelling support for risk
management. This group is working on areas such as analysis of default rates, loss
rates, risk based pricing, economic capital allocation and portfolio modelling. The group
consists of analysts with a strong academic background and work experience in
quantitative analysis.

Internal Audit is reponsible for managing Operational risk, which is an area of

significant importance in a large, growing organisation with multiple products such as
ICICI Bank. With the growth of retail business and introduction of technology based
products, the challenges on this group have increased. The Internal Audit Group has
developed a sophisticated methodology for conducting risk based audit, is equipped to
handle IS Audit and has obtained ISO 9001 certification.

61
ICICI bank is at the forefront of evolving and implementing risk management concepts
in the Indian context. There is a constant endeavor towards further improvement and
benchmarking with international best practices. The bank focuses on providing
training, learning opportunities to facilitate the move towards implementation of global
best practices in risk management. The analysts from RCAG undergo training provided
by renowned experts within India as well as overseas. RCAG regularly deputes analysts
to specialized seminars and facilitates networking with international risk management
experts in rating agencies, banks etc.

The desired key attributes for analysts in RCAG are - strong conceptual knowledge,
ability to identify and analyze key issues, spot trends and interlinkages between issues,
take a logical, independent position under pressure and communication skills.

S & P Ups ICICI Rating

 Internal credit rating agency Standard and Poor’s (S & P) revised its rating outlook on
ICICI Ltd to ‘stable’ from ‘negative’, even as it reaffirmed the financial institution’s
long-term rating of ‘BB’ and short-term foreign currency rating of ‘B’.

With the upward revision in outlook, ICICI’s rating is on par with India’s sovereign
rating and a notch higher than the long-term outlook of other financial rivals like IDBI
and Bob at ‘negative’. The other major player – BANKS – does not have a long-term
rating.

In a release, S & P said the change in outlook is ‘supported by continuing progress in

the strengthening of ICICI’s balance sheet and a lesser probability that asset quality will
deteriorate significantly from current levels.

S & P said ICICI’s steps towards universal banking have helped it diversify its risks
better than its peers, which will give it a competitive advantage. However S & P said it
would still take some time for ICICI’s universal banking strategy to manifest itself fully
in its balance sheet and earnings profile.

S & P has noted that by virtue of its expertise in innovative project and infrastructure
financing, ICICI had taken a leadership position that should enable it to withstand
increased competition from the commercial banks which are now entering this market.

62
 But even while it revised its outlook upwards, S & P said that key concerns continued
to be reflected in ICICI’s ratings. This include a relatively higher risk business as it was
predominantly project financing, although this had been reduced significantly in recent
years; a high level of assets seen as impaired by global standards; wholesale funding
concentrations and the risks associated with the Indian operating environment.

S & P’s also commented on the company’s improved accounting system as the company
passes provisions for non-performing assets through the profit and loss account, rather
than the capital account. ICICI has already audited its balance sheet according to US
GAAP accounting principles.

Non Performing Assets of State Bank of India increased more than three-
fold between 2008-09 and 2010-11

August 31,2011   New Delhi : The government today said provisioning against the non-
performing assets (NPAs) of State Bank of India (SBI) increased more than three-fold to
Rs 8,792 crore in 2010-11 from Rs 2,474 crore in 2008-09 due to a rise in bad debt. 

This provision in 2010-11 includes a counter cyclical buffer of Rs 2,330 crore toward
achieving the 70 per cent Provision Coverage Ratio prescribed by the Reserve Bank of
India over-and-above the prudential provision, Finance Minister Pranab Mukherjee said
in a written reply to a question in the Rajya Sabha.These include deposits of other
countries' central banks, the Bank for International Settlements (BIS) and top-rated
foreign commercial banks, besides securities representing the debt of sovereigns and
supranational institutions with a residual maturity not exceeding 10 years, to provide a
strong bias toward capital preservation and liquidity, Meena said. 

At the end of March, 2011, Meena said out of the total foreign currency assets of USD
274.3 billion, USD 142.1 billion was invested in securities, USD 126.9 billion was
deposited with other central banks, the BIS and IMF and USD 5.3 billion was placed
with External Asset Managers.

63
The country’s largest lender SBI, which has witnessed huge erosion in its net profit, has
set up 14 account tracking centres to check non-performing assets, Parliament was
informed on Tuesday.

“State Bank of India (SBI) has informed that they have set up account tracking centres in
all 14 circles of the Bank to check non-performing assets (NPAs),” Minister of State for
Finance Namo Narain Meena said in a reply in Rajya Sabha.

Mr. Meena also confirmed that the SBI has informed that the Institute of Chartered
Accountants of India (ICAI) had sought reasons for higher provisions of NPAs for the
fourth quarter of 2010-11.

SBI’s Q4 profits plunged by nearly 99 per cent to Rs 20.88 crore for the quarter ended
March 31, 2011 versus Rs 1,866.60 crore it had posted for the same period last year.

One of the major denting factors was a 82 per cent jump in its total provisioning which
increased to Rs 6,059-crore.

To another query on the reason for SBI earmarking higher provision for bad loans, Mr.
Meena said, “Fresh slippages to bad loans during the 4th quarter of the financial year
2010-11 were to the tune of Rs 5,645 crores for which higher prudential provisions were
made as per Reserve Bank of India guidelines.”

Another reason given by the bank was that during the nine-month period ended
December 31, 2010, the Bank had made higher provisions for NPAs over and above the
prescribed Income Recognition Asset Classification (IRAC) norms to achieve the 70 per
cent provision coverage ration as per RBI guidelines.

“During the quarter ended March 31, 2011, pursuant to the revised guidelines issued by
RBI on April 21, 2011, the Bank had created countercyclical provisioning buffer of Rs
2,330 crore till March 31, 2011,” he said.

Mr. Meena added that the provisions made by SBI for NPAs during the last three years
— 2009, 2010, 2011 — were Rs 2,474.97 crore, Rs 5147.85 crore and Rs 8792.09 crore,
respectively.

Responding to another query, Mr. Meena said that as on March 31, 2011, the gross NPA
of public sector banks stood at Rs 71,047 crore, which also include NPA of loans availed
by industrial houses.

He added that RBI and banks have already taken various steps to improve the health of
the financial sector, reduce NPAs, and to improve asset quality, like prescribing

64
prudential norms for provisioning and classification of NPAs, guidelines for prevention
of slippages, debt restructuring schemes, etc.

SBI sets up 14 tracking centres to check NPAs

The country’s largest lender SBI, which has witnessed huge erosion in its net profit, has
set up 14 account-tracking centres to check non-performing assets, Parliament was
informed today.

“State Bank of India has informed that they have set up account tracking centres in all
14 circles of the bank to check non-performing assets (NPAs),” the Minister of State for
Finance, Mr. Namo Narain Meena, said in a reply in Rajya Sabha.

Mr. Meena also confirmed that the SBI has informed that the Institute of Chartered
Accountants of India (ICAI) had sought reasons for higher provisions of NPAs for the
fourth quarter of 2010-11.

SBI’s Q4 profits plunged nearly 99 per cent to Rs 20.88 crore for the quarter ended
March 31, 2011, versus Rs 1,866.60 crore it had posted for the same period last year.

One of the major denting factors was an 82 per cent jump in its total provisioning which
increased to Rs 6,059-crore.

To another query on the reason for SBI earmarking higher provision for bad loans, Mr

65
Meena said, “Fresh slippages to bad loans during the fourth quarter of the financial
year 2010-11 were to the tune of Rs 5,645 crore for which higher prudential provisions
were made as per the Reserve Bank of India guidelines“.

Another reason given by the bank was that during the nine-month period ended
December 31, 2010, the bank had made higher provisions for NPAs over and above the
prescribed Income Recognition Asset Classification (IRAC) norms to achieve the 70 per
cent provision coverage ration as per RBI guidelines.

“During the quarter ended March 31, 2011, pursuant to the revised guidelines issued by
RBI on April 21, 2011, the bank had created countercyclical provisioning buffer of Rs
2,330 crore till March 31, 2011,” he said.

Mr Meena added that the provisions made by SBI for NPAs during the last three years
— 2009, 2010, 2011 — were Rs 2,474.97 crore, Rs 5,147.85 crore and Rs 8,792.09 crore,
respectively.

Responding to another query, Mr Meena said that as on March 31, 2011, the gross NPA
of public sector banks stood at Rs 71,047 crore, which also include NPA of loans availed
of by industrial houses.

He added that the RBI and banks have taken various steps to improve the health of the
financial sector, reduce NPAs, and improve asset quality, like prescribing prudential
norms for provisioning and classification of NPAs, guidelines for prevention of
slippages, debt restructuring schemes, etc.

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 BIBLIOGRPHY

WEBSITES :

www.icici.com

www.sbi.com

www.moneycontrol.com

www.scribd.com

www.cab.org.in

www.indiastudychannel.com

www.dialabank.com

www.equitybulls.com

www.linkedin.com

BOOKS :

1) BUSINESS ASPECTS IN BANKING & INSURANCE, P.K. BANDGAR, VIPUL

PRAKASHAN.

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2) BANKING & INSURANCE , CHAMPA L., RISHABH PUBLISHING HOUSE.

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