A Report On Role of Risk Management in Banking Sector

FOR THE PARTIAL FULFILMENT OF PGDM FULL TIME PROGRAM (2008-2010)

Under the supervision of Prof. V.K.Murti Submitted By: Namita Dubey

Trim-IV Batch-14th Session-2008-2010

Dr. Gaur Hari Singhania Institute of Management & Research, Kanpur

INDEX Topic
Introduction Basel II-An Integrated Risk Management System What Is Risk? Banking risk Liquidity risk Interest rate risk Market risk Credit risk Operational risk Legal risk 10-16 4-9

Page no.
1-3

Market Risk Credit risk Operational risk Risk Management Process Risk regulation Strategic role of risk management Why do banks manage risk Risk Measurement/Management Findings from the survey Bibliography/Webliography

17-19 20-21 22-23 24-26 26-27 28 29-30 31-36 37

To whomsoever it may concern

This is to certify that work entitled A PROJECT REPORT ON Role Of Risk Management In Banking Sector is a piece of work done by NAMITA DUBEY under my guidance and supervision for the partial fulfilment of diploma of PGDM in Dr. Gaur Hari Singhania Institute of Management & Research, Kanpur. To the best of my knowledge and belief the report embodies the work of the candidate herself and has duly been completed. Simultaneously the report fulfils the requirement of the rules and regulations relating to the final research report of the institute and I am assured that the project is up to the standard both in respect to contents and language being referred to the examiner.

Date: 15/01/10

Prof. V.K.Murti Faculty Guide

ACKNOWLEDGEMENT

I would like to express my gratitude to all those who gave me the possibility to complete this project. I would like to thank my college authorities and my Head of the Organization, Prof. Prithvi Yadav first for providing me the opportunity to work on the research project i.e. Role of Risk Management in Banking Sector. I want to thanks my project guide Prof. V.K.Murti for giving me permission to commence this project in the first instance, to do the necessary work. I want to thank all other finance teachers and my friends for all their help, support and valuable hints. Especially, I would like to give my special thanks to my parents, their love and blessing enabled me to complete this work.

NAMITA DUBEY

PREFACE
This project is undertaken for the partial fulfilment of PGDM course from Dr. Gaur Hari Singhania Institute of Management and Research, Kanpur (Batch XIV 2008-2010) Risk is the word which in common terms defined as the deviation from what we achieve and what we plan. There is uncertainties related to in the future and this is so banks also and therefore they are required to manage the risk. This project Role of Risk Management in banking sector aims at providing the understanding of different types of risk faced by banks and how they manage those. It also aims to analyse if they have any risk management system what role it play and how it manages and up to what extent. Understanding Basel II As an Integrated Risk Management solution. Understanding different risk faced by banking sector also understand how to eliminate them Risk analysis (credit risk, market risk, operational risk and others).Financial crisis lead the economy of whole world in a down turn which risk was the main cause for that.

ABBREVIATIONS

ACM AMA BCBS BIS BPV CFO EAD ECAI EM EVA ERM IRB KYE LGD MIS NBFCs PD RRS

Asset Creation Multiple Advanced Management Approach Basel Committee of Banking Supervision Bankers for International Settlement Basic Point Value Chief financial officer Exposure At Default External Credit Assessment Institution Effective Maturity Economic Value Added Enterprise risk management Internal Rating Based Know Your Employee Loss Given Default Management Information System Non-banking Financial Companies Probability of Default Risk Rating System

RRM RAROC S&P SVM VaR

Risk Rating Methodology Risk Adjusted Return on Capital

Standards And Poors

Shareholder Value Maximization Value at Risk

List of tables and figures s.no Tables/figure

Figure 1 Figure 2 Table 1 Figure 3 Chart 1

Basel II Financial risks

Changing Pattern of Off-balance Sheet Exposure of Different Banks In India
Credit risk

Transaction Relevant By Credit Conversion Factor

INTRODUCTION
Financial sector reforms were initiated as part of overall economic reforms in the country and wide ranging reforms covering industry, trade, taxation, external sector, banking and financial

markets have been carried out since mid 1991. A decade of economic and financial sector reforms has strengthened the fundamentals of the Indian economy and transformed the operating environment for banks and financial institutions in the country. The sustained and gradual pace of reforms has helped avoid any crisis and has actually fuelled growth. As pointed out in the RBI Annual Report 2001-02, GDP growth in the 10 years after reforms i.e. 1992-93 to 2001-02 averaged 6.0 against 5.8% recorded during 1980-81 to 1989-90 in the pre-reform period. The most significant achievement of the financial sector reforms has been the marked improvement in the financial health of commercial banks in terms of capital adequacy, profitability and asset quality as also greater attention to risk management. Further, deregulation has opened up new opportunities for banks to increase revenues by diversifying into investment banking, insurance, credit cards, depository services, mortgage financing, securitisation, etc. At the same time, liberalisation has brought greater competition among banks, both domestic and foreign, as well as competition from mutual funds, NBFCs, post office, etc. Post-WTO, competition will only get intensified, as large global players emerge on the scene. Increasing competition is squeezing profitability and forcing banks to work efficiently on shrinking spreads. Positive fallout of competition is the greater choice available to consumers, and the increased level of sophistication and technology in banks. As banks benchmark themselves against global standards, there has been a marked increase in disclosures and transparency in bank balance sheets as also greater focus on corporate governance. The waves of globalisation are sweeping across the world, and have thrown up several opportunities accompanied by concomitant risks. Integration of domestic market with international financial markets has been facilitated by tremendous advancement in information and communications technology. There is a growing realisation that the ability of countries to conduct business across national borders and the ability to cope with the possible downside risks would depend, inter alia, on the soundness of the financial system. This has necessitated convergence of prudential norms with international best practices as well consistent refinement of the technological and institutional framework in the financial sector through a non-disruptive and consultative process.

The Committee on Fuller Capital Account Convertibility (Chairman: Shri S.S. Tarapore) observed that under a full capital account convertibility regime, the banking system would be exposed to greater market volatility, and this necessitated enhancing the risk management capabilities in the banking system in view of liquidity risk, interest rate risk, currency risk, counter-party risk and country risk that arise from international capital flows. The potential dangers associated with the proliferation of derivative instruments credit derivatives and interest rate derivatives also need to be recognised in the regulatory and supervisory system. The issues relating to cross-border supervision of financial intermediaries in the context of greater capital flows are just emerging and need to be addressed.

Therefore the need for a regulation was understood and so basel1 and 2 accords were implemented. Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee (BCBS) in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten (G-10) countries in 1992. Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign debt), ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most corporate debt). Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.

Implementiaon of Basel II The Reserve Bank and the commercial banks have been preparing to implement Basel II, and it has been decided to allow banks some more time in adhering to new norms. As against the deadline of March 31, 2007 for compliance with Basel II, it was decided in October 2006 that foreign banks operating in India and Indian banks having presence outside India would migrate to the standardised approach for credit risk and the basic indicator approach for operational risk under Basel II with effect from March 31, 2008, while all other scheduled commercial banks are required to migrate to Basel II by March 31, 2009. It is widely acknowledged that implementation of Basel II poses significant challenge to both banks and the regulators. Basel II implementation may also be seen as a compliance challenge. But at the same time, it offers two major opportunities to banks, viz., refinement of risk management systems; and

improvement in capital efficiency. The transition from Basel I to Basel II essentially involves a move from capital adequacy to capital efficiency. This transition in how capital is used and how much capital is needed will become a significant factor in return-inequity strategy for years to come. The reliance on the market to assess the riskiness of banks would lead to increased focus on transparency and market disclosure, critical information describing the risk profile, capital structure and capital adequacy. Besides making banks more accountable and responsive to better-informed investors, these processes enable banks to strike the right balance between 10 risks and rewards and to improve the access to markets. Improvements in market discipline also call for greater coordination between banks and regulators.

Understanding Basel II As an Integrated Risk Management Solution.

Basel II has made a more comprehensive approach to manage risks for the banking system. It captures the risk on a consolidated basis for internationally active banks. Banking, Securities

and other financial subsidiaries are consolidated to reckon capital requirements. The framework encompasses all the entities in a banking group. It tries to ensure that the capital recognized in capital adequacy measures provides adequate protection to depositors. The framework of Basel II is as follows: Figure 1.

BASEL II

- Minimum Capital Requirements - Minimum of three -Calculation Capital Requirements types of risk:
-Calculation of three Market types of risk: Credit Market Operational Credit Operational Pillar 1 Pillar 3 Pillar 1 Pillar 3

-Supervisory review process -Supervisory review process Adequate capital Adequate capital

-Market discipline Disclosure of risks and risk practices -Market discipline

supervisory Sound Sound Disclosure of risks reviewsupervisory process and risk practices review Improvement of risk process management Improvement techniques of risk management Pillar 2 techniques Pillar 2

Basel II adopts a three pillar approach to risk management. Under Pillar 1 minimum capital requirements are stipulated for credit risk, market risk and operational risk. Pillar 2 deals with supervisory review process by the central bank. Pillar 3 underlines the need for market discipline and disclosures required there under.

Pillar 1 stipulates the following options for assigning capital to meet credit risk: 1. Standardized Approach 2. Internal Rating Based (IRB) Approach 3. Advanced IRB Approach. Standardized Approach.

Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from AAA to below B- . Similarly, exposure on public sector entities, multilateral development banks, other banks, securities firms and corporate also may have risk weights from 20 percent to 150 percent. Exposure on retail portfolio may carry risk weight of 75 percent. While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets, India has prescribed 9 percent. Under Basel II exposure on a corporate with AAA rating will have a risk weight of only 20 percent. This implies that for Rs. 100 crore exposure on a AAA rated corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%) compared to the earlier requirement of Rs. 9 crore. However, claims on a corporate with below BB- rating will carry a risk weight of 150 percent and the capital requirement will be Rs.13.50 crore (100 x 150% x 9%). Thus, a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital. Risk weights can go beyond 150 percent in respect of exposures with low rating. For example, securitization tranches with rating between BB+ and BB- may carry risk weight of 350 percent. In order to adopt standardized approach, banks will have to encourage their corporate customers to go in for obligor rating and get them rated. The central bank has to accredit External Credit Assessment Institutions (ECAI) who satisfies defined criteria of objectivity, independence, international access, transparency, disclosure, resources and credibility. Internal Ratings Based (IRB) Approach: Foundation and Advanced Approach. Banks, which have developed reliable Management Information System (MIS) and have received the approval of the central bank, can use the IRB approach to measure credit risk on their own. The bank should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and effective maturity (M) to make use of IRB approach. Minimum requirements to adopt the IRB approach are: 1. Banks overall Credit Risk management practices must be consistent with the sound practice guidelines issued by the Basel committee and the National Supervisor. 2. Rating dimensions to include both Borrower Rating and Facility Rating and has to be applied to all asset classes.

3. The Rating Structure adopted need to have minimum 7 grades of performing borrowers and a minimum 1 Grade of non-performing borrowers and Enough grades to avoid undue concentrations of borrowers in particular grades. 4. Criteria of Rating Systems to be documented and have the ability to differentiate risk, predictive and discriminatory power. 5. Assessment Horizon for PD estimation to be 1 year 6. Use of models to be coupled with the use of human judgment and oversight. 7. Rating Assignment and Rating Confirmation to be independent. 8. The PD to be a long run average over an entire economic cycle (at least 5 years) 9. Banks should have confidence in the robustness of PD estimates and the underlying statistical analysis. 10. Data collection and IT systems to improve the predictive power of rating systems and PD estimates. 11. Validation of internal Rating systems/ Models by the Supervisor. 12. Streamlining use of credit risk mitigates and ensuring legal certainty of executed documents. Under foundation approach banks provide more of their own estimates of PD and rely on supervisory estimates for other risk components. In the case of advanced approach banks provide more of their own estimate of PD, LGD, EAD and M, subject to meeting minimum stipulated standards. Market Risk: A banks investment portfolio is impacted by the fluctuation in prices of securities. Even in respect of sovereign exposure there will be change in market price because of interest rate movements. When the prices of securities are marked to market, a bank may incur loss if the prices have declined. Change in interest rates, foreign exchange rates and prices of equity, corporate debt instruments and commodities may involve market risk for the bank. Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The investment portfolio has to be divided into the trading book and the banking book. While the trading book has to be valued on a daily basis on mark to market basis, for the banking book, there should be frequent assessment of shock absorption capacity of the portfolio to interest rate movements. Operational Risk:

A bank also encounters risks other than on account of default by a third party or adverse market rate movements. These risks can be attributed to failed internal systems, processes, people and external events. Mistakes committed because of weak internal systems may lead to losses. Frauds may be committed on the bank by some customers, outsiders and even by employees. If a proper KYC system is not in place, a bank may be exposed to loss of money and reputation in a punitive action by the regulators. To minimize operational risks Know your Employee (KYE) principles are also to be observed before employees are entrusted with sensitive assignments. Pillar 1:- Envisages that banks assess credit risk, market risk and operational risk and provide for adequate capital to cover the risks. Pillar 2:- Supervisory Review Process. Compliance of requirements under Pillar 1 and providing adequate capital alone may not be enough to prevent bank failures and to protect the interests of depositors. Therefore, under Pillar 2 which deals with key principles of supervisory review, risk management guidance and supervisory transparency and accountability with respect to banking risks, including guidance relating to the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk and credit concentration risk), operational risk, enhanced cross border communication and co-operation and securitization, supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors so that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Supervisors may focus more intensely on banks with risk profiles or operational experience, which warrants such attention. There are the following four main areas to be treated under Pillar 2: 1. Risks considered under Pillar 1 that are not fully captured by Pillar 1 process (e.g credit concentration risk); 2. Those factors not taken into account by Pillar 1 process (e.g. interest rate risk in the banking book, business and strategic risk). 3. Factors external to the bank (e.g. business cycle effects). 4. Assessment of compliance with minimum standards and disclosure requirements of the more advanced methods under Pillar 1.

Supervisors have to ensure that these requirements are being met both as qualifying criteria and on a continuing basis. The four key principles of supervisory review are: Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. The five main features of a rigorous process are as follows: 1. Board and senior management oversight; 2. Sound capital assessment; 3. Comprehensive assessment of risks; 4. Monitoring and reporting; and 5. Internal control review. Principle 2: Supervisors should review and evaluate banks internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. Reserve Bank of India has implemented the risk-based supervision and has made a good beginning in implementation of the guidelines under Pillar 2. Internal inspections of banks in India are also tuned more towards risk-based audit. Pillar 3:- Market Discipline. Disclosure requirements are stipulated for banks to encourage market discipline. This will help the market participants to assess the information on capital, risk exposures, risk assessment processes and capital adequacy of the bank. Such disclosures are more important in the case of banks, which are permitted to rely on internal methodologies giving them more discretion in assessing capital requirements. Market discipline supplements regulation as sharing of

information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It also leads to good corporate governance. Supervisors can stipulate the minimum disclosures to be made by banks. Banks can also have Board approved policies on disclosure. A transparent organization may create more confidence in the investors, customers and counter parties with whom the bank has dealings. It would also be easier for such banks to attract more capital. All the requirements under the three Pillars of Basel II can be met only if banks have a robust and reliable MIS. Technology therefore plays a crucial role in implementation of Basel II. Beyond Core Banking which facilitates networking of branches to put through customer transactions with ease and speed, technology should be able to play a supportive role in enabling banks to access and use data in a meaningful manner so that the demands of Basel II can be met in a cost effective manner. Reliance on internal methodologies will save cost and provide greater discretion to banks to make assessment of capital requirements. Capital is a very scarce resource and it needs to be put to optimum use. As per present norms, tier II capital can be only 100 percent of Tier I capital. The stipulation of minimum Government holding of 51 percent poses challenges for public sector banks in raising tier I capital. India may have to find a solution to this issue by asking for acceptance of new instruments as tier I capital. In the context of the very robust growth in credit, which supports a buoyant economy, more capital becomes indispensable for the Indian banking system. And compliance of Basel II norms will help Indian banks adopt best international practices, enable them to have a larger global presence and attract capital even from abroad.

Definition of Risk What is Risk?

"What is risk?" And what is a pragmatic definition of risk? Risk means different things to different people. For some it is "financial (exchange rate, interest-call money rates), mergers of

competitors globally to form more powerful entities and not leveraging IT optimally" and for someone else "an event or commitment which has the potential to generate commercial liability or damage to the brand image". Since risk is accepted in business as a trade off between reward and threat, it does mean that taking risk bring forth benefits as well. In other words it is necessary to accept risks, if the desire is to reap the anticipated benefits. Risk in its pragmatic definition, therefore, includes both threats that can materialize and opportunities, which can be exploited. This definition of risk is very pertinent today as the current business environment offers both challenges and opportunities to organizations, and it is up to an organization to manage these to their competitive advantage.

What is Risk Management - Does it eliminate risk?

Risk management is a discipline for dealing with the possibility that some future event will cause harm. It provides strategies, techniques, and an approach to recognizing and confronting any threat faced by an organization in fulfilling its mission. Risk management may be as uncomplicated as asking and answering three basic questions: 1. What can go wrong? 2. What will we do (both to prevent the harm from occurring and in the aftermath of an "incident")? 3. If something happens, how will we pay for it? Risk management does not aim at risk elimination, but enables the organization to bring their risks to manageable proportions while not severely affecting their income. This balancing act between the risk levels and profits needs to be well-planned. Apart from bringing the risks to manageable proportions, they should also ensure that one risk does not get transformed into any other undesirable risk. This transformation takes place due to the inter-linkage present among the various risks. The focal point in managing any risk will be to understand the nature of the transaction in a way to unbundle the risks it is exposed to. Risk Management is a more mature subject in the western world. This is largely a result of lessons from major corporate failures, most telling and visible being the Barings collapse. In addition, regulatory requirements have been introduced, which expect organizations to have effective risk management practices. In India, whilst risk management is still in its infancy,

there has been considerable debate on the need to introduce comprehensive risk management practices.

Objectives of Risk Management Function

Two distinct viewpoints emerge

One which is about managing risks, maximizing profitability and creating opportunity out of risks And the other which is about minimising risks/loss and protecting corporate assets.

The management of an organization needs to consciously decide on whether they want their risk management function to 'manage' or 'mitigate' Risks.

Managing risks essentially is about striking the right balance between risks and controls and taking informed management decisions on opportunities and threats facing an organization. Both situations, i.e. over or under controlling risks are highly undesirable as the former means higher costs and the latter means possible exposure to risk.

Mitigating or minimising risks, on the other hand, means mitigating all risks even if the cost of minimising a risk may be excessive and outweighs the cost-benefit analysis. Further, it may mean that the opportunities are not adequately exploited. In the context of the risk management function, identification and management of Risk

is more prominent for the financial services sector and less so for consumer products industry. What are the primary objectives of your risk management function? When specifically asked in a survey conducted, 33% of respondents stated that their risk management function is indeed expressly mandated to optimise risk.

Risks in Banking
Risks manifest themselves in many ways and the risks in banking are a result of many diverse activities, executed from many locations and by numerous people. As a financial intermediary, banks borrow funds and lend them as a part of their primary activity. This intermediation activity, of banks exposes them to a host of risks. The volatility in the operating environment of banks will aggravate the effect of the various risks. The case discusses the various risks that arise due to financial intermediation and by highlighting the need for asset-liability management; it discusses the Gap Model for risk management.

Typology of Risk Exposure

Based on the origin and their nature, risks are classified into various categories. The most prominent financial risks to which the banks are exposed to taking into consideration practical issues including the limitations of models and theories, human factor, existence of frictions such as taxes and transaction cost and limitations on quality and quantity of information, as well as the cost of acquiring this information, and more.

FINANCIAL RISKS

MARKET RISK

LIQUIDITY RISK

OPERATIONA L RISK

HUMAN FACTOR RISK

CREDIT RISK

LEGAL & REGULATORY RISK

FUNDING LIQUIDITY RISK

TRADING LIQUIDITY RISK

Figure 2

TRANSACTIO N RISK

PORTFOLIO CONCENTRATIO N

ISSUE RISK

ISSUER RISK

COUNTERPARTY RISK

EQUITY RISK

INEREST RATE RISK

CURRENCY RISK

COMMODITY RISK

TRADING RISK

GAP RISK

GENERAL MARKET RISK

SPECIFIC RISK

Banking risk
Liquidity risk The liquidity risk of banks arises from funding of long-term assets by short term liabilities, herby making the subject to rollover of refinancing risk. Funding liquidity risk is denied as the inability to obtain funds to meet cash flow obligations. The liquidity risk in banks manifest in different dimensions: Funding risk: this arises from the need to replace net outflow due to unanticipated withdrawal of deposits (wholesale and retail). Time risk: this arises from the need to compensate for non-receipt of expected in flows of funds i.e. performing assets turning into non performing assets. Call risk: this arises due to crystallisation of continent liabilities. This may also arise when a bank may not be bale to undertake profitable business opportunities when it arises

Interest rate risk Interest rate risk is the exposure of banks financial condition to adverse movements in interest rates. Interest rate risk refers to potential impact on net interest income or net interest rate margin or market value of equity, caused by unexpected changes in market interest rates. IRR can be viewed in two ways: its impact on the earnings of the banks or its impact on the economic value of the banks assets, liabilities OBS positions. Gap and mismatch risk Yield covers risk Basis risk Embedded option risk Reinvestment risk Net interest position risk

Market risk Market risk is the risk of adverse deviation of the mark to market value of the trading portfolios, due to market movements, during the period required to liquidate the transactions. Market risk is also referred to as price risk. Price risk occurs when assets are sold before their stated maturities. In the financial market, bond prices and yields are inversely related. The term market risk applies to (i) that the part of IRR which affects the price of interest rate instruments (ii) pricing risk for all other portfolios that are held in the trading book of the bank (iii) foreign currency risk. Forex risk Market liquidity risk

Credit risk

Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail to meet its obligation in accordance with agreed terms. For most banks, loans are the largest and most obvious source of credit risk. Default Risk Credit Spread Risk Systematic or Intrinsic Risk Concentration Risk
Transaction Level Risk

Portfolio Risk

Operational risks Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events. Strategic risk and reputation risk are not a part of operational risk. It includes fraud risk, cultural risk, communication risk, documentation risk, competence risk, model risk, external events risk, legal risk, regulatory risk, compliance risk, system risk. Recently legal risk has been taken as a separate as per Shyamala Gopinath, Deputy Governor in his article Changing Dynamics of Legal Risks in Financial Sector Legal risk Legal risk arises for a whole of variety of reasons. For example, counterparty might lack the legal or regulatory authority to engage in a transaction. Legal risks usually only become apparent when counterparty, or an investor, lose money on a transaction and decided to sue the bank to avoid meeting its obligations. Another aspect of regulatory risk is the potential impact of a change in tax law on the market value of a position.

In general there are three main risk faced by banks they are: 1. Market risk 2. Credit risk 3. Operational risk

We will understand them in detail

MARKET RISK
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 banks 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. 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 banks business strategy. Market can also be defined as Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times, also called systematic risk. Market risk in banks Banks also have several activities and undertake transaction that result in market exposure, therefore they are not immune to this risk they also face it. All such transaction is reflected in the grading book of the bank. 1. A trading book consists of banks proprietary positions in financial instrument covering Debt securities Equity Foreign exchange Commodities Derivatives held by trading

2. They also include position in the financial instrument arising form mismatched principal broking and market making or positions taken in order to hedge other elements of the trading books. A banks trading book exposure has the following risks, which arise due to adverse changes in the market variables such as interest rates, currency exchange rate ,commodity prices, market liquidity and their volatilities and therefore these impact on banks earning nad capital adequacy. The main types of market risk faced by banks are:

1. Foreign exchange risk:

Foreign Exchange Risk maybe defined as the risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position, either spot or forward, or a combination of the two, in an individual foreign currency, in forex risk banks are exposed to other risk as well like: Interest rate risk- Which arises from the maturity mismatching of foreign currency positions. Even in cases where spot and forward positions in individual currencies are balanced, the maturity pattern of forward transactions may produce mismatches. As a result, banks may suffer losses as a result of changes in premium/discounts of the currencies concerned. Counter party risk or settlement risk.

The three important issues that need to be addressed in this regard are: 1. Nature and magnitude of exchange risk 2. Exchange managing or hedging for adopted be to strategy> 3. The tools of managing exchange risk 2. Liquidation risk Liquidation involves asset and market liquidity risk. Liquidation risk arises from the lack of trading liquidity and result in Adverse change in market prices Inability of positions at the fair market price Liquidation of position cause large price change Inability to liquidate position at any price

Asset liquidation risk refers to a situation where a specific asset faces lack of trading liquidity. Market liquidation risk refers to a situation when there is a general liquidity crunch in the market and it reflects trading liquidity adversely. Table1:-Changing Pattern of Off-balance Sheet Exposure of Different Banks In India

Group of banks Public sector banks New private sector banks Old private sector banks Foreign banks Scheduled commercial

2001-02 3293 870 243 4460 8866

2002-03 4066 1660 301 5630 11657

2003-04 4864 3536 329 8904 17633

2004-05 6840 4980 600 15906 28326

2005-06 8422 7901 630 25541 42494

CREDIT RISK Credit risk arises from the lending activities of banks. It arises when the borrower does not pay the interest and/or instalments as and when it falls due or in case where a loan is payable on demand, the borrower fails to make payment as and when demanded. Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counterparties. In a bank's portfolio, losses stem from outright default due to inability or unwillingness of a customer or counterparty to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Credit risk emanates from a bank's dealings with an individual, corporate, bank, financial institution or a sovereign.

Credit risk may take the following forms

In the case of direct lending: principal/and or interest amount may not be repaid; In the case of guarantees or letters of credit: funds may not be forthcoming from the constituents upon crystallization of the liability; In the case of treasury operations: the payment or series of payments due from the counter parties under the respective contracts may not be forthcoming or ceases; In the case of securities trading businesses: funds/ securities settlement may not be effected; In the case of cross-border exposure: the availability and free transfer of foreign currency funds may either cease or the sovereign may impose restrictions.

Credit risk can be divided into: Figure 3 Credit risk

Portfolio Risk

Transaction Risk

Concentration risk Default Risk

Systematic Risk

Default Risk r

Credit Spread Risk

Default risk is driven by the potential failure of a borrower to make a promised payment, either partly or wholly. In the event of default, a fraction of the obligation will normally be paid. This is known as the recovery rate. Credit Spread If a borrower does not default, there is still risk due to worsening in credit quality. This result in the possible widening of the credit spread. This is credit spread risk. This may arise from a rating change (i.e. an upgrade or a down grade).It will usually be firm specific. Chart 1:S.No Transaction Relevant By Credit Conversion Factor Credit Conversion Factor (CCF)

Off Balance Sheet Instrument

Direct credit substitutes, in general guarantees of 100 indebtedness including stand by LC, financial guarantees, acceptances and endorsement.

Certain transaction related contingent items such as 50 performance bonds, bid bonds, warranties and indemnities.

Short term self-liquidating trade letters of credit 20 arising from the movement of goods i.e. documentary credits collateralised by the underlying shipments for both issuing and confirming banks.

Sale and repurchase agreement and asset sales with 100 recourse, where credit risk remains with bank

Other commitments i.e. formal standby facilities and 20 credit lines with an original maturity-(a)up to 1 year

Other commitments i.e. formal standby facilities and 100 credit lines with an original maturity-(b)over 1 year

OPERATIONAL RISK Operational risk is one of the areas of risk that is faced by all organisations. More complex the organisation is more exposed it would be to operational risk. Organisational risk would arise due to the deviation from the normal and the planned functioning of systems, procedures, technology and human failures of omission and commission. Basel committee has defined Operational risk as follows, the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. Nature of organisational risk may be listed as: Operational risk exists everywhere in the organisation. Operational risks vary in their components. Some are high occurrence low value risks, while some are low occurrence high value risks.

Operational risks in the organisation continuously change especially when an organisation is undergoing changes.

The performance of the banks have to be viewed in the context of growing number of operational loss events and the consequential banking disasters such as Barclays Bank and Allied Irish Bank. The four fundament principles, which underpin the entire gamut of operational risk, can be summarised as: Accept no unnecessary risk Make risk decisions at appropriate level. Accept risk after careful cost benefit analysis Dovetail the operational risk management into business planning.

The second consultative paper of Basel II suggested classification of operational risks based on the cause and effects .That is classification based on causes that are responsible for operational risk or classifications based on the effects of risk were suggested.

Cause-Based People oriented causes-negligence, incompetence, Insufficient training Process oriented causes-business volume fluctuation, organisational complexity, product complexity Technology oriented causes-poor technology and telecom, obsolete application, lack of automation External causes-natural disaster, operational failures of third party

Effect Based Legal liability Regulatory, compliance and taxation policies

Loss or damage to assets Restitution Loss of recourse Write downs

MANAGEMENT OF RISK Management of risk begins with the identification and its quantification. It is only after the risk is identified and measured it may be decided to accept the risk or to accept the risk at a reduced level, by undertaking steps to mitigate the risk, either full or partial. Therefore the management of risk may sub-divide into following five processes: Risk Identification Risk Management Based on Sensitivity Based on Volatility Based on Downside potential

Risk Pricing Risk Monitoring and control Risk adjusted return on capital

Risk Mitigation

RISK MANAGEMENT PROCESS The process of financial risk management is an ongoing one. Strategies need to be implemented and refined as the market and requirements change. Refinements may reflect changing expectations about market rates, changes to the business environment, or changing international political conditions, for example. In general, the process can be summarized as follows: Identify and prioritize key financial risks. Determine an appropriate level of risk tolerance. Implement risk management strategy in accordance with policy. Measure, report, monitor, and refine as needed.

Risk management needs to be looked at as an organizational approach, as management of risks independently cannot have the desired effect over the long term. This is especially necessary as risks result from various activities in the firm and the personnel responsible for the activities do not always understand the risk attached to them. The steps in risk management process are:

a) Determining objectives Determination of objectives is the first step in the risk management function. The objective may be to protect profits, or to develop competitive advantage. The objective of risk management needs to be decided upon by the management. So that the risk manager may fulfil his responsibilities in accordance with the set objectives. b) Identifying Risks Every organization faces different risks, based on its business, the economic, social and political factors, the features of the industry it operates in like the degree of competition, the strengths and weakness of its competitors, availability of raw material, factors internal to the company like the competence and outlook of the management, state of industry relations,

dependence on foreign markets for inputs, sales or finances, capabilities of its staff and other innumerable factors. c) Risk Evaluation Once the risks are identified, they need to be evaluated for ascertaining their significance. The significance of a particular risk depends upon the size of the loss that it may result in, and the probability of the occurrence of such loss. On the basis of these factors, the various risks faced by the corporate need to be classified as critical risks, important risks and not-so-important risks. Critical risks are those that may result in bankruptcy of the firm. Important risks are those that may not result in bankruptcy, but may cause severe financial distress. d) Development of policy Based on the risk tolerance level of the firm, the risk management policy needs to be developed. The time frame of the policy should be comparatively long, so that the policy is relatively stable. A policy generally takes the form of a declaration as to how much risk should be covered. e) Development of strategy Based on the policy, the firm then needs to develop the strategy to be followed for managing risk. A strategy is essentially an action plan, which specifies the nature of risk to be managed and the timing. It also specifies the tools, techniques and instruments that can be used to manage these risks. A strategy also deals with tax and legal problems. Another important issue that needs to be specified by the strategy is whether the company would try to make profits out of risk management or would it stick to covering the existing risks. f) Implementation Once the policy and the strategy are in place, they are to be implemented for actually managing the risks. This is the operational part of risk management. It includes finding the best deal in case of risk transfer, providing for contingencies in case of risk retention, designing and implementing risk control programs etc. g) Review

The function of risk management needs to be reviewed periodically, depending on the costs involved. The factors that affect the risk management decisions keep changing, thus necessitating the need to monitor the effectiveness of the decisions taken previously.

Risk regulation in banking industry Banking and financial services are regulated because they are the back bone of the economy. Regulations have decisive impact on risk management. Regulation seek to improve the safety of the banking industry, ensure a level playing field, promote sound business and supervisory practices, control and monitor Systematic Risk and protect the interest of depositors. Bankers for International Settlement (BIS) meet at Basel situated at Switzerland to address the common issues concerning bankers all over the world. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries and has been developing standards and establishment of a framework for bank supervision towards strengthening financial stability throughout the world. In consultation with the supervisory authorities of a few non-G-10 countries including India, core principles for effective banking supervision in the form of minimum requirements to strengthen current supervisory regime. In banks asset creation is an event happening subsequent to the capital formation and deposit mobilization. Therefore, the preposition should be for a given capital how much asset can be created? Hence, in ideal situation and taking a radical view, stipulation of Asset Creation Multiple (ACM), in lieu of capital adequacy ratio, would be more appropriate and rational. That is to say, instead of Minimum Capital Adequacy Ratio of 8 percent (implying holding of Rs 8 by way of capital for every Rs 100 risk weighted assets), stipulation of Maximum Asset Creation Multiple of 12.5 times (implying for maximum Asset Creation Multiple of 12.5 time for the given capital of Rs 8) would be more meaningful. However as the assets have been already created when the norms were introduced, capital adequacy ratio is adopted instead of asset creation multiple. At least in respect of the new banks (starting from zero), Asset Creation Multiple (ACM) may be examined/thought of for strict implementation. The main differences between the existing accord and the new one are summarized below:Existing Accord Focus on single risk New Accord More emphasis on banks measure own internal methodology supervisory Review and

One size fits all

market discipline. Flexibility, menu of approaches, incentive for better risk management More risk sensitivity.

Broad brush structure

The structure of the New Accord II consists of three pillars approach as given below. Pillar I Pillar II Pillar III Pillar Strategic Role of Risk Management in Banks Risk management seeks to provide an assurance to the top management that the core objective would be achieved to desired degree of assurance. The higher the risk taken and the greater the level of assurance required for achieving core objective, the higher the sophistication of risk management system that a bank must aim for. The core enterprise objective that is sought to assured by risk management for profit-oriented business is well known but often misinterpreted concept of shareholder value maximization (SVM). In the event of losses, shareholders accept it first before others by providing much needed protection to other capital providers such as debt and deposit holders in a bank. In return for providing capital the shareholders expect the return commensurate with the risks that they are exposed to . while the ultimate test of SVM is addition to market capitalization, difficulties associated with using it in practice has lead to a number of proxies to economic value Added (EVA), risk adjusted return on capital(RAROC), and its variants. Focus area Minimum Capital Requirement Supervisory review process Market Discipline

Why Do Banks Manage These Risks At All? Why banking firms manage risk. According to standard economic theory, managers of value maximizing firms ought to maximize expected profit without regard to the variability around its expected value. However, there is now a growing literature on the reasons for active risk management including the work of Stulz (1984), Smith, Smithson and Wolford (1990), and

Froot, Sharfstein and Stein (1993) to name but a few of the more notable contributions. In fact, the recent review of risk management reported in Santomero (1995) lists dozens of contributions to the area and at least four distinct rationales offered for active risk management. These include managerial selfinterest, the non-linearity of the tax structure, the costs of financial distress and the existence of capital market imperfections. Any one of these justifies the firms' concern over return variability, as the above-cited authors demonstrate. How Are These Risks Managed? In light of the above, what are the necessary procedures that must be in place to carry out adequate risk management? In essence, what techniques are employed to both limit and manage the different types of risk, and how are they implemented in each area of risk control? It is to these questions that we now turn. After reviewing the procedures employed by leading firms, an approach emerges from an examination of large-scale risk management systems. The management of the banking firm relies on a sequence of steps to implement a risk management system. These can be seen as containing the following four parts:
(i) Standards and reports,

(ii) Position limits or rules, (iii) Investment guidelines or strategies, (iv) Incentive contracts and compensation. In general, these tools are established to measure exposure, define procedures to manage these exposures, limit individual positions to acceptable levels, and encourage decision makers to manage risk in a manner that is consistent with the firm's goals and objectives. To see how each of these four parts of basic risk management techniques achieves these ends, we elaborate on each part of the process below. In Section IV we illustrate how these techniques are applied to manage each of the specific risks facing the banking community. Standards and Reports The first of these risk management techniques involves two different conceptual activities, i.e., standard setting and financial reporting. They are listed together because they are the sine qua non of any risk system. Underwriting standards, risk categorizations, and standards of review are all traditional tools of risk management and control. Consistent evaluation and rating of exposures of various types are essential to understand the risks in the portfolio, and the extent to which these risks must be mitigated or absorbed. The standardization of financial reporting is the next ingredient. Obviously outside audits, regulatory reports, and rating agency evaluations

are essential for investors to gauge asset quality and firm level risk. These reports have long been standardized, for better or worse. However, the need here goes beyond public reports and audited statements to the need for management information on asset quality and risk posture. Such internal reports need similar standardization and much more frequent reporting intervals, with daily or weekly reports substituting for the quarterly GAAP periodicity. Position Limits and Rules A second technique for internal control of active management is the use of position limits, and/or minimum standards for participation. In terms of the latter, the domain of risk taking is restricted to only those assets or counterparties that pass some prespecified quality standard. Then, even for those investments that are eligible, limits are imposed to cover exposures to counterparties, credits, and overall position concentrations relative to various types of risks. While such limits are costly to establish and administer, their imposition restricts the risk that can be assumed by any one individual, and therefore by the organization as a whole. In general, each person who can commit capital will have a well-defined limit. This applies to traders, lenders, and portfolio managers. Summary reports show limits as well as current exposure by business unit on a periodic basis. In large organizations with thousands of positions maintained, accurate and timely reporting is difficult, but even more essential. Investment Guidelines and Strategies Investment guidelines and recommended positions for the immediate future are the third technique commonly in use. Here, strategies are outlined in terms of concentrations and commitments to particular areas of the market, the extent of desired asset-liability mismatching or exposure, and the need to hedge against systematic risk of a particular type. The limits described above lead to passive risk avoidance and/or diversification, because managers generally operate within position limits and prescribed rules. Beyond this, guidelines offer firm level advice as to the appropriate level of active management, given the state of the market and the willingness of senior management to absorb the risks implied by the aggregate portfolio. Such guidelines lead to firm level hedging and asset-liability matching. In addition, securitization and even derivative activity are rapidly growing techniques of position management open to participants looking to reduce their exposure to be in line with management's guidelines. Incentive Schemes

To the extent that management can enter incentive compatible contracts with line managers and make compensation related to the risks borne by these individuals, then the need for elaborate and costly controls is lessened. However, such incentive contracts require accurate position valuation and proper internal control systems. Such tools which include position posting, risk analysis, the allocation of costs, and setting Jensen and Meckling (1976), and Santomero (1984) for discussions of the shortcomings in simple linear risk sharing incentive contracts for assuring incentive compatibility between principals and agents. of required returns to various parts of the organization are not trivial. Notwithstanding the difficulty, well designed systems align the goals of managers with other stakeholders in a most desirable way. In fact, most financial debacles can be traced to the absence of incentive compatibility, as the cases of the deposit insurance and maverick traders so clearly illustrate.

RISK MANAGEMENT
MARKET RISK MANAGEMENT After identification of major type of risk faced by banks. The next step for the risk management process is the quantification or measurement of risk. Measurement of market risk (interest rate risk) may be done by:
a) The Interest Sensitive Gap Analysis:-is the most popular analytical tool used by

banks managements to hedge the balance sheet from the interest rate risk. While the Traditional Gap Analysis seeks to manage risk arising from the mismatch in prising of

the assets and liabilities, a more redefined method is known as Standardised Gap Analysis attempts to address basis risk also. Traditional gap analysis involves an analysis and management of the banks positions in interest sensitive assets, liabilities and off-balance sheet items with reference to existing interest sensitivity exposure of the banks on a particular day. Gap analysis is the analysis between the interest rate sensitive assets and interest rate sensitive liabilities.
b) Duration Analysis:-the concept of the duration is helpful to come out of the market

risk which either appreciates the bonds value or vice versa. Duration of a coupon bearing bond is the weighted average maturity of its cash flow streams in present value terms. It can be described as the maturity of an equivalent zero coupons bound. Duration is calculated using the following formula:
PV (C1)*1+PV (C2)*2-----------+P V (C n)*n V 0 c) Simulation Analysis:-In simulation method a financial model of the institution is first

Duration =

developed incorporating interrelationship of the assets, liabilities, prices,costs , volume ,mix and other business related variables.
d) Value at Risk: - Value at Risk or VaR is a recent innovation. The value at risk is based

on some elementary statistical concepts. Quantifying risk obviously means finding out in numbers the likely loss a position would make in the market. value at risk may be commuted using three major methods : The Parametric or The Delta Normal Method The Historical Simulation Method The Monte Carlo Method.

e) Basic point value-this is the change value due basis point (0.01%) change in market

yield. This is used to measure the risk. The higher the BPV of a bond, higher is the risk associated with the bond. Computation of BPV is quite simple.

CREDT RISK MEASUREMENT Measurement of credit risk consist of a) Measurement of risk through credit rating/scoring. Credit rating can be classified as: External credit rating: - A credit rating is, in general, an investment recommendation concerning a given security, in the words of Standards and Poors(S&P). A credit rating is a creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation, based on relevant risk factors. In Moody's words, a rating is, an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed-income security. Financial institutions, when required to hold investment grade bonds by their regulators use the rating of credit agencies such as S&P and Moody's to determine which bonds are of investment grade. The subject of credit rating might be a company issuing debt obligations. In the case of such issuer credit ratings the rating is an opinion on the obligors overall capacity to meet its financial obligations. The opinion is not specific to any particular liability of the company, nor does it consider merits of having guarantors for some of the obligations. In the issuer credit rating categories are a) b) c) Counterparty ratings Corporate credit ratings Sovereign credit ratings

Claims on sovereigns and their central banks will be risk weighted as follows:
Credit AAA to A+ BBB+ to BB+

Below B150%

Unrated 100%

Assessment Risk Weight

AA0%

to A20%

BBB50%

to B100%

Internal credit rating: - A typical risk rating system (RRS) will assign both an obligor rating to each borrower (or group of borrowers), and a facility rating to each available facility. A risk rating (RR) is designed to depict the risk of loss in a credit facility. A robust RRS should offer a carefully designed, structured, and documented series of steps for the assessment of each rating.

The following are the steps for assessment of rating: a) Objectivity and Methodology:

The goal is to generate accurate and consistent risk rating, yet also to allow professional judgment to significantly influence a rating where it is appropriate. The expected loss is the product of an exposure (say, Rs. 100) and the probability of default (say, 2%) of an obligor (or borrower) and the loss rate given default (say, 50%) in any specific credit facility. In this example, The expected loss = 100*.02*.50 = Rs. 1 A typical risk rating methodology (RRM) a. Initial assign an obligor rating that identifies the expected probability of default by that borrower (or group) in repaying its obligations in normal course of business. b. The RRS then identifies the risk loss (principle/interest) by assigning an RR to each individual credit facility granted to an obligor. The obligor rating represents the probability of default by a borrower in repaying its obligation in the normal course of business. The facility rating represents the expected loss of principal and/ or interest on any business credit facility. It combines the likelihood of default by a borrower and conditional severity of loss, should default occur, from the credit facilities available to the borrower. b) Quantifying the risk through estimating expected loans losses.

OPERATIONAL RISK MEASUREMENT

Three methods for calculating operational risk capital charges in a continuum of increasing

sophistication and risk sensitivity:

a) The Basic Indicator Approach:-Banks using the Basic Indicator Approach must hold

capital for operational risk equal to the average over the previous three years of a fixed percentage (denoted alpha) of annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average. The charge may be expressed as follows: KBIA = [(GI1n x )]/n

Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three year n = number of the previous three years for which gross income is positive = 15%, which is set by the Committee, relating the industry wide level of required capital to the industry wide level of the indicator. Gross income is defined as net interest income plus net non-interest income. It is intended that this measure should: (i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers;(iii) exclude realised profits/losses from the sale of securities in the banking book; and (iv) exclude extraordinary or irregular items as well as income derived from insurance. As a point of entry for capital calculation, no specific criteria for use of the Basic Indicator Approach are set out in this Framework. Nevertheless, banks using this approach are encouraged to comply with the Committees guidance on Sound Practices for the Management and Supervision of Operational Risk, February 2003.
b)

The Standardised Approach: - In the Standardised Approach, banks activities are divided into eight business lines: corporate finance, trading & sales, retail banking, commercial banking, payment &settlement, agency services, asset management, and retail brokerage.

Business Lines

Exposure Indicator

Beta Percent

Capital Requirement (GIi*j) G11*0.18 G12*0.18 G13*0.12 G14*0.15 G15*0.18 G16*0.15 G17*0.12 G18*0.12 (GIi)(j)

Corporate Finance Trading and Sales Retail Banking Commercial Banking Payments

G11 G12 G13 G14

18 18 12 15 18 15 12 12

and G15

settlement Agency services G16 Asset management G17 Retail Brokerage G!8 Total capital requirement

c) Advanced Measurement Approaches (AMA):-Under the AMA, the regulatory capital

requirement will equal the risk measure generated by the banks internal operational risk measurement system using the quantitative and qualitative criteria for the AMA discussed below. Use of the AMA is subject to supervisory approval.
d) RAROC:-Development of the RAROC methodology began in the late 1970s, initiated

by a group at Bankers Trust. Their original interest was to measure the risk of the banks credit portfolio, as well as the amount of equity capital necessary to limit the exposure of the banks depositors and other debt holders to a specified probability of loss. Since then, a number of other large banks have developed RAROC or (RAROClike systems) with the aim, in most cases, of quantifying the amount of equity capital necessary to support all of their operating activities -- fee-based and trading activities, as well as traditional lending. RAROC systems allocate capital for two basic reasons: (1) risk management and (2) performance evaluation. For risk management purposes, the overriding goal of allocating capital to individual business units is to determine the banks optimal capital structure. This process involves estimating how much the risk (volatility) of each business unit contributes to the total risk of the bank and, hence, to the banks overall capital requirements. For performance-evaluation purposes, RAROC systems assign capital to business units as part of a process of determining the risk-

adjusted rate of return and, ultimately, the economic value added of each business unit. The economic value added of each business unit, defined in detail below, is simply the units adjusted net income less a capital charge (the amount of equity capital allocated to the unit times the required return on equity). The objective in this case is to measure a business units contribution to shareholder value and, thus, to provide a basis for effective capital budgeting and incentive compensation at the business-unit level. RAROC and Financial Theory Allocating equity capital on the basis of the risk of individual business units seems pointless in the classical theoretical paradigm of frictionless capital markets (one with perfect information and without taxes, bankruptcy costs or conflicts between managers and shareholders). If markets operated in this manner, the pricing of specific risks would be the same for all banks and would not depend on the characteristics of an individual banks portfolio.

RESEARCH METHODOLOGY Problem Definition- risk is something which cannot be defined clearly every organisation needs to minimise the risk up to some extent and for which system, tools, techniques and rules are adopted by them. Bank is an organisation which face many risk and therefore its important to know what role does the risk management system plays in mitigating it.

Objective of StudyThe objective of the study is to understand the role of risk management in banks.
1) Basel II understanding it as an Integrated Risk Management Solution. 2) Understanding different risk faced by banking sector also understand how to

eliminate them
3) Risk analysis (credit risk, market risk, operational risk and others).

4) Role of risk management strategic role. Research Design: - Descriptive Research Source of Information:-Secondary Data Analysis is based on the understanding from various researches, articles and papers. Scope of the Study: - The study will analyze the risk factor which tells about the basis on which banks provide loans to the customers as well as other risks, viz. market risk, operational risk, liquidity risk etc. These are covered under the BASEL II accord which is a set of interesting ideas, and crafts a new framework of banking regulation based on genuine understanding of risk.

Limitations of study: It tells about the risk but the only shortcoming is the lack of terms related to the risk reduction. Very stipulated time is allotted for the research. Many banks may not be able to manage the risk. Many of the banks may not be implementing the risk measurement/management tools in the research

FINDINGS
As per the delottie risk management survey: Risk management is not fully integrated throughout many institutions: 49 percent of the institutions surveyed had completely or substantially incorporated responsibilities for

risk management into performance goals and compensation decisions for senior management. Overall responsibility for oversight and governance of risks rested with the board of directors at 77 percent of the institutions participating, and 63 percent of these had a formal, approved statement of risk appetite. Seventy-three percent of the institutions surveyed had a Chief Risk Officer (CRO) or equivalent position. As an indicator of the roles importance, the CRO reported to the board of directors and/or the CEO at roughly three quarters of these institutions. Only 36 percent of the institutions had an enterprise risk management (ERM) program, although another 23 percent were in the process of creating one. Among institutions with $100 billion or more in assets, 58 percent had an ERM program already in place. The institutions that had ERM programs found them to be valuable: 85 percent of the executives reported that the total value (both quantifiable and non-quantifiable) derived from their ERM programs exceeded costs.

Institutions have made substantial progress towards complying with Basel II. For many areas, more than half of the institutions subject to Basel II reported they had already complied or that little work remained, a far higher number than in our previous global risk management surveys. These responses are clearly influenced by the fact that Basel II has different timeframes for implementation in different countries, with multiple approaches available in many jurisdictions.

BIBLIOGRAPHY/WEBLIOGRAPHY Risk Management

Conference papers 2007 Bank risk management www.rbi.org