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Risk Management in Banks

The document outlines the risk management process in banks, detailing steps such as risk analysis, identification, measurement, control, and monitoring. It describes various types of financial risks including interest rate risk, credit risk, liquidity risk, market risk, foreign exchange risk, operational risk, and reputational risk, along with tools for managing these risks like Asset Liability Management and stress testing. Additionally, it introduces Altman’s Z-Score model for predicting bankruptcy probability in companies.

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Jay Kadam
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11 views16 pages

Risk Management in Banks

The document outlines the risk management process in banks, detailing steps such as risk analysis, identification, measurement, control, and monitoring. It describes various types of financial risks including interest rate risk, credit risk, liquidity risk, market risk, foreign exchange risk, operational risk, and reputational risk, along with tools for managing these risks like Asset Liability Management and stress testing. Additionally, it introduces Altman’s Z-Score model for predicting bankruptcy probability in companies.

Uploaded by

Jay Kadam
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Risk Management in

Banks
Steps in Risk Management Process

• Risk Analysis : is defining the risk, which, in turn requires


understanding the nature of risks to which the bank is exposed to and
then try to quantify their impact on the bank.
• Risk Identification : types of risks such as credit risk, market risk,
technological risk, liquidity risk, and contingent risk.
• Risk Measurement : Gap analysis model, Credit Risk Assessment
(CRA) Mod els
• Risk Control :
• Risk Monitoring
Types of Financial Risks

 Interest Rate Risk


 This arises from adverse movements in interest rates which bring about
changes in a bank’s portfolio
 It arises when the Net Interest Margin or the Market Value of Equity (MVE)
of an institution is affected because of the fluctuations in the interest
rates.
 The IRR is an exposure of the Bank’s financial condition to adverse
movements in the interest rates.
 The interest rate influences the bond’s price to a great extent. When the
interest rate increases, the price of a bond decreases and vice versa.
 IRR can be mitigated through hedging or developing the portfolio.
Credit Risk

 Also known as Default Risk, it is nothing but the potential of the


borrower to fail to meet its obligations as per the signed contract.
 Credit risks include counterparty default risk-the possibility that the
other party in an agreement will default and concentration
 Although credit risk cannot be avoided, there are a few ways to
mitigate it. The banks are able to manage credit risk by evaluating
the worthiness of the borrower before sanctioning their loan amount.
Liquidity Risk

 This risk arises from a bank’s inability to meet its obligations when they
become due.This may be as a result of the conversion of assets into
non-performing assets (NPAs).
 In the modern banking model, the Liquidity Risk is considered to be the
most vulnerable risks that are faced by the banks.
 Liquidity risks can be efficiently managed by creating a difference in the
timeframe between liability maturity and asset maturity.
 Liquidity risk may be classified into:
 Term Liquidity Risk
 Withdrawal/Call Risk
 Structural Liquidity Risk
 Contingent liquidity risk
Market Risk

 The changes in the value of a bank’s investment portfolio as a result


of securities market behavior is called market risk.
 Market risk applies to (i) that part of the Interest Rate Risk which
affects the price of the interest rate instruments (ii) foreign currency
risk (iii) pricing risk for all other portfolio/ assets that are held in the
bank’s trading account
 The most effective way to manage market risk is by diversifying the
funds. That means, ensuring that the assets are held in a myriad of
investment options can help mitigate the market risk.
Foreign exchange risk

 This risk arises from adverse movements in currency exchange rates.


Moreover, banks may suffer losses due to interest rate risk, which
arises from the maturity mismatching of foreign currency.
 A depreciation in the rupee leads to a loss on oversold positions and a
gain on the overbought positions
Operational risk

 Disruptions in operational flow due to failure of internal system


results in financial losses. Operational risk events include internal and
external frauds, workplace safety, system failures, etc
(i) Legal risk-bank’s failure to enact appropriate policies, procedures,
(ii) Documentation risk- arising out of improper or insufficient
documentation
(iii) Technological risk: Technological changes—especially in the fields of
computers and communication
Reputational Risk

 Risk that a bank will lose the confidence of its investors and
customers and thus lose funding or business (respectively). It’s
basically a side effect of any other risk a bank encounters, but that
doesn’t mean it’s any less threatening.
 It can be caused directly by the bank’s business practices or
employee conduct or indirectly by the bank being associated with a
person or group with a negative reputation.
Risk Management Tools

 Risk Assessment Templates and Checklists:


 Risk Analysis Software: like Monte Carlo simulations)
 Financial Risk Management Tools
• Asset Liability Management
• Stress Testing
 Compliance Risk Management Tools:
 Cybersecurity Assessment Tools
Asset Liability Management (ALM)

 Asset liability management is a process of planning, organising and


controlling asset and liability volume maturities, rates and yields so
as to match the structure of liabilities with structure of assets
 ALM builds up Assets and Liabilities of the bank based on the concept
of Net Interest Income (NII) or Net Interest Margin (NIM).
 ALM is concerned with strategic Balance Sheet management
involving all market risks
ALM Objectives

Liquidity Risk Management.


Interest Rate Risk Management.
Currency Risks Management.
Profit Planning and Growth Projection.

By Dr. Sonia Gupta


Stress Testing

 Sensitivity tests are normally used to assess the impact of change in


one variable (for example, a high magnitude parallel shift in the yield
curve)

 Scenario tests include simultaneous moves in a number of variables


(for example, equity prices, oil prices, foreign exchange rates,
interest rates, liquidity etc.)
Altman’s Z-Score Model

 The Z-score model was introduced as a way of predicting the


probability that a company would collapse in the next two years.
 When creating the Z-score model, Altman used a weighting system
alongside other ratios that predicted the chances of a company going
bankrupt.
 In total, Altman created three different Z-scores for different
types of businesses.
Altman’s Z-Score Model Formula

​Z= 1.2A + 1.4B + 3.3C + 0.6D + 1.0E


Where:
Z (Z) is the Altman’s Z-score
A is the Working Capital/Total Assets ratio
B is the Retained Earnings/Total Assets ratio
C is the Earnings Before Interest and Tax/Total Assets ratio
D is the Market Value of Equity/Total Liabilities ratio
E is the Total Sales/Total Assets ratio
Z-Scores Mean

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