In the previous chapters we considered the basic features of Risk assessment & Risk Control, and its importance and application in Corporate Management. We will now consider the specific risks faced by commercial banks, and present the fundamental about these risks and how they are to be covered. The subject in whole is being presented in a nutshell for a preliminary understanding. We will study, in particular, about Interest Rate Risk, as a major challenge. We will also study about Asset, Liability Management as a step to control the major risk i.e. "Interest Rate Risk"

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.

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 are:

1. Interest rate risk: Risk that arises when the interest income/ market value of the bank is sensitive to the interest rate fluctuations.

2. Foreign Exchange/Currency Risk: Risk that arises due to unanticipated changes in exchange rates and becomes relevant due to the presence of multi-currency assets and/or liabilities in the bank's balance sheet.

3. Liquidity risk: Risk that arises due to the mismatch in the maturity patterns of the assets and liabilities. This mismatch may lead to a situation where the bank is not in a position to impart the required liquidity into its system - surplus/ deficit cash situation. In the case of surplus situation this risk arises due to the interest cost on the idle funds. Thus idle funds deployed at low rates contribute to negative returns.

4. Credit Risk: Risk that arises due to the possibility of a default/delay in the repayment obligation by the borrowers of funds.

5. Contingency risk: Risk that arises due to the presence of off-balance sheet items such as guarantees, letters of credit, underwriting commitments etc.

The intermediation activity of the banks exposes them to various risks not by chance but by choice. The price at which the banks mobilize and transfer funds depends essentially on two parameters - the time for which the funds are made available and the credit worthiness of the person to whom the funds are made available. Considering that the long-term transfer of funds are priced higher than short-term funds and a high risk borrower pays high interest rate, banks will have to take liquidity risk and/or credit risk to earn the spreads. There is also a definite linkage between the various risks faced by banks. For example, if the bank charges its client a floating rate of interest, in cases of increasing interest rate scenario, the bank's interest rate risk will be lower. Consequently, the payment obligation of the borrower increases. Other things remaining constant, the default risk increases if the client is not able to bear the burden of the rising rates. There are many instances where the interest rate risk eventually leads to credit risk.

All banks face interest rate risk (IRR) and recent indications suggest it is increasing at least modestly. Although IRR sounds arcane for the layperson, the extra taxes paid after the savings and loan crisis of the 1980s suggests there is good reason to learn at least a little about IRR.

Think of IRR as blood pressure for banks. It can increase or decrease without obvious outward signs, and such changes can cause failure. At the same time, regulators and banks can monitor it and detect changes. Finally, banks can take preventative steps to manage IRR but they do not want to eliminate it completely as it, like blood pressure itself, is vital for survival.

In general, IRR is the potential for changes in interest rates to reduce a bank's earnings and lower its net worth. IRR manifests in several different ways but we will provide a simplified example to illustrate the general issue. The most common manifestation of IRR occurs because the assets of the banks, such as the loans it holds, come due or mature at a different time than the liabilities of the bank, such as deposits.

Take, for example, a bank that funds itself only with certificates of deposit that have a maturity of two years. This bank also only makes mortgage loans with a maturity of 15 years. Should interest rates rise in the future, the bank would face a decline in its expected income. Why? The monthly inflow of cash to the bank from the mortgages are fixed for 15 years. When the certificates of deposit come due before the mortgages, the bank will have to pay more to receive funding so cashflows out of the bank will increase.

Clearly IRR holds the potential to have a negative impact on earnings and net worth of a bank. So why don't banks try to eliminate it by ensuring that all of its assets and liabilities have exactly the same maturities? Banks would earn less money without taking on this risk. By earning the difference between long-term and short-term rates, for example, banks are getting paid to assume IRR and meet the demands of customers for deposits and loans. The challenge for banks is to measure IRR and manage it such that the compensation they receive is adequate for the risks they incur.

Regulators and banks employ a variety of different techniques to measure IRR. A relatively simple method used by many community banks is gap analysis, which involves grouping assets and liabilities by their maturity period, or the time period over which the interest rate will change (the "repricing period"), such as less than three months, three months to one year, etc. The "gap" for each category is then expressed as the dollar value of assets minus liabilities. A large, negative gap would indicate that the bank has a greater amount of liabilities that are repricing during that time than assets, and therefore would be exposed to an increase in rates. A negative gap would suggest an exposure to a decline in rates.

Regulatory agencies often employ a slightly more complex version of gap analysis to estimate the level of IRR for a bank and for the entire banking industry. This technique involves estimating the change in the value of assets and liabilities within each time band at a given institution for a change in interest rate (for example, up 2 percentage points) and then calculating the aggregate difference between the two. This amount roughly represents the loss in net worth a bank would suffer if interest rates moved unexpectedly.

Consider a hypothetical bank with Rs.80 Crore in assets, Rs.60 Crore of it in liabilities and Rs.20 Crore in equity capital. Following a 2 percentage point increase in interest rates, the asset value of the bank drops to RS.70 Crore while the value of liabilities falls to Rs.55 Crore. The change in net worth for this bank would be negative Rs.5 Crore, implying that equity capital is worth only Rs.15 Crore. Typically, the net change in economic value is expressed as a percentage of assets.

Two likely culprits behind the recent increases in IRR at commercial banks are lengthening asset maturities and a greater reliance on short-term, volatile liabilities. Banks have changed the composition of their asset portfolios to include larger holdings of both residential mortgages and mortgage-related securities, two asset categories that typically have longer maturity periods. Additionally, the percentage of such assets that mature or reprice in less than one year has been declining in favor of assets that mature in over 15 years.

At the same time that their asset portfolio maturity has been rising, banks have been forced to rely more heavily on volatile liabilities due to sluggish deposit growth. These instruments typically mature in a very short period (often under a year), exposing banks to higher interest expenses if market rates are rising when these funds are being replaced. Together, these trends are resulting in the asset side of the balance sheet becoming less interest-sensitive while the liability side is becoming more sensitive.

Asset-liability risk is a leveraged form of market risk. Because the capital (surplus) of a financial firm such as a bank or insurance company is small relative to its assets or liabilities, small percentage changes in assets or liabilities can translate into large percentage changes in capital. Consider the evolution over time of a hypothetical company's assets and liabilities. Over the period , the assets and liabilities may change only slightly, but those slight changes dramatically alter the company's capital (which is just the difference between assets and liabilities). In this example if the capital falls by over 50% for an erosion in assets by 10%, a development that would threaten almost any institution.

Banks and Insurance Companies address this risk by structuring their assets to hedge their liabilities. For example, if a liability represents a long-dated fixed income obligation, a company might hold long bonds as a hedging asset. In this way, changes in the value of the liability are mirrored by changes in the value of the assets, and capital-the difference between the two-is unaffected.

Asset-liability management can be performed on a per-liability basis, matching a specific asset to support each liability. Alternatively, it can be performed across the balance sheet. With this approach, the net exposures of the organization's liabilities is determined, and a portfolio of assets is maintained which hedges those exposures. For example, a life insurance company might determine the net duration and convexity of all its liabilities and then structure its assets to have the same duration and convexity.

While most of the banks in other economies began with strategic planning for asset liability management as early as 1970, the Indian banks remained unconcerned about the same. Till eighties, the Indian banks continued to operate in a protected environment. In fact, the deregulation that began in international markets during the 1970s almost coincided with the nationalization of banks in India during 1969. Nationalization brought a structural change in the Indian banking sector. Wholesale banking paved the way for retail banking and there has been an all-round growth in branch network, deposit mobilization and credit disbursement. The Indian banks did meet the objectives of nationalization, as there was overall growth in savings, deposits and advances. But all this was at the cost of profitability of the banks. Quality was subjugated by quantity, as loan sanctioning became a mechanical process rather than a serious credit assessment decision. Political interference has been an additional malady. Paradigm Shift

As the real sector reforms began in 1992, the need was felt to restructure the Indian banking industry. The reform measures necessitated the deregulation of the financial sector, particularly the banking sector. The initiation of the financial sector reforms, brought about a paradigm shift in the banking industry. The Narasimham Committee Report on the banking sector reforms highlighted the weaknesses in the Indian banking system and suggested reform measures based on the Basle norms. The guidelines that were issued subsequently laid the foundation for the reformation of Indian banking sector.

The deregulation of interest rates and the scope for diversified product profile gave the banks greater leeway in their operations. New products and new operating styles exposed the banks to newer and greater risks. Though the types of risks and their dimensions grew, there was not much being done by the banks to address the situation. At this point, the Reserve Bank of India, the chief regulator of the Indian banking industry, has donned upon itself the responsibility of initiating risk management practices by banks. Moving in this direction, the RBI announced the Prudential norms relating to Income Recognition, Asset Classification and Provisioning and the Capital Adequacy norms, for the banks. These guidelines ensured that the Indian banks followed international standards in risk management.

As all transactions of the banks revolve around raising and deploying the funds, Asset-Liability Management gains more significance for them. Asset-liability management is concerned with the strategic management of balance sheet involving the management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. While managing these three risks, forms the crux of the ALM, credit risk and contingency risk also form a part of the ALM. Due to the presence of a host of risks and due to their inter-linkage, the risk management approaches for ALM should always be multi-dimensional. To manage the risks collectively, the ALM technique should aim to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ratio. The purpose of ALM is thus, to enhance the asset quality, quantify the risks associated

The various risks that banks are exposed to will affect the short-term profits, the long-term earnings and the long-run sustenance capacity of the bank and hence the ALM model should primarily aim to stabilize the adverse impact of the risks on the same. Depending on the primary objective of the model, the appropriate parameter should be selected. The most common parameters for ALM in banks are:

1. Net Interest Margin (NIM): he impact of volatility on the short-term profits is measured by NIM, which is the ratio of the net interest income to total assets. Hence, if a bank has to stabilize its short-term profits, it will have to minimize the fluctuations in the NIM.

2. Market Value of Equity (MVE): The market value of equity represents the long-term profits of the bank. The bank will have to minimize adverse movement in this value due to interest rate fluctuations. The target account will thus be MVE. In the case of unlisted banks, the difference between the market value of assets and liabilities will be the target account.

3. Economic Equity Ratio: The ratio of the shareholders funds to the total assets measures the shifts in the ratio of owned funds to total funds. This in fact assesses the sustenance capacity of the bank. Stabilizing this account will generally come as a statutory requirement.

While targeting any one parameter, it is essential to observe the impact on the other parameters also. It is not possible to simultaneously eliminate completely the volatility in both income and market value. If the bank lays exclusive focus on the short-term profits, it may have an adverse impact on the long-term profits of the bank and vice-versa. Thus, ALM is a critical exercise of balancing the risk profile with the long/short term profits as well as its long-run sustenance.

Asset Liability Management is strategic balance sheet management of risks caused by changes in the interest rates, exchange rates and the liquidity position of the bank. To manage these risks, banks will have to develop suitable models based on its product profile and operational style. Ironically, many Indian banks are yet take the required initiative for this purpose. Though the reasons for such lack of initiative are varied, one important reason can be that the management of the banks has so far been in a protected environment with little exposure to the open market. Lack of technology and inadequate MIS, which prevented banks from moving towards effective ALM. The apathy on the part of the banks made it imperative for the RBI to step in and push the process.

The guidelines of RBI on ALM are primarily aimed to enable banks to tackle the liquidity risk and interest rate risk. For liquidity risk management, the assets and liabilities of the bank are segregated into different groups based on their maturity profile. Based on the maturity profile, the Statement of Structural Liquidity will have to be prepared by the banks. And to monitor the short-term liquidity, the banks are required to prepare the Statement of Short-term Dynamic Liquidity.

For managing the interest rate risk, the RBI guidelines prescribe the Gap Analysis. Based on the sensitivity of the assets and liabilities to the interest rate fluctuations, they are classified into different maturity buckets. The Rate Sensitive Gap (RSG), which is the difference between the rate sensitive assets (RSAs) and the rate sensitive liabilities (RSLs), will enable the banks to assess the impact of the rate fluctuations on their net interest margin (NIM). The model can also be extended to target a RSG so as to attain a positive impact on the NIM. An essential ingredient for this is however, an elaborate MIS at the micro-level. In the case of currency risk management, banks in India have been given the discretion to maintain overnight open positions subject to maintenance of adequate capital.

Before considering comprehensive guidelines provided by RBI to cover different types of risks faced by commercial banks, we intend to present one more summarised articles on Risk-management. RBI in its website has provided an informative article, contributed by two of its senior executives giving summarised guidelines about measures for containing different risks faced by commercial banks and financial institutions. We will have a look into this article in the next three chapters. We will thereafter study the exhaustive guidelines of RBI with reference each type of banking risk. We will also study RBI guidelines on the subject "Risk Based Supervision." But a study of risk analysis is complete without studying about the largest tool to cover risks effectively, viz. derivatives trading, options, futures, OTC and Swaps. All these are covered in sequence under this project