Explain Operational Risk ?
The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external eventsFor emergence of such a risk four causes have been mentioned and they are people, process, systems and external factors.
(a) People risk – Lack of key personnel, lack of adequate training/experience of dealer (measured in terms of opportunity cost/employee turnover), unauthorised access to the dealing room, tampering voice recorders, nexus between the front and back offices, etc.
(b) Process risk – Wrong reporting of important market developments to the management resulting in faulty decision making, errors in entry of data in deal slips, non-monitoring of exposure in positions, loss of interest owing to the liquidity beyond prescribed limits, non-revision of card rates in cases of volatility, non-monitoring of closing and opening positions, wrong funding of accounts (wrong currency, wrong way swap), lack of policies, particularly in respect of new products.
(c) Systems: Losses due to systems failure such as NDS — not maintaining secrecy of system passwords.
(d) Legal and regulatory risk: Treasury activities should comply with the regulatory and statutory obligation . It is necessary that formal policies are in place with respect to trigger limits; stop loss limits; prudential limits; well defined procedures and check lists; effective internal controls and audit; insurance, wherever possible; business process re-engineering to eliminate weak links in the process chain; prudential limits on investments in banks; cap on unrated issues and private placements; sub-limits for PSU bonds, corporate bonds and guaranteed bonds; same degree of credit risk analysis in the case of any loan proposal; and more stringent appraisal for non-borrower issuers.
Explain Credit Risk ?
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 restrictions may be
imposed by the sovereign.
Explain Foreign Exchange Risk?
Foreign exchange risk may be 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. The banks are also exposed to 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 due to changes in premium/discounts of the currencies concerned.
In the forex business, banks also face the risk of default of the counterparties or settlement risk. While such type of risk crystallisation does not cause principal loss, banks may have to undertake fresh transactions in the cash/spot market for replacing the failed transactions. Thus, banks may incur replacement cost, which depends upon the currency rate movements. Banks also face another risk called time-zone risk or “Herstatt risk” which arises out of time lags in settlement of one currency in one centre and the settlement of another currency in another time zone. The forex transactions with counterparties from another country also trigger sovereign or country risk. The three important issues that need to be addressed in this regard are:
(a) Nature and magnitude of exchange risk;
(b) Strategy to be adopted for hedging or managing exchange risk; and
(c) Tools of managing exchange risk
Explain Interest Rate Risk?
Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s financial condition. The immediate impact of changes in interest rates is on the Net Interest Income (NII). A long term impact of changing interest rates is on the bank’s net worth since the economic value of a bank’s assets, liabilities and off-balance sheet positions get affected due to variation in market interest rates. The interest rate risk when viewed from these two perspectives is known as ‘earnings perspective’ and ‘economic valueperspective’, respectively. Management of interest rate risk aims at capturing the risks arising from the maturity and repricing mismatches and is measured both from the earnings and economic value perspective.
(a) Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) or Net Interest Margin (NIM), i.e., the difference between the total interest income and the total interest expense.
(b) Economic Value perspective involves analysing the changes of impact of interest on the expected cash flows on assets minus the expected cash flows on liabilities plus the net cash flows on off-balance sheet items. It focuses on the risk to networth arising from all repricing mismatches and other interest rate sensitive positions. The economic value perspective identifies risk arising from long term interest rate gaps.
Explain Liquidity Risk?
Liquidity risk is the potential inability to meet the bank’s liabilities as they become due. It arises when the banks are unable to generate cash to cope with a decline in deposits or increase in assets. It originates from the mismatches in the maturity pattern of assets and liabilities. Measuring and managing liquidity needs are vital for effective operation of commercial banks. By assuring a bank’s ability to meet its liabilities as they become due, liquidity management can reduce the probability of an adverse situation developing.The liquidity risk in banks manifest in different dimensions: a) Funding Risk – need to replace net outflows due to unanticipated withdrawal/non-renewal of deposits (wholesale and retail);
(b) Time Risk – need to compensate for non-receipt of expected inflows of funds, i.e., performing assets turning into non-performing assets; and (c) Call Risk – due to crystallisation of contingent liabilities and unable to undertake profitable business opportunities when desirable.
Explain Market Risk ?
Market risk may be defined as the possibility of loss to a bank caused by changes in the market variables. The Bank for International Settlements (BIS) defines market risk as “the risk that the value of on or off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”. Thus, market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those prices. Market risk broadly covers liquidity risk, interest rate risk and foreign exchange risk.
