Risk management and Basel

Unit II:

Introduction to Risk Management and Basel I,II

&III Accords. Role and functions of CIBIL. Fair

Accords
practices code for debt collection. Principles of
Lending: Cardinal Principles, Non-fund based
limits, Credit appraisal Techniques. Cash
management services and its importance.
Possibility of loss or
injury Risk
RISK MANAGEMENT

• Meaning: Risk management is the process of identifying, assessing and

controlling threats to an organization's capital and earnings. These
threats, or risks, could stem from a wide variety of sources, including
financial uncertainty, legal liabilities, strategic management errors,
accidents and natural disasters.
THE RISK
MANAGEMENT
Definition of Risk Management

• Risk management is an integrated process of delineating specific areas of risk, developing

a comprehensive plan, integrating the plan, and conducting the ongoing evaluation.-Dr.
P.K. Gupta

• “Risk Management is the process of measuring, or assessing risk and then developing strategies
to manage the risk.”-Wikipedia

• Managing the risk can involve taking out insurance against a loss, hedging a loan against interest
rate rises, and protecting an investment against a fall in interest rates’ – Oxford Business
Dictionary.
Introduction
• The concept of risk management in banking arose in the 1990s.

• However, risk management before the 1990s was used to

explain the techniques and risks related to insurance.

• This kind of risk management refers to the purchase of

traditional insurance products that are suitable for any events
to protect from future hazards.

• More recently in the financial markets, derivatives have also

been promoted as risk management tools to use for hedging
activity purposes.

• This form of risk management is often called “Financial risk

management” and derivatives are used as solutions to manage
the risks associated with financial activities.
Introduction
The management of risk in banking became necessary in 1997 when the Basel
Committee on Banking Supervision (BCBS) published the “core principles” for
effective banking supervision.
This framework provides an essential linkage between capital and risks.

In particular, Banks need to adopt risk measurement and risk management

procedures and processes in order to guarantee their risk-adjusted return in
their business.
Therefore, the core concept of banking risk management is to ensure the
profitability and safety of the banking industry.
 • Risk management in banking is theoretically defined as “the logical
development and execution of a plan to deal with potential losses”.

Risk • Usually, the focus of risk management practices in the banking

industry is to manage an institution’s exposure to losses or risk and to
Managemen protect the value of its assets.

t • In general banking business is regarded as risky business.

• Economic theory suggests that there are two economic units - surplus
unit and deficit unit - and these economic units prefer to use financial
institutions (intermediaries) to transfer the necessary funds to each
other.

• Certainly, this process increases the importance of the financial

intermediaries in the economy but also poses some risks to these
institutions
 • Economic units usually prefer to use intermediaries because of the
problems associated with asymmetric information.

Risk • In order to solve the asymmetric information problems, institutions

Managemen are recruiting skilled employees and systems, which is why the scarce
sources of funds are now used more effectively by units in the
t economy.

• Therefore, the funds are channeled to the most valuable projects that
are beneficial to the economy.

• However, this process of channeling funds from one unit to another

naturally has some inherent risks within the process.

• Banks are usually managing those risks are part of their normal
operations.
Risk Management
• The risk management process in
banking raises various questions.
• These issues highlight the importance
of having risk management practices
in banking.
• What kind of events can damage
the banking business and how
much damage can be done?
• What kind of actions should be
taken by the institutions in order
to manage those risks?
• Did the institution make the right
decision?
 • The risk management process can be summarised with
the following three steps:
Risk 1. Identifying and assessing the potential risk in the
banking business: Investigating the activities of the
Managemen banks that are creating risk or losses and also assessing
the potential damage that those risks could cause.
t Therefore, it can be said that the risk management
process starts with the identification of potential
losses or risks and continues by assessing or measuring
those issues.
2. Developing and executing an action plan to deal with
and manage these activities that incur potential losses,
3. Continuously reviewing and reporting the risk
management practices after they have been put into
action/operation.
Risk Management

• The risk management process can be summarised with the following three steps:
1. Identifying and assessing the potential risk in the banking business:
2. Developing and executing an action plan to deal with and manage these
activities that incur potential losses: After identifying and analyzing the risk, it is
necessary to determine what kind of actions/activities can be implemented by the
banks to address these potential hazards. Otherwise, if banks do not address the
risks, this can lead to significant losses for the institution. Therefore, in order to
have a sound and healthy institution, new techniques have been developed in
the modern banking industry to manage these losses.
3. Continuously reviewing and reporting the risk management practices after they
have been put into action/operation.
Risk Management

The risk management process can be summarized with the

following three steps:
• Identifying and assessing the potential risk in the banking business:
• Developing and executing an action plan to deal with and manage these activities
that incur potential losses:
• Continuously reviewing and reporting the risk management practices after they
have been put into action/operation: After a decision has been made and
implemented by an institution, monitoring and reporting usually take place. This
step is the last part of the risk management practices checking and reporting the
activities of bank risk management
Types of risks are being considered in Banking

1. Credit Risk: One of the main activities conducted by a bank is lending. When
some of its credits are not returned to the bank when a customer experiences
financial problems, this is partially causing credit risk for the banks. This kind of
financial loss results from the failure of credit customers to repay the banks.
2. Liquidity Risk
3. Market Risk or Systematic Risk
4. Interest Rate Risk
5. Earning Risk
6. Solvency or Default Risk
Types of risks are being considered in Banking

1. Credit Risk
2. Liquidity Risk: Banks are also highly focused on the problems of having insufficient
liquid assets to compensate the cash needs or withdrawals from depositors and loan
demands. Usually, maintaining the liquidity positions of the banks is one of their
crucial tasks, because the consequences of having a low level of liquidity cause
problems for the banks in terms of banking insolvency
3. Market Risk or Systematic Risk
4. Interest Rate Risk
5. Earning Risk
6. Solvency or Default Risk
Types of risks are being considered in Banking

1. Credit Risk
2. Liquidity Risk
3. Market Risk or Systematic Risk: Systematic risk is related to the bank’s assets
where their values are changed by systematic factors. It is also called market
risk and banks are usually engaged in market activities. Market risk can be
related to any prices which are continuously traded on the financial markets.
4. Interest Rate Risk
5. Earning Risk
6. Solvency or Default Risk
Types of risks are being considered in Banking

1. Credit Risk
2. Liquidity Risk
3. Market Risk or Systematic Risk
4. Interest Rate Risk: After deregulation, most of the ceilings and restrictions on the interest
rates were removed by the regulators and authorities. Market interest rates are
determined by the market dynamics. Nowadays, interest rates are changing based on the
supply and demand conditions. Under these circumstances, movements of the interest
rates which banks are using for their activities also have effects on the banks incomes and
expenses.
5. Earning Risk:
6. Solvency or Default Risk
Types of risks are being considered in Banking

1. Credit Risk
2. Liquidity Risk
3. Market Risk or Systematic Risk
4. Interest Rate Risk
5. Earning Risk: Earning risk is related to a bank’s net income, which is the last
item on the income statement. Due to changes in the competition level of the
banking sector as well as the law and regulations, this could cause a reduction
in the bank's net income.
6. Solvency or Default Risk
Types of risks are being considered in Banking

1. Credit Risk
2. Liquidity Risk
3. Market Risk or Systematic Risk
4. Interest Rate Risk
5. Earning Risk
6. Solvency or Default Risk: Banks’ initial concerns about their institutions should be the
long-term sustainability of the sector; this is related to the solvency or default of
banks. Two critical situations may cause solvency problems, including when bank
management has a significant amount of bad loans in their credit account, or when its
portfolio investments substantially decline in value and generate a severe capital loss.
Regulation of Bank
Capital
It is the amount of capital that the banks are
required to hold against their assets.

Then people become concerned that if a bank

had to liquidate its portfolio, there wouldn’t be
enough money to do that.

So, Regulatory Capital, or Capital Adequacy, or

just plain capital needs to address the worst of
eventual loss and potential mark to market loss.
Regulatory Capital

When banks calculate their RC

requirement and eligible capital, they
have to consider regulatory
definitions, rules and guidance.

From a regulatory perspective, the

minimum amount of capital is a part
of a bank's eligible capital.
The need to
regulate Bank
Capital
To limit risk and reduce our potential,
unexpected losses.

Unlike normal companies, banks are in the

business of issuing loans to individuals and
businesses – which means that if those
individuals and businesses default on their
loans, the bank loses money.
The need to regulate
Bank Capital
• If the bank “runs out” of shareholders’ equity,
something else will have to decrease – deposits
or other funding sources.

• So that a bank can absorb sufficient losses

through its shareholders’ equity rather than
through customer deposits or other funding
sources.
Basel Accords
• The Basel accord was originally organized by central bankers from the G10 countries, who
were at that time working toward building new international financial structures.

• The Basel Committee on Banking Supervision (BCBS) was founded in 1974 as a forum for
regular cooperation between its member countries on banking supervisory matters.

• The Basel Accords were developed over several years beginning in the 1980s.

• The BCBS describes its original aim as the enhancement of "financial stability by
improving supervisory know-how and the quality of banking supervision worldwide."

• Later, the BCBS turned its attention to monitoring and ensuring the capital adequacy
of banks and the banking system.
 • Total Eligible Capital according to regulatory guidance under Basel II is
provided by the following three tiers of capital:

• Tier 1 (core) capital: broadly includes elements such as

• common stock,
• qualifying preferred stock,

Regulatory • Surplus and retained earnings.

Capital • Tier 2 (supplementary) capital: Includes elements such as

• General loan loss reserves,
• Certain forms of preferred stock,
• Term subordinated debt, (second priority debt)
• Perpetual debt, (no maturity date only interest, principal is never
paid)
• Hybrid debt (Equity and Debt) and equity instruments.

• Tier 3 capital: includes

• Short-term subordinated debt and
• Net trading book profits that have not been externally verified.
 Credit Information Bureau (India) Limited
(CIBIL)
CIBIL is the oldest credit rating agency in India
and functions based on a license granted by the
RBI.

It adheres to the Credit Information Act of

2005 and records the repayment of loans and
credit cards by both individuals and companies.
Role and functions of CIBIL
 Role and functions of CIBIL

• Nov 1999: Report submitted by Siddiqui Committee for setting up India's first Credit Information Bureau.

• Apr 2004: CIBIL Launched Credit Bureau services in India (Consumer Bureau).

• After its establishment, CIBIL played a vital role in Indian Financial System.

• It helps in collecting and maintaining records of Individual payments affecting loans and Credit cards.

• The member bank and all the credit institution submit their records to CIBIL on monthly basis.

• The information received from banks and credit institutions would be used to create Credit Information Reports
and Credit Scores that are provided to credit institutions to help in the evaluation and approving loan applications.
Role and functions of CIBIL

Role of CIBIL
• It takes pride in having the topmost credit information sharing in India which makes enables credit grantors in
accepting payment and information-backed decisions.
• CIBIL has gained knowledge, experience, and expertise to offer data and technology-backed solutions.
• Wide gamut solutions were developed diligently for helping customers in making an intelligent decisions in the entire
stage of the customer life cycle.

Functions of CIBIL
• The Consumer Bureau of CIBIL keep its dynamic information repository in India to provide its member with
comprehensive risk management tools.
• Consumer Credit Information is an important tool used by credit grantors at the time of new customer acquisition.
• Portfolio Review provides the credit grantor with a comprehensive view of their borrower’s credit relationships across
multiple lenders.
Fair practices code
for debt collection
 Fair practices code for debt collection
• The fair practices code for debt collection framed by the banks is revolved
around dignity and respect to customers.

• The codes are outlined based on recommendations of the Working Group on

Lenders’ Liability Laws constituted by the Government of India.

• Security repossession policies were aimed at recovery of dues in the event of

default and not aimed at whimsical deprivation of the property.

• The debt collection codes framed by the commercial banks in India are in line with
regulatory or supervisory instructions of RBI, the Model policy of The Indian
Banks' Association (IBA), fair practice codes and charters of Banking Codes and
Standards Board of India (BCSBI).
 Fair practices code for debt collection
• In terms of IBA model policy, the customer would be contacted ordinarily at the
place of his/her choice and in the absence of any specified place at the place
of his/her residence.

• If the customer is unavailable at his/her residence, he/she will be contacted at

the place of business/occupation.

• Normally the bank’s representatives will contact the borrower between 0700 hrs
and 1900 hrs unless the special circumstance of his/her business or occupation
requires the bank to contact at a different time.

• In the circumstances where the customer is refusing to pay, is not contactable, is

non-cooperative, disputing earlier commitments, and if they are unable to
establish contact during specified calling hours, banks may contact the borrower
up to 2100 hrs.
 Fair practices code for debt collection
• While written communications, telephonic reminders or visits by the
bank’s representatives to the borrower’s place or residence will be
used as loan follow up measures, the bank will not initiate any legal
or other recovery measures including repossession of the security
without giving due notice in writing.

• Banks are committed to ensure that all written

and verbal communication with
its borrowers will be in simple business language and will adopt
civil manners for interaction with borrowers.

• Borrower’s requests to avoid calls at a particular time or at a

particular place would be honored as far as possible.
 Fair practices code for debt collection

The Reserve Bank of India’s fair practice code for collection of credit cards dues
states that “in regard to appointment of third party agencies for debt collection,
it is essential that such agents refrain from action that could damage the
integrity and reputation of the bank and that they observe strict customer
confidentiality.

The guidelines further state that banks and their agents should not resort to
intimidation or harassment of any kind, either verbal or physical, against any
person in their debt collection efforts, including acts intended to humiliate
publicly or intrude the privacy of the credit card holders’ family members,
referees and friends, making threatening and anonymous calls or making false
and misleading representations.
Fair practices code for debt collection

In line with model policies adapted by the member banks of IBA, the Identity and authority of persons authorized to
represent bank for follow up and recovery of dues would be made known to the borrowers at the first instance.

The bank staff or any person authorized to represent the bank in collection of dues or/and security repossession
will identify himself / herself and display the authority letter issued by the bank and upon request.

In the recovery process the bank would respect the privacy of its borrowers, contacting the borrower on phone or
personal visits for recovery of dues cannot be construed as an intrusion of the privacy of the borrower.

However, inappropriate occasions such as bereavement in the family or such other calamitous occasions will be
avoided by the bank for making calls/visits to collect dues.

The bank may document the efforts made for the recovery of dues and gist of interactions with the borrowers.
Principles of
Lending:
Cardinal
Principles
Principles of Lending:
Cardinal Principles

• The business of lending, Which is the main business of banks, carries

certain inherent risks and the bank cannot take more than calculated
risk.

• Whenever it wants to lend the activity has necessarily adhered to

certain principles.

• Lending principles can be conveniently divided into two areas

I. Activity
II. Individual
Principles of Lending: Cardinal Principles
Principles of Lending: Cardinal Principles
Liquidity is an important principle of bank lending.
Liquidity
Banks lend for a short period only because they lend public money which can be withdrawn at
any time by depositors.

They, therefore, advance loans on the security of such assets which are easily marketable and
convertible into the case at short notice.

A bank chooses such securities in its investment portfolio which possess sufficient liquidity.

It is essential because if the bank needs cash to meet the urgent requirement of its customers,
it should be in a position to sell some of the securities at very short notice without disturbing
the market price much.
There are certain securities such as central, states and local bonds that are easily saleable
without affecting the price of the market.
 Principles of Lending: Cardinal Principles
Safety
• The safety of funds lent is another principle of lending.

• Safety means that the borrower should be able to repay the loan and interest in
time at regular intervals without default.

• The repayment of the loan depends upon the nature of the security, the character
of the borrower, his capacity to repay, and his financial standing.

• Like other investments, Bank investments involve risk, but the degree of risk varies
with the type of securities of the central Govt. are safer than those of state Govt.
and local bodies.
Principles of
Lending:
Cardinal
Principles
Principles of
Lending:
Cardinal
Principles
Principles of
Lending:
Cardinal
Principles
Non-fund-
based limits
 Non-fund-based limits
• Working capital finance can be divided into fund-based and non-
fund-based credits.

• The difference between the two is whether they’re physical funds or

guaranteed by assurance.
 Non-fund-based limits
What is a fund-based credit limit?
• Fund-based credit limits are financial products that a bank or lender will
give that allow businesses to physically draw funds out of their
accounts.
• Fund-based working capital includes funding such as:
• Short-term loans
• Cash credit or business overdrafts
• Term loans for fixed assets
• Businesses typically use fund-based credit limits to gain quicker access
to cash to help address things like cash flow problems or even stock.
 • What is a non-fund-based credit limit?
• Non-fund-based finance is not physical
Non-fund-based funding but more of a promise of
financial support compared to actual

limits
funds.
• Non-based-credit limits include:
• a bank guarantee
• letter of credit.

• A bank guarantee is a guarantee from

lenders that ensures the debtor will be able
to repay the debt. If they can not settle it,
the bank covers it.

• A letter of credit is a legal document a bank

can present that outlines payment will be
made back by the business.

• A non-based credit limit allows businesses

to use funds to help grow and develop their
business without physical finance. The
guarantee still lets a business buy
equipment or draw down loans and expand
Credit Appraisal
Techniques
Cash management services and its
importance
Cash Management
• In a banking institution, the term Cash
Management refers to the day-to-day
administration of managing cash inflows and
outflows. Because of the multitude of cash
transactions on a daily basis, they must be
managed.

• The ultimate goal of cash management is to

maximize liquidity and minimize the cost of
funds.

• Cash management refers to a broad area of

finance involving the collection, handling, and
usage of cash. It involves assessing
market liquidity, cash flow, and investments.
Important of Cash Management

Management needs to ensure that there is

adequate cash to meet the current obligations
Just like a ‘no cash situation’ in our day to day
while making sure that there are no idle funds.
lives can be a nightmare, for a business it can be
This is very important as businesses depend on
devastating. Especially for small businesses, it
the recovery of receivables. If a debt turns bad
can lead to a point of no return. It affects the
(irrecoverable debt) it can jeopardize the cash
credibility of the business and can lead to them
flow. Therefore, cash management is also about
shutting down. Hence, the most important task
being cautious and making enough provision for
for business managers is to manage cash.
contingencies like bad debts, economic
slowdown, etc.
Important of Cash Management

• Sustaining a company’s financial stability

• Maximize earnings
• Impacts future growth for the company
Thank you