Govind Gurnani, Former AGM, Reserve Bank of India

Management Of Di erent Types Of Risks In The Banking

Sector : Simpli ed
The banking sector has a huge role to play in the development of the
economy. Certainly, it is the driver of the economic growth of the
country. It plays an important role in identifying the idle resources for
their e cient utilisation to attain maximum productivity. However, this
process involves risk. Banks are highly regulated in order to promote
nancial stability, foster competition, and protect consumers. And since
the risk is directly proportional to returns, the more risk a bank take, the
higher it can generate pro ts. Hence, it is very important to manage the
risks and identify if they are worth taking.
In March 2023, when the US banking turmoil had taken place, the
Reserve Bank of India Governor had said “the recent developments in
the US banking system drive home the importance of ensuring prudent
asset liability management, robust risk management and sustainable
growth in liabilities and assets in the banking sector, among others.”

Risk management refers to identifying, assessing, and mitigating risks

that banks face in their day-to-day operations. It is a comprehensive
approach involving various risk management tools, techniques, and
methodologies to manage risks e ectively.The objective of risk
management in banking is to minimise the impact of risks on the bank’s
operations, nancial performance, and reputation.

Risks Faced By Banks

1⃣ Credit Risk

2⃣ Market Risk

3⃣ Liquidity Risk

4⃣ Operational Risk
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5⃣ Interest Rate Risk

6⃣ Foreign Exchange Risk

7⃣ Asset Liability Management Risk

8⃣ Compliance Risk & Legal Risk

9⃣ Counterparty Credit Risk

🔟 Concentration Risk

1⃣ 1⃣ Country Risk

1⃣ 2⃣ Solvency Risk

1⃣ 3⃣ Climate Risk

1. Credit Risk Management

Credit risk refers to the possibility of losses associated with diminution

in the credit quality of borrowers or counterparties. Credit risk
management is an ongoing process in the borrower’s journey to
examine credit risk according to their nancial behavior. In a bank’s
portfolio, losses stem from outright default due to the inability or
unwillingness of a customer or counterparty to meet commitments
concerning lending, trading, settlement, and other nancial
transactions.

In simple terms, banks experience credit risk when assets in a bank’s

portfolio are threatened by loan defaults. Credit risk is a sum of default
risk and portfolio risks.

Default risk happens due to the inability or unwillingness of a borrower

to return the promised loan amount to the lender. Whereas, portfolio
risks depend upon several internal and external factors.
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Internal factors can be bank policy, absence of prudential limits on
credit, lack of a loan review mechanism within the company, and
more. External factors may include the state of the economy, forex
rates, trade restrictions, economic sanctions, and more.

The presence of credit risk deteriorates the expected returns and

creates more than expected losses for banks.

Tools For Credit Risk Management

1⃣ Creating multi-tier credit approving system at origination of loan

assets

2⃣ Setting up prudential credit limits for lending in di erent sectors

3⃣ Framing Of Credit Risk Policy

4⃣ Risk rating of borrower’s credit worthiness

5⃣ Risk pricing of loan products based on borrower’s credit score

6⃣ Analytics for risk detection and control

7⃣ Credit risk monitoring in real time

8⃣ Loan review mechanism

2. Market Risk Management

Market Risk Management refers to the process of identifying &

measuring the risk of losses in balance sheet & o -balance sheet items
arising from changes in market prices viz. equity prices, interest rates,
exchange rates, credit spreads & commodity prices. Banks are required
to maintain a minimum amount of capital to account for this risk.
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 Example▪ The failure to prudently measure risks associated with
traded instruments caused major losses in banks during global nancial
crises.
▪ In 2013, when the US Fed indicated that it would look to taper its
bond purchases, there was a massive sell-o globally & even Indian
markets were not spared.

Measures of Market Risk (MR)

Value at Risk (VaR) : A measure of the worst expected loss on a

portfolio of instruments resulting from market movements over a given
time & a per-de ned con dence level. As VaR model does not give a
complete picture of exposure to MR, it is used as a complementary to
stress testing.
Stress Testing : It refers to measure of the average of all potential
losses arising from bank’s market risk factors exceeding the VaR at a
given con dence level, which makes up for VaR’s shortcomings in
capturing the risk of extreme losses.

3. Liquidity Risk Management

The main objective of liquidity risk management is to ensure su cient

reliable liquidity at all times and in the all circumstances. E ective
liquidity risk management (LRM)helps ensure a bank’s ability to meet
cash ow obligations, which are uncertain as they are a ected by
external events and other agent’s behaviour. LRM is of paramount
importance because a liquidity shortfall at a single institution can have
system-wide repercussions.

Liquidity risk refers to the risks resulted from an entity’s failure to pay
debts and obligations when come due because of its inability to convert
assets into cash.

Characteristics Of Liquidity Risk

First, it is di cult to measure liquidity risk due to uncertain cash ow

obligations, which depends on external events and on other agent’s
behaviour.

Second, the liquidity risk is likely unpredictable because a secondary

event often occurs following another type of risk event.
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Third, the severity of liquidity risk can grow rapidly and system wide
connected.

Lastly, there is a tipping point beyond which recovery is impossible

once a system faces liquidity crises.

Types Of Liquidity Shortages In The Banks

➡ Central Bank Liquidity
➡ Market Liquidity
➡ Funding Liquidity

Central bank liquidity is the term used to refer to deposits of nancial

institutions at the central bank. It is synonymous with reserves, or
settlement balances. These reserve balances are held by nancial
institutions to meet reserve requirements, if any, and to achieve nal
settlement of all nancial transactions in the payments system.
Individual institutions can borrow and lend these funds in the interbank
market, but, for the system as a whole, the only source of these funds
is the central bank itself.

Market liquidity refers to the ability to buy and sell assets in

reasonably large quantities without signi cantly a ecting price. This use
of the term “liquidity” is closest to the common, textbook de nition: the
ease with which an asset can be converted into means of payment viz
cash.

Funding liquidity refers to the ability of an individual or institution to

raise cash, or its equivalent, again in reasonably large quantities, either
via asset sales or by borrowing. As such, market and funding liquidity
are closely linked.

The above types of liquidity shortages do not always occur in isolation.

Important interdependencies exist and the occurrence of one can lead
to another with dynamics that often reinforce one another.

Tools For Managing Liquidity In The Banks

▪ Availing Repo & Variable Rate Repo facilities & Marginal Standing
Facility from the central bank by the banks.
▪ Availing intra day facility against reserves with the central bank.
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▪ Sale of Govt securities under open market operations to the central
bank.
▪ By borrowing funds from interbank market.

The Basel Committee has prescribed maintenance of two liquidity ratios

at 100 % level viz.Liquidity Coverage Ratio (LCR) & Net Stable Funding
Ratio (NSFR) & Comprehensive Liquidity Assessment Review (CLAR)
for managing the liquidity risk.

LCR refers to the ratio of bank’s stock of high quality assets to the
estimated total net cash out ows over a 30 days period.
NSFR requires banks to maintain enough stable funding to cover the
potential use of funds over a one year horizon.

CLAR tests a bank’s ability to meet funding obligations under periods

of stress.

4. Operational Risk Management

Operational risk refers to the risk of loss due to errors, breaches,

interruptions or damages, either intentional or accidental, caused by
people, internal processes, systems or external events.

Banks that take a comprehensive approach to operational risk

management (ORM) recognise four broad areas that requires attention :

1⃣ People

Even in a digital age, employees and the customers with whom they
interact can cause substantial damage when they do things wrong,
either by accident or on purpose. Problems can arise from a
combination of factors, including intentional and illegal breaches of
policies and rules, sloppy execution, lack of knowledge and training,
and unclear and sometimes contradictory procedures. Unauthorised
trading, for example, can cause billions in direct losses and
multimillions more in regulatory, legal and restructuring costs.
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 2⃣ Information Technology (IT)

Systems can be hacked and breached; data can be corrupted or stolen.

The risks banks face extend to the third-party IT providers that so many
banks now rely on for cloud-based storage and other services. Systems
can slow down or crash, leaving customers unable to access ATMs or
mobile apps. Even the speed of technological change presents an
operational risk. With the cyber landscape evolving so rapidly, banks
can have trouble keeping up with new threats.

3⃣ Organisational Structure

By setting aggressive sales targets and rewarding employees for how

well they meet them, the bank management can encourage, and, in
some cases, explicitly condone inappropriate risk taking. Such activity,
when exposed, can lead to management changes, shareholder losses
and regulatory nes.

4⃣ Regulation

The fourth area that vexes ORM planners is regulation. Since the global
nancial crisis, regulators have increased the number and complexity of
rules that banks must follow. The banks that operate in multiple
jurisdictions can face overlapping, inconsistent and con icting
regulatory regimes. Lapses can be expensive and embarrassing,
triggering regulatory sanctions and customer defections. As is the case
with technology, the speed and magnitude of regulatory change can be
daunting. Even as banks are trying to contain costs, they must invest in
the people, systems and processes that foster compliance.

Types Of Operational Risks

The top operational risks in banks include:

Cybersecurity risks: Cyber risks including ransomware & phishing
have become more frequent posing a major risk to banks.

Third-party risks: Increasingly, the banks have to identify & evaluate

the risks associated with vendors, suppliers & contractors that their
third-party vendors use.
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 Business Disruption & System Failures: Hardware/software system
failures, power failures & disruption in telecommunications can interrupt
business operations & cause nancial loss.

Steps In Operational Risk Management

▪ Identi cation of risks
▪ Assessment of risks
▪ Develop a scale to measure risks
▪ Risks monitoring
▪ Strategise a policy to avoid potential risk

5. Interest Rate Risk Management

Measuring and assessing interest rate risk is essential for e ective risk
management in the banks. Various methods can be used to quantify the
potential impact of interest rate uctuations on a bank’s nancial
position and performance.

Gap Analysis
Gap analysis is a commonly used method for measuring interest rate
risk. It involves comparing the repricing of assets and liabilities within
speci ed time periods, which helps identify potential mismatches that
could a ect a bank’s net interest income.

Using gap analysis, banks can assess their exposure to repricing risk
and develop strategies to mitigate the potential impact of interest rate
changes.

However, this method may not fully capture the complexity of a rm's
interest rate risk exposure, particularly when considering yield curve
risk and optionality risk.

Duration Analysis
Duration analysis is another method for assessing interest rate risk, focusing on
the sensitivity of a bank’s assets and liabilities to changes in interest
rates.Duration measures the weighted average time until an instrument's cash
flows are received, which can help estimate the potential impact of interest rate
changes on the value of assets and liabilities.
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By comparing the duration of assets and liabilities, banks can gauge their
exposure to interest rate risk and develop strategies to manage this risk, such as
duration matching. However, duration analysis may not fully capture the effects
of non-parallel shifts in the yield curve or the impact of embedded
options.

Simulation Analysis
Simulation analysis involves using computer models to estimate the
potential impact of various interest rate scenarios on a bank’s nancial
position and performance.This method can help rms assess their
exposure to di erent types of interest rate risk, including repricing risk,
yield curve risk, and optionality risk.

By simulating the potential impact of interest rate changes under

various scenarios, banks can better understand their interest rate risk
exposure and develop appropriate risk management strategies.
However, the accuracy of simulation analysis depends on the quality of
the underlying models and assumptions.

Value at Risk
Value at Risk (VaR) is a statistical technique used to estimate the
potential losses a bank could incur due to changes in market factors,
including interest rates.

VaR calculates the maximum potential loss a bank could experience

within a speci ed time period and con dence level. Using VaR, banks
can quantify their interest rate risk exposure and develop strategies to
manage this risk. However, VaR has limitations, as it may not fully
capture the potential losses in extreme market events and may
underestimate the tail risk associated with interest rate uctuations.

6. Foreign Exchange Risk Management

Foreign exchange risk is the exposure of an institution to the potential

impact of movements in foreign exchange rates. The risk is that
adverse uctuations in exchange rates may result in a loss in rupee
terms to the institution.

Foreign exchange risk arises from two factors: currency mismatches in

an institution's assets and liabilities (both on and o -balance sheet) that
are not subject to a xed exchange rate vis-a-vis the Indian rupee and
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currency cash ow mismatches. Such risk continues until the foreign
exchange position is covered. This risk may arise from a variety of
sources such as foreign currency retail accounts and retail cash
transactions and services, foreign exchange trading, investments
denominated in foreign currencies and investments in foreign
companies. The amount at risk is a function of the magnitude of
potential exchange rate changes and the size and duration of the
foreign currency exposure.

Managing foreign exchange risk is a fundamental component in the

safe and sound management of all institutions that have exposures in
foreign currencies. It involves prudently managing foreign currency
positions in order to control, within set parameters, the impact of
changes in exchange rates on the nancial position of the institution.
The frequency and direction of rate changes, the extent of the foreign
currency exposure and the ability of counterparts to honour their
obligations to the institution are signi cant factors in foreign exchange
risk management.

Foreign Exchange Risk Management Policies

Well articulated policies, setting forth the objectives of the institution's

foreign exchange risk management strategy and the parameters within
which this strategy is to be controlled, are the focal point of e ective
and prudent foreign exchange risk management. These policies need to
include:

1⃣ A statement of risk principles and objectives governing the extent to

which the institution is willing to assume foreign exchange risk

2⃣ Explicit and prudent foreign exchange risk limits : Each institution

needs to establish explicit and prudent foreign exchange limits, and
ensure that the level of its foreign exchange risk exposure does not
exceed these limits. Where applicable, these limits need to cover, at a
minimum:

▪ the currencies in which the institution is permitted to incur exposure;

and;
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 ▪ the level of foreign currency exposure that the institution is prepared
to assume.

Foreign exchange risk limits need to be set within an institution's overall

risk pro le, which re ects factors such as its capital adequacy, liquidity,
credit quality, investment risk and interest rate risk. Foreign exchange
positions should be managed within an institution's ability to quickly
cover such positions if necessary. Moreover, foreign exchange risk
limits needs to be reassessed on a regular basis to re ect potential
changes in exchange rate volatility, the institution's overall risk
philosophy and risk pro le.

3⃣ Clearly de ned levels of delegation of trading authorities

7. Asset Liability Risk Management

Asset Liability Risk Management is the practice of managing nancial
risks that arise due to mismatches between the assets and liabilities.
These discrepancies can occur due to changes to the economic
landscape, such as di erent interest rates or liquidity requirements.
ALM helps to ensure that assets are invested most optimally and
liabilities are moderated over the long term. The success of ALM
depends on matching of assets and liabilities in terms of rate and
maturity to optimise the yield and maintain the net interest margin.

Tools of Asset and Liability Risk Management

Preparation of Statement of Liquidity

The Statement of Liquidity is prepared by placing all cash in ows and

out ows in the maturity ladder according to the expected timing of
cash ows. A maturing liability is referred as a cash out ow while a
maturing asset is referred as a cash in ow. Maturity pro le of assets
and liabilities is used for measuring the future cash ows of banks in
di erent time buckets viz. i) 1 to 14 days ii) 15 to 28 days iii) 29 days to
3 months iv) Over 3 months and up to 6 months v) Over 6 months and
up to 12 months vi) Over 1 year and to up to 2 years vii) Over 2 years
and up to 5 years viii) Over 5 years. It is also necessary to take into
account the rupee in ows and out ows on account of forex operations.
Thus, the foreign currency resources raised abroad but swapped into
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 rupees and deployed in rupee assets, is also re ected in the rupee
liquidity. The wider the negative mismatch, the higher is the liquidity
risk.

Gap Analysis Model

The Gap or Mismatch risk is measured by calculating gaps over

di erent time intervals as at a given date. Gap analysis measures
mismatches between rate sensitive liabilities (RSLs) and rate sensitive
assets (RSAs) including o -balance sheet positions.The Gap Report is
generated by grouping rate sensitive liabilities, assets and o -balance
sheet positions into time buckets (as stated above in ‘statement of
liquidity’) according to residual maturity or next re-pricing period,
whichever is earlier. All investments, advances, deposits and
borrowings, etc. that mature/re-price within a speci ed timeframe are
interest rate sensitive. Similarly, any principal repayment of loan is also
rate sensitive if the bank expects to receive it within the time horizon.
This includes nal principal repayment and interim instalments. The
positive gap indicates that it has more RSAs than RSLs whereas the
negative gap indicates that it has more RSLs.

8. Compliance Risk And Legal Risk Management

Compliance risk refers to the risk of regulatory sanctions, nancial loss,
or damage to reputation that may arise from a bank's failure to comply
with laws, regulations, and industry standards related to that sector.

This includes risks associated with anti-money laundering, know-your-

customer requirements, data privacy, consumer protection, nancial
stability, and other areas.

Banks use manage compliance risk by implementing policies and

procedures to assure that they comply with applicable laws and
regulations, as well as by conducting regular monitoring and testing to
detect and address potential compliance issues.

A well developed compliance management system with e ective risk

controls should establish and communicate compliance responsibilities
to employees, the board of directors, and senior management;
incorporate legal requirements and internal policies into business
processes; and, ultimately, improve the e ectiveness of the bank’s
compliance programs.
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 Regulatory compliance audits by internal team ensures adherence to
regulatory requirements.

Legal Risk

Legal risk is when a bank fails to comply with regulations or contractual

terms. It is caused by internal errors, awed processes, and deliberate
infractions.

Under Basel capital accord, operational risk includes the legal risk. For
example, operational risks arising from the failure of internal tasks,
internal processes, disrupted policies, and uncompelled regulations can
lead to legal action.

Legal risks associated with banks are as follows:

▪ Claims against the institution
▪ Damages, penalties, and nes
▪ Documentation defects
▪ Record keeping errors
▪ Loss of reputation

Legal risk assessments identi es and manages legal risks associated

with contracts, litigation, and other legal matters.

9. Counterparty Credit Risk Management

Counterparty credit risk (CCR) is the risk that the counterparty to a

transaction could default before the nal settlement of the transaction's
cash ows. An economic loss would occur if the transactions or
portfolio of transactions with the counterparty has a positive economic
value at the time of default.

From OTC derivatives trading to prime brokerage, securities lending,

and repos, CCR is inherently bound to the daily operations of markets
businesses and markets environments. It is most often manifested in
default risk, replacement risk and settlement risk—albeit at the tail end
of probabilities.
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 BCBS Guidelines On Managing CCR

1⃣ Conduct comprehensive due diligence of counterparties both at

initial onboarding and on an ongoing basis. The aim is to ensure banks
have a full understanding of the risks they are taking before they make
key credit risk decisions and that they are able to act swiftly and with
su cient information on the changing risk pro les of counterparties
during times of stress.

2⃣ Develop a comprehensive credit risk mitigation strategy to

e ectively manage counterparty exposures. This entails the use of
robust contractual terms and tools such as risk-sensitive margining

3⃣ Measure, control, and limit counterparty credit risk using a wide

variety of complementary metrics. This should be done while ensuring
that counterparty credit risk metrics comprehensively cover the bank’s
range of material risks, portfolios, and counterparties.

4⃣ Build a strong counterparty credit risk governance framework. This

should be guided by clear risk management processes, including limits
and escalations, and supported by informative and reliable reporting
that is integrated into decision-making processes.

10. Concentration Risk Management

Concentration risk can be de ned as the potential for nancial loss due
to an overexposure to a single counterparty, sector, or geographic
region.

The presence of concentration risk increases the vulnerability of a

portfolio to market uctuations and economic downturns. It is essential
for investors to understand the di erent types of concentration risk and
their potential impact on their investments.

Types of Concentration Risk

There are mainly three types of concentration risk: credit, sector, and
geographic concentration risk. Each type represents a di erent aspect
of potential overexposure in a portfolio or nancial institution.
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 1⃣ Credit Concentration Risk
Credit concentration risk arises when a nancial institution or investor
has a signi cant exposure to a single borrower or a group of
borrowers.This risk can lead to substantial losses if the borrower
defaults on their obligations, a ecting the nancial stability of the
institution or investor.

2⃣ Sector Concentration Risk

Sector concentration risk occurs when a portfolio or institution has a
signi cant exposure to a particular industry or sector. This risk can
result in losses if the sector experiences a downturn or faces
challenges that negatively impact its performance. Diversifying across
di erent sectors can help mitigate sector concentration risk.

3⃣ Geographic Concentration Risk

Geographic concentration risk is the potential for loss that arises when
a portfolio or nancial institution has a signi cant exposure to a
particular geographic area.This risk can result from economic or
political instability in the area or from external events such as natural
disasters. To mitigate geographic concentration risk, diversi cation
across di erent regions is recommended.

Management Of Concentration Risk

▪ Risk Identi cation & Assessment

The rst step in managing concentration risk is identifying and
assessing the potential areas of overexposure in a portfolio or nancial
institution. This can be achieved through regular portfolio reviews,
market analysis, and the use of concentration ratios and portfolio
analytics.

▪ Diversi cation Strategies

Diversi cation strategies are essential for managing concentration risk.
These strategies include asset allocation, sector and geographic
diversi cation, and rebalancing portfolios.Rebalancing portfolios
involves adjusting the weights of di erent assets, sectors, & regions
within a portfolio to maintain a desired level of diversi cation.

▪ Risk Limits And Monitoring

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Setting risk limits & regular monitoring are important aspects of
managing concentration risk. Risk limits involve establishing thresholds
for acceptable levels of concentration risk within a portfolio or nancial
institution.

11. Country Risk Management

Country risk refers to the ability and willingness of borrowers within a

country to meet their obligations. It is thus a credit risk on obligations
advanced across borders. Assessment of country risk relies on the
analysis of economic, social and political variables that relate to the
particular country in question. Although the economic factors can be
measured objectively, the social and political variables will often involve
subjective judgments.

Country risk can be categorised under two headings. The rst sub-
category of country risk is sovereign risk, which refers to both the risk
of default by a sovereign government on its foreign currency
obligations, and the risk that direct or indirect actions by the sovereign
government may a ect the ability of other entities in that country to use
their available funds to meet foreign currency debt obligations.

In the former case, sovereign risk addresses the credit risk of national
governments, but not the speci c default risks of other debt issuers.
Here, credit risk relates to two key aspects: economic risk, which
addresses the government's ability to repay its obligations on time, and
political risk, which addresses its willingness to repay debt. In practice,
these risks are related, since a government that is unwilling to repay
debt is often pursuing economic policies that weaken its ability to do
so.

12. Solvency Risk Management

Solvency risk refers to the risk of having insu cient capital to cover
losses generated by all types of risks, and is thus e ectively the risk of
default of the bank. From a regulatory viewpoint, the issue of adequate
capital is critically important for the stability of the banking system.

To address solvency risk, it is necessary to de ne the level of capital

which is appropriate for given levels of overall risk. The key principles
involved can be summarised as follows:
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▪ Risks generate potential losses.

▪ The ultimate protection for such losses is capital.

▪ Capital should be adjusted to the level required to ensure capability

to absorb the potential losses generated by all risks.

To implement the latter, all risks should be quanti ed in terms of

potential losses, and a measure of aggregate potential losses should be
derived from the potential losses of all component risks.

13. Climate Risk Management

Climate change can pose many risks to the banking sector, including
extreme weather events, long-term climate shifts, and asset value
declines. These risks can negatively impact clients' creditworthiness,
cause business interruptions, and lead to the closure of retail
branches.

Initially, the banks should reassess their credit business strategies to

address climate change issues: the markets, segments, and clients they
will serve; the products they will o er, and the innovations they will
bring to the market. The revised strategies may derive from the banks'
sustainability commitments, including goals for reducing nanced
emissions or overall risk exposure.

The consequences of global warming can manifest through physical

risks and transition risks.

Physical risks deal with the impact of extreme weather events like
hurricanes, oods, or droughts; transition risks are those that result
from changing policies, practices, and technologies as organizations
shift toward a low-carbon economy. Physical risk and transition risk are
not independent of each other-e orts to limit global warming may
reduce physical risk but increase. transition risk through higher market,
technology, and regulatory costs.
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To embed these considerations into the credit risk framework, the
banks should rst develop a taxonomy and map of climate risks and
their transmission channels, such as macroeconomic outcomes, capital
depreciation, new customer preferences, or business disruptions. They
could use a scoring system, based on emissions or other indicators, to
visualize the magnitude of each risk on a heatmap. The heatmap would
show risks across di erent dimensions, including industries/ sectors,
geographies, and client types.

The next step for banks is to translate the overarching credit business
strategy and product focus into appropriate risk appetite, credit risk
processes and policies.

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