EXECUTIVE SUMMARY

This project at Punjab National Bank was undertaken during the period of 2
months (JUNE 1st 08 to JULY 31st 08) as part of my summer training

As part of summer training, I was made to accompany Customer

Relationship Officer to observe Client Interaction, gauge the level of
satisfaction by listening and solving quarries of existing clients also helped in
making new clients.
My Summer Training included the following-

An in-depth induction through the Computer Based Training Module

Learning the basics of the various Baking Operations such as procedure
of opening new account (Savings, Current), printing and updating of
passbook, procedure of opening a F.D, deposits / withdrawals, issuing of
ATM cards and internet banking passwords etc.
Various Documents Necessary or Required at the Time of Opening of
Account
Accompanying Customer Relationship Officer to observe client
interaction.
Client Acquisition.

During the course of my training, I got valuable insights about the workings
in a bank branch, internet banking and client interface.

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 OBJECTIVES

To study broad outline of management of credit, market and operational

risks associated with banking sector .

Though the risk management area is very wide and elaborated, still the
project covers whole subject in concise manner.

The study aims at learning the techniques involved to manage the various
types of risks, various methodologies undertaken. The application of the
techniques involves us to gain an insight into the following aspects:

An overview of the risks in general.

An insight of the various credit, market and operational risks

attached to the banking sector

The methodology related to the management of operational risk

followed at PNB.

Tools applied in for measurement and management of various types

of risks.

Having an insight into the practical aspects of the working of various

departments.

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 SCOPE OF THE STUDY
The report seeks to present a comprehensive picture of the various risks
inherent in the bank. The risks can be broadly classified into three
categories:

Credit risk

Market risk

Operational risk

Within each of these broad groups, an attempt has been made to cover as
comprehensively as possible, the various sub-groups

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The computation of capital charge for market risk will also be taken
practically as also the assigning the ratings for individual borrowers. PNB is
also under the key process of testing and implementation of Reuters
"KONDOR" software for its VaR calculations and other aspects of market
risk.

LIMITATION OF THE STUDY

1. The major limitation of this study shall be data availability as the data is
proprietary and not readily shared for dissemination.

2. Due to the ongoing process of globalization and increasing competition, no

one model or method will suffice over a long period of time and constant up
gradation will be required. As such the project can be considered as an
overview of the various risks prevailing in Punjab National Bank and in the
Banking Industry.

3. Each bank, in conforming to the RBI guidelines, may develop its own
methods for measuring and managing risk.

4. The concept of risk management implementation is relatively new and risk

management tools can prove to be costly.

5. Out of the various ways in which risks can be managed, none of the
method is perfect and may be very diverse even for the work in a similar
situation for the future.

6. Due to ever changing environment , many risks are unexpected and the
remedial measures available are based on general experience from the past.

7. Selection of methods depends on the firms expectations as well as the risk

appetite. Also risks can only be minimized not completely erased.

INTRODUCTION

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 The significant transformation of the banking industry in India is
clearly evident from the changes that have occurred in the financial markets,
institutions and products. While deregulation has opened up new vistas for
banks to argument revenues, it has entailed greater competition and
consequently greater risks. Cross- border flows and entry of new products,
particularly derivative instruments, have impacted significantly on the
domestic banking sector forcing banks to adjust the product mix, as also to
effect rapid changes in their processes and operations in order to remain
competitive to the globalized environment. These developments have
facilitated greater choice for consumers, who have become more discerning
and demanding compelling banks to offer a broader range of products
through diverse distribution channels. The traditional face of banks as mere
financial intermediaries has since altered and risk management has emerged
as their defining attribute.

Currently, the most important factor shaping the world is

globalization. The benefits of globalization have been well documented and
are being increasingly recognized. Integration of domestic markets with
international financial markets has been facilitated by tremendous
advancement in information and communications technology. But, such an
environment has also meant that a problem in one country can sometimes
adversely impact one or more countries instantaneously, even if they are
fundamentally strong.

There is a growing realisation that the ability of countries to conduct

business across national borders and the ability to cope with the possible
downside risks would depend, interalia, on the soundness of the financial
system. This has consequently meant the adoption of a strong and
transparent, prudential, regulatory, supervisory, technological and
institutional framework in the financial sector on par with international best
practices. All this necessitates a transformation: a transformation in the
mindset, a transformation in the business processes and finally, a
transformation in knowledge management. This process is not a one shot
affair; it needs to be appropriately phased in the least disruptive manner.

The banking and financial crises in recent years in emerging

economies have demonstrated that, when things go wrong with the financial
system, they can result in a severe economic downturn. Furthermore,
banking crises often impose substantial costs on the exchequer, the

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incidence of which is ultimately borne by the taxpayer. The World Bank
Annual Report (2002) has observed that the loss of US $1 trillion in banking
crisis in the 1980s and 1990s is equal to the total flow of official
development assistance to developing countries from 1950s to the present
date. As a consequence, the focus of financial market reform in many
emerging economies has been towards increasing efficiency while at the
same time ensuring stability in financial markets. From this perspective,
financial sector reforms are essential in order to avoid such costs. It is,
therefore, not surprising that financial market reform is at the forefront of
public policy debate in recent years. The crucial role of sound financial
markets in promoting rapid economic growth and ensuring financial stability.
Financial sector reform, through the development of an efficient financial
system, is thus perceived as a key element in raising countries out of their
'low level equilibrium trap'. As the World Bank Annual Report (2002)
observes, a robust financial system is a precondition for a sound investment
climate, growth and the reduction of poverty .

Financial sector reforms were initiated in India a decade ago with a

view to improving efficiency in the process of financial intermediation,
enhancing the effectiveness in the conduct of monetary policy and creating
conditions for integration of the domestic financial sector with the global
system. The first phase of reforms was guided by the recommendations of
Narasimham Committee.

The approach was to ensure that the financial services industry

operates on the basis of operational flexibility and functional
autonomy with a view to enhancing efficiency, productivity and
profitability'.

The second phase, guided by Narasimham Committee II, focused on

strengthening the foundations of the banking system and bringing
about structural improvements. Further intensive discussions are held
on important issues related to corporate governance, reform of the
capital structure, (in the context of Basel II norms), retail banking, risk
management technology, and human resources development, among
others.

Since 1992, significant changes have been introduced in the Indian

financial system. These changes have infused an element of competition in

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the financial system, marking the gradual end of financial repression
characterized by price and non-price controls in the process of financial
intermediation. While financial markets have been fairly developed, there still
remains a large extent of segmentation of markets and non-level playing field
among participants, which contribute to volatility in asset prices. This
volatility is exacerbated by the lack of liquidity in the secondary markets.
The purpose of this paper is to highlight the need for the regulator and
market participants to recognize the risks in the financial system, the
products available to hedge risks and the instruments, including derivatives
that are required to be developed/introduced in the Indian system.

The financial sector serves the economic function of intermediation by

ensuring efficient allocation of resources in the economy. Financial
intermediation is enabled through a four-pronged transformation mechanism
consisting of liability-asset transformation, size transformation, maturity
transformation and risk transformation.

Risk is inherent in the very act of transformation. However, prior to

reform of 1991-92, banks were not exposed to diverse financial risks mainly
because interest rates were regulated, financial asset prices moved within a
narrow band and the roles of different categories of intermediaries were
clearly defined. Credit risk was the major risk for which banks adopted
certain appraisal standards.

Several structural changes have taken place in the financial sector

since 1992. The operating environment has undergone a vast change
bringing to fore the critical importance of managing a whole range of
financial risks. The key elements of this transformation process have been

1. The deregulation of coupon rate on Government securities.

2. Substantial liberalization of bank deposit and lending rates.

3. A gradual trend towards disintermediation in the financial system in

the wake of increased access of corporates to capital markets.

4. Blurring of distinction between activities of financial institutions.

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5. Greater integration among the various segments of financial markets
and their increased order of globalisation, diversification of ownership
of public sector banks.

6. Emergence of new private sector banks and other financial

institutions, and,

7. The rapid advancement of technology in the financial system.

DEFINITION OF RISK

What is Risk?

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 "What is risk?" And what is a pragmatic definition of risk? Risk means
different things to different people. For some it is "financial (exchange rate,
interest-call money rates), mergers of competitors globally to form more
powerful entities and not leveraging IT optimally" and for someone else "an
event or commitment which has the potential to generate commercial liability
or damage to the brand image". Since risk is accepted in business as a trade
off between reward and threat, it does mean that taking risk bring forth
benefits as well. In other words it is necessary to accept risks, if the desire is
to reap the anticipated benefits.

Risk in its pragmatic definition, therefore, includes both threats that

can materialize and opportunities, which can be exploited. This definition of
risk is very pertinent today as the current business environment offers both
challenges and opportunities to organizations, and it is up to an organization
to manage these to their competitive advantage.

What is Risk Management - Does it eliminate risk?

Risk management is a discipline for dealing with the possibility that
some future event will cause harm. It provides strategies, techniques, and an
approach to recognizing and confronting any threat faced by an organization
in fulfilling its mission. Risk management may be as uncomplicated as
asking and answering three basic questions:

1. What can go wrong?

2. What will we do (both to prevent the harm from occurring and in the
aftermath of an "incident")?

3. If something happens, how will we pay for it?

Risk management does not aim at risk elimination, but enables the
organization to bring their risks to manageable proportions while not
severely affecting their income. This balancing act between the risk levels
and profits needs to be well-planned. Apart from bringing the risks to
manageable proportions, they should also ensure that one risk does not get
transformed into any other undesirable risk. This transformation takes place
due to the inter-linkage present among the various risks. The focal point in
managing any risk will be to understand the nature of the transaction in a
way to unbundle the risks it is exposed to.

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 Risk Management is a more mature subject in the western world. This
is largely a result of lessons from major corporate failures, most telling and
visible being the Barings collapse. In addition, regulatory requirements have
been introduced, which expect organizations to have effective risk
management practices. In India, whilst risk management is still in its
infancy, there has been considerable debate on the need to introduce
comprehensive risk management practices.

Objectives of Risk Management Function

Two distinct viewpoints emerge

One which is about managing risks, maximizing profitability and

creating opportunity out of risks

And the other which is about minimising risks/loss and protecting

corporate assets.

The management of an organization needs to consciously decide on

whether they want their risk management function to 'manage' or 'mitigate'
Risks.

Managing risks essentially is about striking the right balance between

risks and controls and taking informed management decisions on
opportunities and threats facing an organization. Both situations, i.e.
over or under controlling risks are highly undesirable as the former
means higher costs and the latter means possible exposure to risk.

Mitigating or minimising risks, on the other hand, means mitigating all

risks even if the cost of minimising a risk may be excessive and
outweighs the cost-benefit analysis. Further, it may mean that the
opportunities are not adequately exploited.

In the context of the risk management function, identification and

management of Risk is more prominent for the financial services sector and
less so for consumer products industry. What are the primary objectives of
your risk management function? When specifically asked in a survey

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conducted, 33% of respondents stated that their risk management function
is indeed expressly mandated to optimise risk.

Risks in Banking
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.

Typology of Risk Exposure

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 taking into consideration practical issues including the
limitations of models and theories, human factor, existence of frictions such
as taxes and transaction cost and limitations on quality and quantity of
information, as well as the cost of acquiring this information, and more.

FINANCIAL RISKS

MARKET LIQUIDITY OPERATIONAL HUMAN

RISK RISK RISK FACTOR RISK

CREDIT RISK LEGAL &

REGULATORY RISK

FUNDING11 TRADING
LIQUIDITY RISK LIQUIDITY RISK
 TRANSACTION PORTFOLIO
RISK CONCENTRATION

ISSUE RISK ISSUER RISK COUNTERPARTY

RISK

EQUITY RISK INEREST CURRENCY COMMODITY

RATE RISK RISK RISK

TRADING GAP RISK

RISK

GENERAL SPECIFIC
MARKET RISK RISK

1. MARKET RISK
Market risk is that risk that changes in financial market prices and
rates will reduce the value of the banks positions. Market risk for a fund is
often measured relative to a benchmark index or portfolio, is referred to as a
risk of tracking error market risk also includes basis risk, a term used in
risk management industry to describe the chance of a breakdown in the
relationship between price of a product, on the one hand, and the price of
the instrument used to hedge that price exposure on the other. The market-
Var methodology attempts to capture multiple component of market such as
directional risk, convexity risk, volatility risk, basis risk, etc.

2. CREDIT RISK
Credit risk is that risk that a change in the credit quality of a
counterparty will affect the value of a banks position. Default, whereby a
counterparty is unwilling or unable to fulfill its contractual obligations, is
the extreme case; however banks are also exposed to the risk that the
counterparty might downgraded by a rating agency.

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 Credit risk is only an issue when the position is an asset, i.e., when it
exhibits a positive replacement value. In that instance if the counterparty
defaults, the bank either loses all of the market value of the position or, more
commonly, the part of the value that it cannot recover following the credit
event. However, the credit exposure induced by the replacement values of
derivative instruments is dynamic: they can be negative at one point of time,
and yet become positive at a later point in time after market conditions have
changed. Therefore the banks must examine not only the current exposure,
measured by the current replacement value, but also the profile of future
exposures up to the termination of the deal.

3. LIQUIDITY RISK
Liquidity risk comprises both
Funding liquidity risk
Trading-related liquidity risk.
Funding liquidity risk relates to a financial institutions ability to raise
the necessary cash to roll over its debt, to meet the cash, margin, and
collateral requirements of counterparties, and (in the case of funds) to satisfy
capital withdrawals. Funding liquidity risk is affected by various factors
such as the maturities of the liabilities, the extent of reliance of secured
sources of funding, the terms of financing, and the breadth of funding
sources, including the ability to access public market such as commercial
paper market. Funding can also be achieved through cash or cash
equivalents, buying power , and available credit lines.
Trading-related liquidity risk, often simply called as liquidity risk, is
the risk that an institution will not be able to execute a transaction at the
prevailing market price because there is, temporarily, no appetite for the deal
on the other side of the market. If the transaction cannot be postponed its
execution my lead to substantial losses on position. This risk is generally
very hard to quantify. It may reduce an institutions ability to manage and
hedge market risk as well as its capacity to satisfy any shortfall on the
funding side through asset liquidation.

4. OPERATIONAL RISK
It refers to potential losses resulting from inadequate systems,
management failure, faulty control, fraud and human error. Many of the
recent large losses related to derivatives are the direct consequences of
operational failure. Derivative trading is more prone to operational risk than
cash transactions because derivatives are, by their nature, leveraged
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transactions. This means that a trader can make very large commitment on
behalf of the bank, and generate huge exposure in to the future, using only
small amount of cash. Very tight controls are an absolute necessary if the
bank is to avoid huge losses.
Operational risk includes fraud, for example when a trader or other
employee intentionally falsifies and misrepresents the risk incurred in a
transaction. Technology risk, and principally computer system risk also fall
into the operational risk category.

5. LEGAL RISK
Legal risk arises for a whole of variety of reasons. For example,
counterparty might lack the legal or regulatory authority to engage in a
transaction. Legal risks usually only become apparent when counterparty, or
an investor, lose money on a transaction and decided to sue the bank to
avoid meeting its obligations. Another aspect of regulatory risk is the
potential impact of a change in tax law on the market value of a position.

6. HUMAN FACTOR RISK

Human factor risk is really a special form of operational risk. It relates
to the losses that may result from human errors such as pushing the wrong
button on a computer, inadvertently destroying files, or entering wrong value
for the parameter input of a model.

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 MARKET RISK

What is 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 changes. Besides, it is equally
concerned about the bank's ability to meet its obligations as and when they
fall due. In other words, it should be ensured that the bank is not exposed to
Liquidity Risk. Thus, focus on the management of Liquidity Risk and Market
Risk, further categorized into interest rate risk, foreign exchange risk,
commodity price risk and equity price risk. An effective market risk
management framework in a bank comprises risk identification, setting up of
limits and triggers, risk monitoring, models of analysis that value positions
or measure market risk, risk reporting, etc.

Types of market risk

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 networth 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

15
when viewed from these two perspectives is known as 'earnings perspective'
and 'economic value' perspective, 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.

Earnings perspective involves analyzing 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.

Economic Value perspective involves analyzing the changes of

impact on 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.

The management of Interest Rate Risk should be one of the critical

components of market risk management in banks. The regulatory
restrictions in the past had greatly reduced many of the risks in the banking
system. Deregulation of interest rates has, however, exposed them to the
adverse impacts of interest rate risk. The Net Interest Income (NII) or Net
Interest Margin (NIM) of banks is dependent on the movements of interest
rates. Any mismatches in the cash flows (fixed assets or liabilities) or
repricing dates (floating assets or liabilities), expose bank's NII or NIM to
variations. The earning of assets and the cost of liabilities are now closely
related to market interest rate volatility

Generally, the approach towards measurement and hedging of IRR

varies with the segmentation of the balance sheet. In a well functioning risk
management system, banks broadly position their balance sheet into
Trading and Banking Books. While the assets in the trading book are held
primarily for generating profit on short-term differences in prices/yields, the
banking book comprises assets and liabilities, which are contracted basically
on account of relationship or for steady income and statutory obligations and

16
are generally held till maturity. Thus, while the price risk is the prime
concern of banks in trading book, the earnings or economic value changes
are the main focus of banking book.

Equity price risk:

The price risk associated with equities also has two components
General market risk refers to the sensitivity of an instrument / portfolio
value to the change in the level of broad stock market indices. Specific /
Idiosyncratic risk refers to that portion of the stocks price volatility that is
determined by characteristics specific to the firm, such as its line of
business, the quality of its management, or a breakdown in its production
process. The general market risk cannot be eliminated through portfolio
diversification while specific risk can be diversified away.
Foreign exchange risk:
Foreign Exchange Risk maybe 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
as a result of changes in premia/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 crystallization 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 center and the
settlement of another currency in another time-zone. The forex transactions
with counterparties from another country also trigger sovereign or country
risk (dealt with in details in the guidance note on credit risk).

The three important issues that need to be addressed in this regard

are:

1. Nature and magnitude of exchange risk

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 2. Exchange managing or hedging for adopted be to strategy>

3. The tools of managing exchange risk

Commodity price risk:

The price of the commodities differs considerably from its interest rate
risk and foreign exchange risk, since most commodities are traded in the
market in which the concentration of supply can magnify price volatility.
Moreover, fluctuations in the depth of trading in the market (i.e., market
liquidity) often accompany and exacerbate high levels of price volatility.
Therefore, commodity prices generally have higher volatilities and larger
price discontinuities.

Treatment of Market Risk in the Proposed Basel Capital Accord

The Basle Committee on Banking Supervision (BCBS) had issued
comprehensive guidelines to provide an explicit capital cushion for the price
risks to which banks are exposed, particularly those arising from their
trading activities. The banks have been given flexibility to use in-house
models based on VaR for measuring market risk as an alternative to a
standardized measurement framework suggested by Basle Committee. The
internal models should, however, comply with quantitative and qualitative
criteria prescribed by Basle Committee.

Reserve Bank of India has accepted the general framework suggested

by the Basle Committee. RBI has also initiated various steps in moving
towards prescribing capital for market risk. As an initial step, a risk weight
of 2.5% has been prescribed for investments in Government and other
approved securities, besides a risk weight each of 100% on the open position
limits in forex and gold. RBI has also prescribed detailed operating
guidelines for Asset-Liability Management System in banks. As the ability of
banks to identify and measure market risk improves, it would be necessary
to assign explicit capital charge for market risk. While the small banks
operating predominantly in India could adopt the standardized methodology,
large banks and those banks operating in international markets should
develop expertise in evolving internal models for measurement of market
risk.

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 The Basle Committee on Banking Supervision proposes to develop
capital charge for interest rate risk in the banking book as well for banks
where the interest rate risks are significantly above average ('outliers'). The
Committee is now exploring various methodologies for identifying 'outliers'
and how best to apply and calibrate a capital charge for interest rate risk for
banks. Once the Committee finalizes the modalities, it may be necessary, at
least for banks operating in the international markets to comply with the
explicit capital charge requirements for interest rate risk in the banking
book. As the valuation norms on banks' investment portfolio have already
been put in place and aligned with the international best practices, it is
appropriate to adopt the Basel norms on capital for market risk. In view of
this, banks should study the Basel framework on capital for market risk as
envisaged in Amendment to the Capital Accord to incorporate market risks
published in January 1996 by BCBS and prepare themselves to follow the
international practices in this regard at a suitable date to be announced by
RBI.

The Proposed New Capital Adequacy Framework

The Basel Committee on Banking Supervision has released a Second
Consultative Document, which contains refined proposals for the three
pillars of the New Accord - Minimum Capital Requirements, Supervisory
Review and Market Discipline. It may be recalled that the Basel Committee
had released in June 1999 the first Consultative Paper on a New Capital
Adequacy Framework for comments. However, the proposal to provide
explicit capital charge for market risk in the banking book which was
included in the Pillar I of the June 1999 Document has been shifted to Pillar
II in the second Consultative Paper issued in January 2001. The Committee
has also provided a technical paper on evaluation of interest rate risk
management techniques. The Document has defined the criteria for
identifying outlier banks. According to the proposal, a bank may be defined
as an outlier whose economic value declined by more than 20% of the sum of
Tier 1 and Tier 2 capital as a result of a standardized interest rate shock
(200 bps.)

The second Consultative Paper on the New Capital Adequacy

framework issued in January, 2001 has laid down 13 principles intended to

19
 be of general application for the management of interest rate risk,
independent of whether the positions are part of the trading book or reflect
banks' non-trading activities. They refer to an interest rate risk management
process, which includes the development of a business strategy, the
assumption of assets and liabilities in banking and trading activities, as well
as a system of internal controls. In particular, they address the need for
effective interest rate risk measurement, monitoring and control functions
within the interest rate risk management process. The principles are
intended to be of general application, based as they are on practices
currently used by many international banks, even though their specific
application will depend to some extent on the complexity and range of
activities undertaken by individual banks. Under the New Basel Capital
Accord, they form minimum standards expected of internationally active
banks. The principles are given in Annexure II.

CREDIT RISK

What is 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;

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 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 the sovereign may
impose restrictions.

Types of Credit Rating

Credit rating can be classified as:
2. External credit rating.
3. Internal credit rating

External credit rating:

A credit rating is not, in general, an investment recommendation
concerning a given security. In the words of S&P, A credit rating is S&P's
opinion of the general creditworthiness of an obligor, or the creditworthiness
of an obligor with respect to a particular debt security or other financial
obligation, based on relevant risk factors. In Moody's words, a rating is, an
opinion on the future ability and legal obligation of an issuer to make timely
payments of principal and interest on a specific fixed-income security.
Since S&P and Moody's are considered to have expertise in credit
rating and are regarded as unbiased evaluators, there ratings are widely
accepted by market participants and regulatory agencies. Financial
institutions, when required to hold investment grade bonds by their
regulators use the rating of credit agencies such as S&P and Moody's to
determine which bonds are of investment grade.
The subject of credit rating might be a company issuing debt
obligations. In the case of such issuer credit ratings the rating is an
opinion on the obligors overall capacity to meet its financial obligations.
The opinion is not specific to any particular liability of the company, nor does

21
it consider merits of having guarantors for some of the obligations. In the
issuer credit rating categories are
a) Counterparty ratings
b) Corporate credit ratings
c) Sovereign credit ratings
The rating process includes quantitative, qualitative, and legal
analyses. The quantitative analyses. The quantitative analysis is mainly
financial analysis and is based on the firms financial reports. The qualitative
analysis is concerned with the quality of management, and includes a
through review of the firms competitiveness within its industry as well as
the expected growth of the industry and its vulnerability to technological
changes, regulatory changes, and labor relations.

Internal credit rating:

A typical risk rating system (RRS) will assign both an obligor rating to
each borrower (or group of borrowers), and a facility rating to each available
facility. A risk rating (RR) is designed to depict the risk of loss in a credit
facility. A robust RRS should offer a carefully designed, structured, and
documented series of steps for the assessment of each rating.
The following are the steps for assessment of rating:
a) Objectivity and Methodology:
The goal is to generate accurate and consistent risk rating, yet also to
allow professional judgment to significantly influence a rating where it is
appropriate. The expected loss is the product of an exposure (say, Rs. 100)
and the probability of default (say, 2%) of an obligor (or borrower) and the
loss rate given default (say, 50%) in any specific credit facility. In this
example,
The expected loss = 100*.02*.50 = Rs. 1
A typical risk rating methodology (RRM)
a. Initial assign an obligor rating that identifies the expected
probability of default by that borrower (or group) in repaying its
obligations in normal course of business.
b. The RRS then identifies the risk loss (principle/interest) by
assigning an RR to each individual credit facility granted to an
obligor.
The obligor rating represents the probability of default by a borrower in
repaying its obligation in the normal course of business. The facility rating

22
represents the expected loss of principal and/ or interest on any business
credit facility. It combines the likelihood of default by a borrower and
conditional severity of loss, should default occur, from the credit facilities
available to the borrower.

Risk Rating Continuum (Prototype Risk Rating System)

RISK RR Corresponding
Probable S&P or
Moody's Rating
Sovereign 0 Not Applicable
Low 1 AAA
2 AA Investment Grade
3 A
4 BBB+/BBB
Average 5 BBB-
6 BB+/BB
7 BB-
High 8 B+/B
9 B- Below Investment
10 CCC+/CCC Grade
11 CC-
12 In Default

The steps in the RRS (nine, in our prototype system) typically start
with a financial assessment of the borrower (initial obligor rating), which sets
a floor on the obligor rating (OR). A series of further steps (four) arrive at the
final obligor rating. Each one of steps 2 to 5 may result in the downgrade of
the initial rating attributed at step 1. These steps include analyzing the
managerial capability of the borrower (step 2), examining the borrowers
absolute and relative position within the industry (step 3), reviewing the
quality of the financial information (step 4) and the country risk (step 5). The
process ensures that all credits are objectively rated using a consistent
process to arrive at the accurate rating.

23
Additional steps (four, in our example) are associated with arriving at a final
facility rating, which may be above OR below the final obligor rating. These
steps include examining third-party support (step 6), factoring in the
maturity of the transaction (step 7), reviewing how strongly the transaction is
structured. (step 8), and assessing the amount of collateral (step 9).
b) Measurement of Default Probability and Recovery Rates.
Credit rating systems can be compared to multivariate credit scoring
systems to evaluate their ability to predict bankruptcy rates and also to
provide estimates of the severity of losses. Altman and Saunders (1998)
provide a detailed survey of credit risk management approaches. They
compare four methodologies for credit scoring:
1. The linear probability model
2. The logit model
3. The probit model
4. The discriminant analysis model
The logit model assumes that the default probability is logistically
distributed, and applies a few accounting variables to predict the default
probability. The linear probability model is based on a linear regression
model, and makes use of a number of accounting variables to try to predict
the probability of default. The multiple discriminant analysis (MDA),
proposed and advocated by Aitman is based on finding a linear function of
both accounting and market based variables that best discriminates between
two groups: firms that actually defaulted and firms that did not default.
The linear models are based on empirical procedures. They are not
found in theory of the firm OR any theoretical stochastic processes for
leveraged firms.

Credit Risk Management

In this backdrop, it is imperative that banks have a robust credit risk

management system which is sensitive and responsive to these factors. The
effective management of credit risk is a critical component of comprehensive
risk management and is essential for the long term success of any banking
organization. Credit risk management encompasses identification,
measurement, monitoring and control of the credit risk exposures.

Building Blocks of Credit Risk Management:

24
 In a bank, an effective credit risk management framework would
comprise of the following distinct building blocks:

Policy and Strategy

Organizational Structure

Operations/ Systems

Policy and Strategy

The Board of Directors of each bank shall be responsible for approving

and periodically reviewing the credit risk strategy and significant credit risk
policies.

Credit Risk Policy

1. Every bank should have a credit risk policy document approved by the
Board. The document should include risk identification, risk
measurement, risk grading/ aggregation techniques, reporting and
risk control/ mitigation techniques, documentation, legal issues and
management of problem loans.

2. Credit risk policies should also define target markets, risk acceptance
criteria, credit approval authority, credit origination/ maintenance
procedures and guidelines for portfolio management.

3. The credit risk policies approved by the Board should be

communicated to branches/controlling offices. All dealing officials
should clearly understand the bank's approach for credit sanction and
should be held accountable for complying with established policies and
procedures.

4. Senior management of a bank shall be responsible for implementing

the credit risk policy approved by the Board.</P< LI>

Credit Risk Strategy

1. Each bank should develop, with the approval of its Board, its own
credit risk strategy or plan that establishes the objectives guiding the
25
 bank's credit-granting activities and adopt necessary policies/
procedures for conducting such activities. This strategy should spell
out clearly the organizations credit appetite and the acceptable level of
risk-reward trade-off for its activities.

2. The strategy would, therefore, include a statement of the bank's

willingness to grant loans based on the type of economic activity,
geographical location, currency, market, maturity and anticipated
profitability. This would necessarily translate into the identification of
target markets and business sectors, preferred levels of diversification
and concentration, the cost of capital in granting credit and the cost of
bad debts.

3. The credit risk strategy should provide continuity in approach as also

take into account the cyclical aspects of the economy and the resulting
shifts in the composition/ quality of the overall credit portfolio. This
strategy should be viable in the long run and through various credit
cycles.

4. Senior management of a bank shall be responsible for implementing

the credit risk strategy approved by the Board.

Organizational Structure

Sound organizational structure is sine qua non for successful

implementation of an effective credit risk management system. The
organizational structure for credit risk management should have the
following basic features:

1. The Board of Directors should have the overall responsibility for

management of risks. The Board should decide the risk management
policy of the bank and set limits for liquidity, interest rate, foreign
exchange and equity price risks.

The Risk Management Committee will be a Board level Sub committee

including CEO and heads of Credit, Market and Operational Risk
Management Committees. It will devise the policy and strategy for integrated
risk management containing various risk exposures of the bank including
26
 the credit risk. For this purpose, this Committee should effectively
coordinate between the Credit Risk Management Committee (CRMC), the
Asset Liability Management Committee and other risk committees of the
bank, if any. It is imperative that the independence of this Committee is
preserved. The Board should, therefore, ensure that this is not compromised
at any cost. In the event of the Board not accepting any recommendation of
this Committee, systems should be put in place to spell out the rationale for
such an action and should be properly documented. This document should
be made available to the internal and external auditors for their scrutiny and
comments. The credit risk strategy and policies adopted by the committee
should be effectively

Operations / Systems

Banks should have in place an appropriate credit administration,

credit risk measurement and monitoring processes. The credit
administration process typically involves the following phases:

1. Relationship management phase i.e. business development.

2. Transaction management phase covers risk assessment, loan pricing,

structuring the facilities, internal approvals, documentation, loan
administration, on going monitoring and risk measurement.

3. Portfolio management phase entails monitoring of the portfolio at a

macro level and the management of problem loans

4. On the basis of the broad management framework stated above, the

banks should have the following credit risk measurement and
monitoring procedures:

5. Banks should establish proactive credit risk management practices

like annual / half yearly industry studies and individual obligor
reviews, periodic credit calls that are documented, periodic visits of
plant and business site, and at least quarterly management reviews of
troubled exposures/weak credits

Credit Risk Models

27
 A credit risk model seeks to determine, directly or indirectly, the
answer to the following question: Given our past experience and our
assumptions about the future, what is the present value of a given loan or
fixed income security? A credit risk model would also seek to determine the
(quantifiable) risk that the promised cash flows will not be forthcoming. The
techniques for measuring credit risk that have evolved over the last twenty
years are prompted by these questions and dynamic changes in the loan
market.

The increasing importance of credit risk modeling should be seen as

the consequence of the following three factors:

1. Banks are becoming increasingly quantitative in their treatment of

credit risk.

2. New markets are emerging in credit derivatives and the marketability

of existing loans is increasing through securitization/ loan sales
market."

3. Regulators are concerned to improve the current system of bank

capital requirements especially as it relates to credit risk.

Importance of Credit Risk Models

Credit Risk Models have assumed importance because they provide

the decision maker with insight or knowledge that would not otherwise be
readily available or that could be marshalled at prohibitive cost. In a
marketplace where margins are fast disappearing and the pressure to lower
pricing is unrelenting, models give their users a competitive edge. The credit
risk models are intended to aid banks in quantifying, aggregating and
managing risk across geographical and product lines. The outputs of these
models also play increasingly important roles in banks' risk management
and performance measurement processes, customer profitability analysis,
risk-based pricing, active portfolio management and capital structure
decisions. Credit risk modeling may result in better internal risk
management and may have the potential to be used in the supervisory
oversight of banking organizations.

28
 RBI Guidelines on Credit Risk New Capital Accord: Implications
for Credit Risk Management

The Basel Committee on Banking Supervision had released in June

1999 the first Consultative Paper on a New Capital Adequacy Framework
with the intention of replacing the current broad-brush 1988 Accord. The
Basel Committee has released a Second Consultative Document in January
2001, which contains refined proposals for the three pillars of the New
Accord - Minimum Capital Requirements, Supervisory Review and Market
Discipline.

The Committee proposes two approaches, for estimating regulatory

capital. viz.,

1. Standardized and

2. Internal Rating Based (IRB)

Under the standardized approach, the Committee desires neither to

produce a net increase nor a net decrease, on an average, in minimum
regulatory capital, even after accounting for operational risk. Under the
Internal Rating Based (IRB) approach, the Committee's ultimate goals are
to ensure that the overall level of regulatory capital is sufficient to address
the underlying credit risks and also provides capital incentives relative to the
standardized approach, i.e., a reduction in the risk weighted assets of 2% to
3% (foundation IRB approach) and 90% of the capital requirement under
foundation approach for advanced IRB approach to encourage banks to
adopt IRB approach for providing capital.

The minimum capital adequacy ratio would continue to be 8% of the

risk-weighted assets, which cover capital requirements for market (trading
book), credit and operational risks. For credit risk, the range of options to
estimate capital extends to include a standardized, a foundation IRB and an
advanced IRB approaches.

29
 RBI Guidelines for Credit Risk Management Credit Rating
Framework

A Credit-risk Rating Framework (CRF) is necessary to avoid the

limitations associated with a simplistic and broad classification of
loans/exposures into a "good" or a "bad" category. The CRF deploys a
number/ alphabet/ symbol as a primary summary indicator of risks
associated with a credit exposure. Such a rating framework is the basic
module for developing a credit risk management system and all advanced
models/approaches are based on this structure. In spite of the advancement
in risk management techniques, CRF is continued to be used to a great
extent. These frameworks have been primarily driven by a need to
standardize and uniformly communicate the "judgment" in credit selection
procedures and are not a substitute to the vast lending experience
accumulated by the banks' professional staff.
Broadly, CRF can be used for the following purposes:

1. Individual credit selection, wherein either a borrower or a particular

exposure/ facility is rated on the CRF

2. Pricing (credit spread) and specific features of the loan facility. This
would largely constitute transaction-level analysis.

3. Portfolio-level analysis.

4. Surveillance, monitoring and internal MIS

Assessing the aggregate risk profile of bank/ lender. These would be relevant
for portfolio-level analysis. For instance, the spread of credit exposures
across various CRF categories, the mean and the standard deviation of
losses occurring in each CRF category and the overall migration of exposures
would highlight the aggregated credit-risk for the entire portfolio of the bank.

30
 OPERATIONAL RISK

What is Operational Risk?

Operational risk is the risk associated with
operating a business. Operational risk covers such a wide area that it is
useful to subdivide operational risk into two components:
Operational failure risk.
Operational strategic risk.

Operational failure risk arises from the potential for failure in the
course of operating the business. A firm uses people, processes and
technology to achieve the business plans, and any one of these factors may
experience a failure of some kind. Accordingly, operational failure risk can be
defined as the risk that there will be a failure of people, processes or
technology within the business unit. A portion of failure may be anticipated,
and these risks should be built into the business plan. But it is
unanticipated, and therefore uncertain, failures that give rise to key
operational risks. These failures can be expected to occur periodically,
although both their impact and their frequency may be uncertain.
The impact or severity of a financial loss can be divided into two
categories:
An expected amount
An unexpected amount.
The latter is itself subdivided into two classes: an amount classed as severe,
and a catastrophic amount. The firm should provide for the losses that arise

31
from the expected component of these failures by charging expected revenues
with a sufficient amount of reserves. In addition, the firm should set aside
sufficient economic capital to cover the unexpected component, or resort to
insurance.

Operational strategic risk arises from environmental factors, such as a

new competitor that changes the business paradigram, a major political and
regulatory regime change, and earthquakes and other such factors that are
outside the control of the firm. It also arises from major new strategic
initiatives, such as developing a new line of business or re-engineering an
existing business line. All business rely on people, processes and technology
outside their business unit, and the potential for failure exists there too, this
type of risk is referred to as external dependency risk.

Operational Risk

Operational failure risk Operational strategic risk

(Internal operational risk) (External operational risk)

The risk encountered in pursuit The risk of choosing an

of a particular strategy due to: inappropriate strategy in
response to environmental
People factor, such as
Process
Technology Political
32 Taxation
Regulation
Figure: Two Broad Categories Government
of Operational Risk
Societal
Competition, etc.
The figure above summarizes the relationship between operational failure
risk and operational strategic risk. These two principal categories of risk are
also sometimes defined as internal and external operational risk.

Operational risk is often thought to be limited to losses that can occur

in operating or processing centers. This type of operational risk, sometimes
referred as operations risk, is an important component, but it by no means
covers all of the operational risks facing the firm. Our definition of
operational risk as the risk associated with operating the business means
significant amounts of operational risk are also generated outside the
processing centers.
Risk begins to accumulate even before the design of the potential
transaction gets underway. It is present during negotiations with the client
(regardless of whether the negotiation is a lengthy structuring exercise or a
routine electronic negotiation.) and continues after the negotiation as the
transaction is serviced.
A complete picture of operational risk can only be obtained if the
banks activity is analyzed from beginning to end. Several things have to be
in place before a transaction is negotiated, and each exposes the firm to
operational risk. The activity carried on behalf of the client by the staff can
expose the institution to people risk. People risk are not only in the form
of risk found early in a transaction. But they further rely on using
sophisticated financial models to price the transaction. This creates what is
called as Model risk which can arise because of wrong parameters like input
to the model, or because the model is used inappropriately and so on.

33
 Once the transaction is negotiated and a ticket is written, errors can
occur as the transaction is recorded in various systems or reports. An error
here may result in the delayed settlement of the transaction, which in turn
can give rise to fines and other penalties. Further an error in market risk
and credit risk report might lead to the exposures generated by the deal
being understated. In turn this can lead to the execution of additional
transactions that would otherwise not have been executed. These are
examples of what is often called as process risk
The system that records the transaction may not be capable of
handling the transaction or it may not have the capacity to handle such
transactions. If any one of the step is out-sourced, then external dependency
risk also arises. However, each type of risk can be captured either as people,
processes, technology, or an external dependency risk, and each can be
analyzed in terms of capacity, capability or availability

Who Should Manage Operational Risk?

The responsibility for setting policies concerning operational risk
remains with the senior management, even though the development of those
policies may be delegated, and submitted to the board of directors for
approval. Appropriate policies must be put in place to limit the amount of
operational risk that is assumed by an institution. Senior management
needs to give authority to change the operational risk profile to those who
are the best able to take action. They must also ensure that a methodology
for the timely and effective monitoring of the risks that are incurred is in
place. To avoid any conflict of interest, no single group within the bank
should be responsible for simultaneously setting policies, taking action and
monitoring risk.

Internal Audit

Senior
Management
Business Management Risk Management

Legal Insurance
Operations Finance
Information
Technology
34
 POLICY SETTING

The authority to take action generally rests with business

management, which is responsible for controlling the amount of operational
risk taken within each business line. The infrastructure and the governance
groups share with business management the responsibility for managing
operational risk.
The responsibility for the development of a methodology for measuring
and monitoring operational risks resides most naturally with group risk
management functions. The risk management function also needs to ensure
the proper operational risk/ reward analysis is performed in the review of
existing businesses and before the introduction of new initiatives and
products. In this regard, the risk management function works very closely
with, but independent from, business management, infrastructure, and
other governance group
Senior management needs to know whether the responsibilities it has
delegated are actually being tended to, and whether the resulting processes
are effective. The internal audit function within the bank is charged with this
responsibility.

Key to Implementing Bank-wide Operational Risk Management:

The eight key elements are necessary to successfully implement a
bank-wide operational risk management framework. They involve setting
policy and identifying risk as an outgrowth of having designed a common
language, constructing business process maps, building a best measurement
methodology, providing exposure management, installing a timely reporting
capability, performing risk analysis inclusive of stress testing, and allocating
economic capital as a function of operational risk.

EIGHT KEY ELEMENTS TO ACHIEVE BEST OPERATIONAL RISK

MANAGEMENT.

1. Policy
35 2.Risk Identification
 8. Economic Capital

7. Risk Analysis Best Practice 3. Business Process

6. Reporting 4. Measuring Methodology

5. Exposure Management

1. Develop well-defined operational risk policies. This includes explicitly

articulating the desired standards for the risk measurement. One also
needs to establish clear guidelines for practices that may contribute to
a reduction of operational risk.
2. Establish a common language of risk identification. For e.g., the term
people risk includes a failure to deploy skilled staff. Technology risk
would include system failure, and so on.
3. Develop business process maps of each business. For e.g., one should
create an operational risk catalogue which categories and defines the
various operational risks arising from each organizational unit in
terms of people, process, and technology risk. This catalogue should
be tool to help with operational risk identification and assessment.

Types of Operational Failure Risk

1. People Risk 1. Incompetancy.
2. Fraud.
2. Process Risk
Model Risk 1. Model/ methodology error
2. Mark-to-model error.
TR 1. Execution error.
2. Product complexity.
3. Booking error.
OCR 4. Settlement error.
1. Exceeding limits.
2. Security risk.
3.Volume risk.
3. Technology Risk 1. System failure.

36
 2. Programming error.
3. Information risk.
4. Telecommunications failure.

4. Develop a comprehensible set of operational risk metrics. Operational

risk assessment is a complex process. It needs to be performed on a
firm-wide basis at regular intervals using standard metrics. In early
days, business and infrastructure groups performed their own
assessment of operational risk. Today, self-assessment has been
discredited. Sophisticated financial institutions are trying to develop
objective measures of operational risk that build significantly more
reliability into the quantification of operational risk.
5. Decide how to manage operational risk exposure and take appriate
action to hedge the risks. The bank should address the economic
question of th cost-benefit of insuring a given risk for those operational
risks that can be insured.
6. Decide how to report exposure.
7. Develop tools for risk analysis, and procedures for when these tools
should deploped. For e.g., risk analysis is typically performed as part
of a new product process, periodic business reviews, and so on. Stress
testing should be a standard part of risk analysis process. The
frequency of risk assessment should be a function of the degree to
which operational risks are expected to change over time as businesses
undertake new initiatives, or as business circumstances evolve. This
frequency might be reviewed as operational risk measurement is rolled
out across the bank a bank should update its risk assessment more
frequently. Further one should reassess whenever the operational risk
profile changes significantly.
8. Develop techniques to translate the calculation of operational risk into
a required amount of economic capital. Tools and procedures should
be developed to enable businesses to make decisions about operational
risk based on risk/reward analysis.

Four-Step Measurement Process For Operational Risk

Clear guiding principle for the operational risk measurement process
should be set to ensure that it provides an appropriate measure of
operational risk across all business units throughout the bank. This problem
of measuring operational risk can be best achieved by means of a four-step

37
operational risk process. The following are the four steps involved in the
process:
1. Input.
2. Risk assessment framework.
3. Review and validation.
4. Output.
1. Input:
The first step in the operational risk measurement process is to gather
the information needed to perform a complete assessment of all significant
operational risks. A key source of this information is often the finished
product of other groups. For example, a unit that supports the business
group often publishes report or documents that may provide an excellent
starting point for the operational risk assessment.

Sources of Information in the Measurement Process of Operational Risk

:The Inputs (for Assessment)
Likelihood of Occurrence Severity
Audit report Management interviews
Regulatory report Loss history
Management report
Expert opinion
Business Recovery Plan
Business plans
Budget plans
Operations plans

For example, if one is relying on audit documents as an indication of

the degree of control, then one needs to ask if the audit assessment is
current and sufficient. Have there been any significant changes made since
the last audit assessment? Did the audit scope include the area of
operational risk that is of concern to the present risk assessment? As one
diligently works through available information, gaps often become apparent.
These gaps in the information often need to be filled through discussion with
the relevant managers.
Typically, there are not sufficient reliable historical data available to
confidently project the likelihood or severity of operational losses. One often
needs to rely on the expertise of business management, until reliable data
are compiled to offer an assessment of the severity of the operational failure
38
for each of the risks. The time frame employed for all aspects of the
assessment process is typically one year. The one-year time horizon is
usually selected to align with the business planning cycle of the bank.

2. Risk Assessment Framework

The input information gathered in the above step needs to be analyzed
and processed through the risk assessment framework. Risk assessment
framework includes:
1. Risk categories:
The operational risk can be broken down into four headline risk
categories like the risk of unexpected loss due to operational failure in
people, process and technology deployed within the business
Internal dependencies should each be reviewed according to a set of
factors. We examine these 9nternal dependencies according to three key
components of capability, capacity and availability.
External dependencies can also be analyzed in terms of the specific type
of external interaction.
2. Connectivity and interdependencies
The headline risk categories cannot be viewed in isolation from one
another. One needs to examine the degree of interconnected risk
exposures that cut across the headline operational risk categories, in
order to understand the full impact of risk.
3. Change, complexity, compliancy:
One may view the sources that drive the headline risk categories as
falling under the broad categories of Change refers to such items as
introducing new technology or new products, a merger or acquisition, or
moving from internal supply to outsourcing, etc. Complexity refers to
such items as complexity of products, process or technology.
Complacency refer to ineffective management of the business.
4. Net likelihood assessment
The likelihood that an operational failure might occur within the next year
should be assessed, net of risk mitigants such as insurance, for each
identified risk exposure and for each of the four headline risk categories.
Since it is often unclear how to quantify risk, this assessment can be
rated along five point likelihood continuum from very low, low, medium,
high and very high.

39
 5. Severity assessment
Severity describes the potential loss to the bank given that an
operational risk failure has occurred. It should be assessed for each
identified risk exposure.
6. Combined likelihood and severity into the overall Operational Risk
Assessment
Operational risk measures are constrained in that there is not usually a
defensible way to combine the individual likelihood of loss and severity
assessments into overall measure of operational risk within a business
unit. To do so, the likelihood of loss would need to be expressed in
numerical terms. This cannot be accomplished without statistically
significant historical data on operational losses.
7. Defining Cause and Effect:
Loss data are easier to collect than data associated with the cause of loss.
This complicates the measurement of operational risk because each loss
is likely to have several causes. This relationship between these causes,
and the relative importance of each, can be difficult to assess in an
objective fashion.
3. Review and validation:
Once the report is generated. First the centralised operational risk
management group (ORMG) reviews the assessment results with senior
business unit management and key officers, in order to finalize the proposed
operational risk rating. Second, one may want an operational risk rating
committee to review the assessment a validation process similar to that
followed by credit rating agencies. This takes the form of review of the
individual risk assessments by knowledgeable senior committee personnel to
ensure that the framework has been consistently applied across businesses,
that there has been sufficient scrutiny to remove any imperfections, and so
on. The committee should have representation from business management,
audit, and functional areas, and be chaired by risk management unit.
4. Output
The final assessment of operational risk will be formally reported to
business management, the centralised risk-adjusted return on capital
(RAROC) group, and the partners in corporate governance such as internal
audit and compliance. The output of the assessment process has two main
uses:
1. The assessment provides better operational risk information to
management for use in improving risk management decisions.

40
 2. The assessment improves the allocation of economic capital to better
reflect the extent of the operational riskier, being taken by a business
unit.
3. The over all assessment of the likelihood of operational risk & severity
of loss for a business unit can be shown as:
Mgmt. Attention
Medium High
Risk Risk

Severity of Loss ($) Low Medium

Risk Risk

Likelihood of Loss ($)

A business unit may address its operational risks in several ways. First, one
can invest in business unit. Second, one can avoid the risk by withdrawing
from business activity. Third, one can accept and manage risk through
effective monitoring and control. Fourth, one can transfer risk to another
party. Of course, not all-operational risks are insurable, and in that case of
those that are insurable the required premium may be prohibitive. The
strategy and eventually the decision should be based on cost benefit
analysis.

An Idealized Bank Of The Future

The efficient bank of the future will be driven by a single analytical
risk engine that draws its data from a single logical data repository. This
engine will power front-, middle-, and back-office functions, and supply
information about enterprise-wide risk. The ability to control and manage
risk will be finely tuned to meet specific business objectives. For example, far
fewer significantly large losses, beyond a clearly articulate tolerance for loss,
will be incurred and the return to risk profile will be vastly improved.
With the appropriate technology in place, financial trading across all
asset classes will move from the current vertical, product-oriented
environment (e.g., swaps, foreign exchange, equities, loans, etc.) to a
horizontal, customer-oriented environment in which complex combinations
of asset types will be traded.
There will be less need for desks that specialize in single product lines.
The focus will shift to customer needs rather than instrument types. The

41
management of limits will be based on capital, set in such a manner so as to
maximize the risk-adjusted return on capital for the firm.
The firms exposure will be known and disseminated in real time.
Evaluating the risk of a specific deal will take into account its effect on the
firms total risk exposure, rather than simply the exposure of the individual
deal.
Banks that dominate this technology will gain a tremendous
competitive advantage. Their information technology and trading
infrastructure will be cheaper than todays by orders of magnitude.
Conversely, banks that attempt to build this infrastructure in-house will
become trapped in a quagmire of large, expensive IT departments-and poorly
supported software.
The successful banks will require far fewer risk systems. Most of which
will be based on a combination of industry standard, reusable, robust risk
software and highly sophisticated proprietary analytics. More importantly,
they will be free to focus on their core business and offer products more
directly suited to their customers desired return to risk profiles.

42
 Study of Operational Risk at Punjab National Bank

About Punjab National Bank

Established in 1895 at Lahore, undivided India, Punjab National Bank
(PNB) has the distinction of being the first Indian bank to have been started
solely with Indian capital.The bank was nationalised in July 1969 along with
13 other banks. From its modest beginning, the bank has grown in size and
stature to become a front-line banking institution in India at present. It is a
professionally managed bank with a successful track record of over 110
years.
It has the largest branch network in India - 4525 Offices including 432
Extension Counters spread throughout the country. With its presence
virtually in all the important centres of the country, Punjab National Bank
offers a wide variety of banking services which include corporate and
personal banking, industrial finance, agricultural finance, financing of trade
and international banking. Among the clients of the Bank are Indian
conglomerates, medium and small industrial units, exporters, non-resident
Indians and multinational companies. The large presence and vast resource
base have helped the Bank to build strong links with trade and industry.

Operational Risk
Punjab National Bank is exposed to many types of operational risk.
Operational risk can result from a variety of factors, including:
1. Failure to obtain proper internal authorizations,
2. Improperly documented transactions,
3. Failure of operational and information security procedures,
4. Computer systems,
5. Software or equipment,
6. Fraud,
7. Inadequate training and employee errors.
PNB attempts to mitigate operational risk by maintaining a comprehensive
system of internal controls, establishing systems and procedures to monitor
transactions, maintaining key backup procedures and undertaking regular
contingency planning.
I. Operational Controls and Procedures in Branches
PNB has operating manuals detailing the procedures for the processing of
various banking transactions and the operation of the application software.

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Amendments to these manuals are implemented through circulars sent to all
offices.
When taking a deposit from a new customer, PNB requires the new customer
to complete a relationship form, which details the terms and conditions for
providing various banking services.
Photographs of customers are also obtained for PNBs records, and specimen
signatures are scanned and stored in the system for online verification. PNB
enters into a relationship with a customer only after the customer is properly
introduced to PNB. When time deposits become due for repayment, the
deposit is paid to the depositor. System generated reminders are sent to
depositors before the due date for repayment. Where the depositor does not
apply for repayment on the due date, the amount is transferred to an
overdue deposits account for follow up.
PNB has a scheme of delegation of financial powers that sets out the
monetary limit for each employee with respect to the processing of
transactions in a customer's account. Withdrawals from customer accounts
are controlled by dual authorization. Senior officers have delegated power to
authorize larger withdrawals. PNBs operating system validates the check
number and balance before permitting withdrawals. PNBs banking software
has multiple security features to protect the integrity of applications and
data.
PNB gives importance to computer security and has s a comprehensive
information technology security policy. Most of the information technology
assets including critical servers are hosted in centralized data centers, which
are subject to appropriate physical and logical access controls.

II. Operational Controls and Procedures for Internet Banking

In order to open an Internet banking account, the customer must provide
PNB with documentation to prove the customer's identity, including a copy of
the customer's passport, a photograph and specimen signature of the
customer. After verification of the same, PNB opens the Internet banking
account and issues the customer a user ID and password to access his
account online.

III. Operational Controls and Procedures in Regional Processing

Centers & Central Processing Centers
To improve customer service at PNBs physical locations, PNB handles
transaction processing centrally by taking away such operations from

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branches. PNB has centralized operations at regional processing centers
located at 15 cities in the country. These regional processing centers process
clearing checks and inter-branch transactions, make inter-city check
collections, and engage in back office activities for account opening, standing
instructions and auto-renewal of deposits.
PNB has centralized transaction processing on a nationwide basis for
transactions like the issue of ATM cards and PIN mailers, reconciliation of
ATM transactions, monitoring of ATM functioning, issue of passwords to
Internet banking customers, depositing post-dated cheques received from
retail loan customers and credit card transaction processing. Centralized
processing has been extended to the issuance of personalized check books,
back office activities of non-resident Indian accounts, opening of new bank
accounts for customers who seek web broking services and recovery of
service charges for accounts for holding shares in book-entry form.

IV. Operational Controls and Procedures in Treasury

PNB has a high level of automation in trading operations. PNB uses
technology to monitor risk limits and exposures. PNBs front office, back
office and accounting and reconciliation functions are fully segregated in
both the domestic treasury and foreign exchange treasury. The respective
middle offices use various risk monitoring tools such as counterparty limits,
position limits, exposure limits and individual dealer limits. Procedures for
reporting breaches in
limits are also in place.
PNBs front office treasury operation for rupee transactions consists of
operations in fixed income securities, equity securities and inter-bank money
markets. PNBs dealers analyze the market conditions and take views on
price movements. Thereafter, they strike deals in conformity with various
limits relating to counterparties, securities and brokers. The deals are then
forwarded to the back office for settlement.

The inter-bank foreign exchange treasury operations are conducted through

Reuters dealing systems. Brokered deals are concluded through voice
systems. Deals done through Reuters systems are captured on a real time
basis for processing. Deals carried out through voice systems are input in
the system by the dealers for processing. The entire process from deal
origination to settlement and accounting takes place via straight through
processing. The processing ensures adequate checks at critical stages. Trade
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strategies are discussed frequently and decisions are taken based on market
forecasts, information and liquidity considerations. Trading operations are
conducted in conformity with the code of conduct prescribed by internal and
regulatory guidelines.
The Treasury Middle Office Group, monitors counterparty limits, evaluates
the mark-to-market impact on various positions taken by dealers and
monitors market risk exposure of the investment portfolio and adherence to
various market risk limits set up by the Risk, Compliance and Audit Group.
PNBs back office undertakes the settlement of funds and securities. The
back office has procedures and controls for minimizing operational risks,
including procedures with respect to deal confirmations with counterparties,
verifying the authenticity of counterparty checks and securities, ensuring
receipt of contract notes from brokers, monitoring receipt of interest and
principal amounts on due dates, ensuring transfer of title in the case of
purchases of securities, reconciling actual security holdings with the
holdings pursuant to the records and reports any irregularity or shortcoming
observed.

V. Audit
The Internal Audit Group undertakes a comprehensive audit of all business
groups and other functions, in accordance with a risk-based audit plan. This
plan allocates audit resources based on an assessment of the operational
risks in the various businesses. The Internal Audit group conceptualizes and
implements improved systems of internal controls, to minimize operational
risk. The audit plan for every fiscal year is approved by the Audit Committee
of PNBs board of directors. The Internal Audit group also has a dedicated
team responsible for information technology security audits. Various
components of information technology from applications to databases,
networks and operating systems are covered under the annual audit plan.

REFERENCES

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Books:
Galai, Mark, Crouny , Risk Management, second edition.
Bhole L. M, Financial Institutions and Markets Structure,
Growth and Innovations, fourth edition.
Gleason T .James, Risk. The new Management Imperative in
Finance, fourth edition
Saunders Anthony, Credit Risk Management, second edition.
Schleiferr Bell, Risk Management, third edition.

WEBSITES:
www.rbi.org
www.bis.com
www.iib.org
www.pnbindia.com
www.google.co.in

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