CAIIB BFM Unit 8 - Risk and Basic Risk Management Framework

Risk Management

Risk and Capital
Risk is possible unfavorable impact on net cash flow in future due to uncertainty of happening or non-happening of events. Capital is a cushion or shock observer required to absorb potential losses in future. Higher the Risks, high will be the requirement of Capital and there will be rise in RAROC (Risk Adjusted Return on Capital).

Types of Risks
Risk is anticipated at Transaction level as well as at Portfolio level.

Transaction Level
Credit Risk, Market Risk and Operational Risk are transaction level risk and are managed at Unit level.

Portfolio Level
Liquidity Risk and Interest Rate Risk are also transaction level risks but are managed at Portfolio level.

Risk Measurement

Based on Sensitivity
It is change in Market Value due to 1% change in interest rates. The interest rate gap is sensitivity of the interest rate margin of Banking book. Duration is sensitivity of Investment portfolio or Trading book.

Based on Volatility:
It is common statistical measure of dispersion around the average of any random variable such as earnings, Markto market values, losses due to default etc.

Statistically Volatility is Standard deviation of Value of Variables
Calculation
Example 1 : We have to find volatility of Given Stock price over a given period. Volatility may be weekly or monthly. Suppose we want to calculate weekly volatility. We will note down Stock price of nos. of weeks.
Mean Price = 123.62 and
Variance (sum of Squared deviation from mean) is 82.70
(extracted from weekly Stock prices)
Volatility i.e. sd = ∫Variance = ∫82.70 = 9.09
Volatility over Time Horizon T = Daily Volatility X ∫T

Example 2
Daily Volatility =1.5%
Monthly Volatility = 1.5 X ∫30 = 1.5 X 5.48 = 8.22
Volatility will be more if Time horizon is more.

Downside Potential
It captures only possible losses ignoring profits and risk calculation is done keeping in view two components:
1. Potential losses
2. Probability of Occurrence.

The measure is more relied upon by banks/FIs/RBI. VaR (Value at Risk is a downside Risk Measure.)

Risk Pricing Risk Premium is added in the interest rate because of the following:
• Necessary Capital is to be maintained as per regulatory requirements.
• Capital is raised with cost.

For example there are 100 loan accounts with Level 2 Risk. It means there can be average loss of 2% on such type of loan accounts: Risk Premium of 2% will be added in Rate of Interest.

Pricing includes the following:
1. Cost of Deploying funds
2. Operating Expenses
3. Loss Probabilities
4. Capital Charge