CAIIB BFM Unit 9 - Risk Mitigation

Credit Risk can be mitigated by accepting Collaterals, 3rd party guarantees, Diversification of Advances and Credit Derivatives.
Interest rate Risk can be reduced by Derivatives of Interest Rate Swaps.
Forex Risk can be reduced by entering into Forward Contracts and Futures etc.

If we make advances to different types of business with different Risk percentage, the overall risk will be reduced through diversification of Portfolio.

Banking Book, Trading Book and Off Balance Sheet Items

Banking Book
It includes all advances, deposits and borrowings which arise from Commercial and Retail Banking. These are Held till maturity and Accrual system of accounting is applied. The Risks involved are: Liquidity Risk, Interest Rate Risk, Credit Default Risk, Market Risk and Operational Risk.

Trading Book
It includes Assets which are traded in market.
• These are not held till maturity.
• The positions are liquidated from time to time.
• These are Mark- to–market i.e. Difference between market price and book value is taken as profit.
• Trading Book comprises of Equities, Foreign Exchange Holdings and Commodities etc.
• These also include Derivatives

The Risks involved are Market Risks. However Credit Risks and Liquidity Risks can also be there.

Off Balance Sheet Exposures
The Off Balance sheet exposures are Contingent Liabilities, Guarantees, LC and other obligations. It includes Derivatives also. These may form part of Trading Book or Banking Book after they become Fund based exposure.

Types of Risks

1. Liquidity Risk
It is inability to obtain funds at reasonable rates for meeting Cash flow obligations. Liquidity Risk is of following types:

Funding Risk: It is risk of unanticipated withdrawals and non-renewal of FDs which are raw material for Fund based facilities.

Time Risk: It is risk of non-receipt of expected inflows from loans in time due to high rate NPAs which will create liquidity crisis.

Call Risk: It is risk of crystallization of contingent liabilities.

2. Interest Rate Risk
Risk of loss due to adverse movement of interest rates. Interest rate risk is of following types:

Gap or Mismatch Risk: The risk of Gap between maturities of Assets and Liabilities. Sometimes, Long term loans are funded by short term deposits. After maturity of deposits, these liabilities are get repriced and Gap of Interest rates between Assets and Liabilities may become narrowed thereby reduction of profits.

Basis Risks: Change of Interest rates on Assets and Liabilities may change in different magnitudes thus creating variation in Net Interest Income.
Yield Curve Risk: Yield is Internal Rate of Return on Securities. Higher Interest Rate scenario will reduce Yield and thereby reduction in the value of assets. Adverse movement of yield will certainly affect NII (Net Interest Income).

Embedded Option Risk : Adverse movement of Interest Rate may result into pre-payment of CC/DL and TL. It may also result into pre-mature withdrawal of TDs/RDs. This will also result into reduced NII. This is called Embedded Risk.

Re-investment Risk: It is uncertainty with regard to interest rate at which future cash flows could be reinvested.

3. Market Risk
Market Risk is Risk of Reduction in Mark-to-Market value of Trading portfolio i.e. equities, commodities and currencies etc. due to adverse market sensex. Market Risk comprises of:

- Price Risk occurs when assets are sold before maturity. Bond prices and Yield are inversely related.
- IRR affects the price of the instruments.
- Price of Other commodities like Gold etc,. is also affected by the market trends.
- Forex Risks are also Market Risks.
- Liquidity Risk or Settlement Risk is also present in the market.

4. Credit Risk or Default Risk
Credit Risk is the risk of default by a borrower to meet commitment as per agreed terms and conditions. There are two types of credit Risks:

Counter party Risk: This includes non-performance by the borrower due to his refusal or inability.

Country Risk : When non-performance of the borrower arises due to constrains or restrictions imposed by a country.

5. Operational Risk
Operation Risk is the risk of loss due to inadequate or Failed Internal procedures, people and the system. The external factors like dacoity, floods, fire etc. may also cause operational loss. It includes Frauds Risk, Communication Risk, Documentation Risk, Regulatory Risk, Compliance Risk and legal risks but excludes strategic /reputation risks.

Two of these risks are frequently occurred.

Transaction Risk: Risk arising from fraud, failed business processes and inability to maintain Business Continuity.
Compliance Risk: Failure to comply with applicable laws, regulations, Code of Conduct may attract penalties and compensation.

Other Risks are:
1. Strategic Risk: Adverse Business Decisions, Lack of Responsiveness to business changes and no strategy to achieve business goals.
2. Reputation Risk ; Negative public opinions, Decline in Customer base and litigations etc.
3. Systemic Risks ; Single bank failure may cause collapse of whole Banking System and result into large scale failure of banks.
In 1974, closure of HERSTATT Bank in Germany posed a threat for the entire Banking system