RISK MANAGEMENT IN BANKING SECTOR
CHAPTER I: INTRODUCTION
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RISK MANAGEMENT IN BANKING SECTOR
THEME OF THE STUDY Risk management underscores the fact that the survival of an organization depends heavily on its capabilities to anticipate and prepare for the change rather than just waiting for the change and react to it. The objective of risk management is not to prohibit or prevent risk taking activity, but to ensur ensuree that that the the risk riskss are are cons consci cious ously ly take taken n with with full full know knowle ledg dge, e, purpo purpose se and and clear clear understanding so that it can be measured and mitigated. It also prevents an institution from suffering unacceptable loss causing an institution to suffer or materially damage its competitive position. Functions of risk management should actually be bank specific dictated by the size and uality of balance sheet, comple!ity of functions, technical" professional manpower and the status of #I$ in place in that bank.
1.2 INTRODUCTION Risk: the meaning meaning of %Risk& %Risk& as per 'ebst 'ebster& er&ss compre comprehens hensive ive dictio dictionar nary y is (a chance chance of
encountering harm or loss, hazard, danger) or (to e!pose to a chance of injury or loss). Thus, something that has potential to cause harm or loss to one or more planned objectives is called Risk. The word risk is derived from an Italian word (Risicare) which means (To *are). It is an e!pression of danger of an adverse adve rse deviation in the actual result from any e!pected result. +anks for International $ettlement +I$- has defined it as (Risk is the threat that an event or action will adversely affect an organization&s ability to achieve its objectives and successfully e!ecute its strategies.) Risk Manageen!: Risk #anagement is a planned method of dealing with the potential loss or
damage. It is an ongoing process of risk appraisal through various methods and tools which continuously
•
/ssess what could go wrong
•
*etermine which risks are important to deal with
•
Implement strategies to deal with those risks
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1." STUDY PROB#EM +asel II norms came as an attempt to reduce the gap in point of views between conflict practices. Therefore, Therefore, the implementa implementation tion of those resolutions resolutions emerged by the banks. Regarding this issue issue the survey has been made.
$tudy problem can be stated as follows0 T$ %&a! e'!en! (anks &a)e i*+een!e, Base+ II n$-s -e+a!e, !$ en&aning in!e-na+ $n!-$+ in !&e (anks/
1.0 OBECTIES
1overing different aspects of risk assessment
Identifying keys for effective risk management
To understand the challenges and impact of Implementing +asel II
To analyze the current progress of +asel II in 2ubli.
1.3 METHODO#OGY
3iterature Review
*ata collection
4rimary information0 4ersonal interview" 5uestionnaire
$econdar $econdary y inform informati ation0 on0 Through Through intern internet, et, #anual #anuals, s, 6ourna 6ournals ls,, /udit /udit"/n "/nnua nuall reports
The +enefits and limitation of +asel II
The 1hallenges of Implementing +asel II
Impact of +asel II
Research method
Findings and suggestions
1onclusion BABASAB PATIL
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RISK MANAGEMENT IN BANKING SECTOR
CHAPTER II: #ITRETURE REIE4
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RISK MANAGEMENT IN BANKING SECTOR
2.1 INTRODUCTION Base+ I A$-,: The +asel 1ommittee on +anking $upervision, which came into e!istence in
789:, volunteered to develop a framework for sound banking practices internationally. In 78;; the full set of recommendations was documented and given to the 1entral banks of the countries for implementation to suit their national systems. This is called the +asel 1apital /ccord or +asel I /ccord. It provided level playing field by stipulating the amount of capital that needs to be maintained by internationally active banks.
Base+ II A$-,: +anking has changed dramatically since the +asel I document of 78;;.
/dvances in risk management and the increasing comple!ity of financial activities " instruments like options, hybrid securities etc.- prompted international supervisors to review the appropriateness of regulatory capital standards under +asel I. To meet this reuirement, the +asel I accord was amended and refined, which came out as the +asel II accord.
The new proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the various risks that banks have to face and realign regulatory capital more closely with underlying risks.
= Risk based capital 4illar 7= Risk based supervision 4illar >= Risk disclosure to enforce market discipline 4illar ?-
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2.2 BASE# II FRAME4ORK T&e ne% *-$*$sa+ is (ase, $n !&-ee 5!5a++6 -ein7$-ing *i++a-s !&a! a++$% (anks an, s5*e-)is$-s !$ e)a+5a!e *-$*e-+6 !&e )a-i$5s -isks !&a! (anks 7ae an, -ea+ign -eg5+a!$-6 a*i!a+ $-e +$se+6 %i!& 5n,e-+6ing -isks.
Base+ II F-ae%$-k
Pi++a- I
Pi++a- II
Pi++a- III
Mini5 Ca*i!a+
S5*e-)is$-6
Ma-ke!
Re85i-een!s
Re)ie% P-$ess
Disi*+ine
2.2.1 THE FIRST PI##AR 9 MINIMUM CAPITA# REUIREMENTS The first pillar sets out minimum capital reuirement for the bank. The new framework maintains minimum capital reuirement of ;@ of risk assets. +asel II focuses on improvement in measurement of risks. The revised credit risk measurement methods are more elaborate than the current accord. It proposes for the first time, a measure for operational risk, while the market risk measure remains unchanged.
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2.2.2 THE SECOND PI##AR ; SUPERISORY REIE4 PROCESS $upervisory review process has been introduced to ensure not only that bank have adeuate capital to support all the risks, but also to encourage them to develop and use better risk management techniues in monitoring and managing their risks. The process has four key principles a- +anks should have a process for assessing their overall capital adeuacy in relation to their risk profile and a strategy for monitoring their capital levels.
b- $upervisors should review and evaluate bank&s internal capital adeuacy assessment and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios.
c- $upervisors should e!pect banks to operate above the minimum regulatory capital ratios and should have the ability to reuire banks to hold capital in e!cess of the minimum.
d- $upervisors should seek to intervene at an early stage to prevent capital from decreasing below minimum level and should reuire rapid remedial action if capital is not mentioned or restored.
2.2." THE THIRD PI##AR 9 MARKET DISCIP#INE #arket discipline imposes strong incentives to banks to conduct their business in a safe, sound and effective manner. It is proposed to be effected through a series of disclosure reuirements on capital, risk e!posure etc. so that market participants can assess a bank&s capital adeuacy. These disclosures should be made at least semiannually and more freuently if appropriate. 5ualitative disclosures such as risk management objectives and policies, definitions etc. may be published annually.
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2." TYPES OF RISKS 'hen we use the term (Risk), we all mean financial risk or une!pected financial loss. If we consider risk in terms of probability or occur freuently, we measure risk on a scale, with certainty of occurrence at one end and certainty of nonoccurrence at the other end. Risk is the greatest phenomena where the probability of occurrence or nonoccurrence is eual. /s per the Reserve +ank of India guidelines issued in Act. 7888, there are three major types of risks encountered by the banks and these are 1redit Risk, #arket Risk B Aperational Risk. Further after eliciting views of banks on the draft guidelines on 1redit Risk #anagement and market risk management, the R+I has issued the final guidelines and advised some of the large 4$C banks to implement so as to gauge the impact. Risk is the potentiality that both the e!pected and une!pected events may have an adverse impact on the bank&s capital or its earnings. The e!pected loss is to be borne by the borrower and hence is taken care of by adeuately pricing the products through risk premium and reserves created out of the earnings. It is the amount e!pected to be lost due to changes in credit uality resulting in default. 'here as, the une!pected loss on account of the individual e!posure and the whole portfolio is entirely borne by the bank itself and hence care should be taken. Thus, the e!pected losses are covered by reserves"provisions and the une!pected losses reuire capital allocation.
2.".1 CREDIT RISK In the conte!t of +asel II, the risk that the obligor borrower or counterparty- in respect of a particular asset will default in full or in part on the obligation to the bank in relation to the asset is termed as 1redit Risk. 1redit Risk is defined as(The risk of loss arising from outright default due to inability or unwillingness of the customer or counter party to meet commitments in relation to lending, trading, hedging, settlement and other financial transaction of the customer or counter party to meet commitments). 1redit Risk is also defined, (as the potential that a borrower or counter party will fail to meets its obligations in accordance in agreed terms).
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2.".2 MARKET RISK It is defined as (the possibility of loss caused by changes in the market variables such as interest rate, foreign e!change rate, euity price and commodity price). It is the risk of losses in, various balance sheet positions arising from movements in market prices. R+I has defined market risk as the possibility of loss to a bank caused by changes in the market rates" prices. R+I Duidance Eote focus on the management of liuidity Risk and #arket Risk, further categorized into interest rate risk, foreign e!change risk, commodity price risk and euity price risk. #arket risk includes the risk of the degree of volatility of market prices of bonds, securities, euities, commodities, foreign e!change rate etc., which will change daily profit and loss over time it&s the risk of une!pected changes in prices or rates. It also addresses the issues of +anks ability to meets its obligation as and when du e, in other words, liuidity risk.
2."." OPERATIONA# RISK Aperational risk is the risk associated with the operations of an organization. It is defined as (risk of loss resulting from inadeuate or failed internal process, people and systems or from e!ternal events.) It includes legal risk. It e!cludes strategic and reputational risks, as the same are not uantifiable. Aperational risk includes the risk of loss arising from fraud, system failures, trading error and many other internal organizational risks as well as risk due to e!ternal events such as fire, flood etc. the losses due to operation risk can be direct as well as indirect. *irect loss means the financial losses resulting directly from an incident or an event. <.g. forgery, fraud etc. indirect loss means the loss incurred due to the impact of an incident.
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2.".0 REGU#ATORY RISK The owned funds alone are managed by an entity, it is natural that very few regulators operate and supervise them. 2owever, as banks accept deposit from public obviously better governance is e!pected from them. This entails multiplicity of regulatory controls. #any +anks, having already gone for public issue, have a greater responsibility and accountability in this regard. /s banks deal with public funds and money, they are subject to various regulations. The various regulators include Reserve +ank of India R+I-, $ecurities
2.".3 ENIRONMENTA# RISK /s the years roll the technological advancement takes place, e!pectation of the customers change and enlarges. 'ith the economic liberalization and globalization, more national and international players are operating the financial markets, particularly in the banking field. This provides the platform for environmental change and e!posure of the bank to the environmental risk. Thus, unless the banks improve their delivery channels, reach customers, innovate their products that are service oriented they are e!posed to the environmental risk.
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2.0 BASE#GG7 by +asel 1ommittee of +anking $upervision. It provides spectrum of approaches for the measurement of credit, market and operational risks to determine the capital reuired. The spread and nature of the ownership structure is important as it impinges on the propensity to induct additional capital. 'hile getting support from a large body of shareholders is a difficult proposition when the bank&s performance is adverse, a smaller shareholder base constrains the ability of the bank to garner funds. Tier I capital is not owed to anyone and is available to cover possible une!pected losses. It has no maturity or repayment reuirement, and is e!pected to remain a permanent component of the core capital of the counter party. 'hile +asel standards currently reuire banks to have a capital adeuacy ratio of ;@ with Tier I not less than :@, R+I has mandated the banks to maintain 1/R of 8@. The maintenance of capital adeuacy ratio is like aiming at a moving target as the composition of riskweighted assets gets changed every now and then on account of fluctuations in the risk profile of a bank. Tier I capital is known as the core capital providing permanent and readily available support to the bank to meet the une!pected losses. In the recent past, owners of 4$C banks, the government provided adeuate capital to weaker banks to ease the burden. In doing so, the government was not acting as a prudent investor as return on such capital was never a consideration. Further, capital infusion did not result in any cash flow to the receiver, as all the capital was reuired to be reinvested in government securities yielding low returns. Receipt of capital was just a book entry with the only advantage of income from the securities.
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2.3 CAPITA# ADEUACY $ubseuent to nationalization of banks, capitalization in banks was not given due importance as it was felt necessary for the reason that the ownership of the banks rested with the government, creating the reuired confidence in the mind of the public. 1ombined forces of globalization and liberalization compelled the public sector banks, hitherto shielded from the vagaries of market forces, come by the condition of terms market realities, where certain minimum capital adeuacy has to be maintained in the face of stiff norms in respect of income recognition, asset classification and provisioning. It is clear that multi pronged approach would be reuired to meet the challenges of maintaining capital at adeuate levels in the face of mounting risks in the banking sector. In banks, asset creation is an event happening subseuent to the capital formation and deposit mobilization.
2.= RISK AGGREGATION > CAPITA# A##OCATION 1apital /deuacy in relation to economic risk is a necessary condition for the longterm soundness of banks. /ggregate risk e!posure is estimated through Risk /djusted Return on 1apital R/RA1- and
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2.? RISK BASED SUPERISION @RBS The Reserve +ank of India presently has its supervisory mechanism by way of onsite inspection and offsite monitoring on the basis of the audited balance sheet of a bank. In order to enhance the supervisory mechanism, the R+I has decided to put in place, a system of Risk +ased $upervision. Cnder risk based supervision, supervisors are e!pected to concentrate their efforts on ensuring that financial institutions use the process necessarily to identify measure and control risk e!posure. The R+$ is e!pected to focus supervisory attention in accordance with the risk profile of the bank. The R+I has already structured the risk profile templates to enable the bank to make a selfassessment of their risk profile. It is designed to ensure continuous monitoring and evaluation of risk profile of the institution through risk matri!. This may optimize the utilization of the supervisory resources of the R+I so as to minimize the impact of a crises situation in the financial system. The transaction based audit and supervision is getting shifted to risk focused audit. Risk based supervision approach is an attempt to overcome the deficiencies in the traditional pointintime, transaction validation and value based supervisory system. It is forward looking enabling the supervisors to differentiate between banks to focus attention on those having highrisk profile. The implementation of risk based auditing would imply that greater emphasis is placed on the internal auditor&s role for mitigating risks. +y focusing on effective risk management, the internal auditor would not only offer remedial measures for current troubleprone areas, but also anticipate problems to play an active role in protecting the bank from risk hazards.
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2. RISK MANAGEMENT: KEYS FOR EFFECTIE RISK MANAGEMENT:
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To direct risk behaviour B influence the shape of a firm&s risk profile, management should use all available options. Csing financial incentives and penalties to influence risk taking behaviour is effective management tool.
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$haring of information by keeping confidentiality intact is also helpful to find out different ways for controlling the risk as valuable inputs may be received through this sharing.
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*iversification is e!tremely important. /s it lowers the variance in investor portfolios, improves corporate ability to raise debt, reduces employment risks, B heightens operating efficiency.
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Dovernance should never be ignored. 1areful structuring of the alliance in advance of the deal and continual adjustment thereafter help to build a constructive relationship.
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Ane should not trust while in business. 4ersonal chemistry is good but is no substitute for monitoring mechanism, cooperation incentives, B organizational alignment.
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'ithout support system within the organization itself, e!ternal alliances are doomed to fail.
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2..1 MARKET RISK MANAGEMENT: 'e may believe that there are limited tools available to mitigate this risk, but this is not so. Future, option, derivatives trading and its many sub types are some of the tools which help to investors to protect the investment or minimize there e!posure toward market risk. In case of derivatives as in broader sense derivatives are considered to be used to hedge against market risk, but they can be used to mitigate various other types of risks, like credit risk, operational risk. The importance of managing market risk has now been well understood by financial institutions and corporate across the world. #arket risk has made the global financial conditions uncertain and unsettled and still recovery of problem is not visible in the near time.
2..2 CREDIT RISK MANAGEMENT Tools of 1redit Risk #anagement0 The instruments and tools, through which credit risk is managed are0
2.." OPERATIONA# RISK MANAGEMENT: This risk can be reduced to great e!tent by effectively controlling organization as a whole by taking certain steps, like assuring that designed processes is carried out carefully B with the help of e!perts, and are followed in desired way.
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2. COMPUTATION OF CAPITA# REUIREMENT
2..1 CREDIT RISK APPROACHES C-e,i! Risk
S!an,a-,ie, a**-$a&
A,)ane, A**-$a&
F$5n,a!i$n IRB
A,)ane, IRB
S!an,a-,ie, a**-$a& 0 the +asel committee as well as R+I provides a simple methodology
for risk assessment and calculating capital reuirements for credit risk called $tandardized approach. This approach is divided into the following broad topics for simpler and easier understanding 7. /ssignment of Risk 'eights0 all the e!posures are first classified into various customer types defined by +asel committee or R+I. Thereafter, assignment of standard risk weights is done, either on the basis of customer type or on basis of the asset uality as determined by rating of the asset, for calculating risk weighted assets.
>.
?. 1redit Risk #itigation0 +asel recognized 1ollaterals and +asel recognized Duarantees are two securities that banks obtain for loans " advances to cover credit risk, which are termed as (1redit Risk #itigants)
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RISK MANAGEMENT IN BANKING SECTOR A,)ane, A**-$a&: +asel II framework also provides for advanced approaches to calculate
capital reuirement for credit risk. These approaches rely heavily on a banks internal assessment of its borrowers and e!posures. These advanced approached are based on the internal ratings of the bank and are popularly known as Internal Rating +ased IR+- approaches. Cnder /dvanced /pproaches, the banks will have > options as under a- Foundation Internal Rating +ased FIR+- /pproaches. b- /dvanced Internal Rating +ased /IR+- /pproaches.
The differences between foundation IR+ and advanced IR+ have been captured in the following table0 Table >.8.7.70 The differences between foundation IR+ and advanced IR+
Da!a In*5! 4robability of *efault
F$5n,a!i$n IRB A,)ane, IRB 4rovided by bank based on 4rovided by bank based on own
3oss Diven *efault
own estimates estimates $upervisory values set by the 4rovided by bank based on own
1ommittee estimates $upervisory values set by the 4rovided by bank based on own
1ommittee estimates $upervisory values set by the 4rovided by bank based on own 1ommittee
estimates Ar /t the national discretion, provided by bank based on own estimates
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2..2 MARKET RISK APPROACHES
Ma-ke! Risk
S!an,a-,ie,
In!e-na+ M$,e+
A**-$a&
Base, a**-$a&
Ma!5-i!6
D5-a!i$n
Base,
Base,
R+I has issued detailed guidelines for computation of capital charge on #arket Risk in 6une >GG:. The guidelines seek to address the issues involved in computing capital charge for interest rate related instruments in the trading book, euities in the trading book and foreign e!change risk including gold and precious metals- in both trading and banking book. Trading book will include0 •
$ecurities included under the 2eld for trading category
•
$ecurities included under the /vailable for $ale category
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Apen gold position limits
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Apen foreign e!change position limits
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Trading position in derivatives and derivatives entered into for hedging trading book e!posures.
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2.." OPERATIONA# RISK APPROACHES
O*e-a!i$na+ Risk
Basi In,ia!$-
S!an,a-,ie,
A**-$a&
A**-$a&
A,)ane, Meas5-een! A**-$a&
+asic Indicator /pproach0 Cnder the basic indicator approach, +anks are reuired to hold capital for operational risk eual to the average over the previous three years of a fi!ed percentage 7H@ denoted as alpha- of annual gross income. Dross income is defined as net interest income plus net noninterest income, e!cluding realized profit"losses from the sale of securities in the banking book and e!traordinary and irregular items.
$tandardized /pproach0 Cnder the standardized approach, banks activities are divided into eight business lines. 'ithin each business line, gross income is considered as a broad indicator for the likely scale of operational risk. 1apital charge for each business line is calculated by multiplying gross income by a factor denoted beta- assigned to that business line. Total capital charge is calculated as the threeyear average of the simple summations of the regulatory capital across each of the business line in each year.
/dvanced /dvanced #easurement #easurement /pproach0 Cnder advanced advanced measuremen measurementt approach, approach, the regulatory capital will be eual to the risk measures generated by the bank&s internal risk measurement system using the prescribed uantitative and ualitative criteria.
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2.1 BENEFITS OF BASE# II 1. Be!!e- a++$a!i$n $7 a*i!a+ an, -e,5e, i*a! $7 $-a+ &aa-, !&-$5g& -e,5!i$n in !&e s$*e 7$- -eg5+a!$-6 -eg5+a!$-6 a-(i!-age: a-(i!-age: +y assessing the amount of capital reuired for each e!posure
or pool of e!posures, the advanced approach does away with the simplistic risk buckets of current capital rules.
2. I*-$)e, signa+ 85a+i!6 $7 a*i!a+ as an in,ia!$- $7 s$+)en6: the proposed rule is
designed to more accurately align regulatory capital with risk, which will improve the uality of capital as an indicator of solvency.
". En En$5-a $5-ages ges (anking (anking $-gani $-gania!i$ a!i$ns ns !$ i*-$)e i*-$)e -e -e,i! ,i! -isk anage anageen!: en!: Ane of the
principal objectives of the proposed rule is to more closely align capital charges and risk. For any type type of credit credit,, risk risk increa increases ses as either either the probabi probabilit lity y of defaul defaultt or the loss given given defaul defaultt increases.
0. M$-e e77iien! 5se $7 -e85i-e, (ank a*i!a+: Increased risk sensitivity and improvements in
risk measurement will allow prudential objectives to be achieved more efficiently.
3. In$-*$-a!es an, en$5-ages a,)anes in -isk eas5-een! an, -isk anageen! 0 The
proposed rule seeks to improve upon e!isting capital regulations by incorporating advances in risk measurement and risk management made over the past 7H years.
=. Re$gni Re$gnies es ne% ,e)e+$* ,e)e+$*en en!s !s an, a$$, a$$,a!e a!ess $n!in5i $n!in5ing ng inn$)a!i inn$)a!i$n $n in 7inania 7inania++ *-$,5!s *-$,5!s (6 7$5sing $n -isk: The proposed rule also has the benefit of facilitating recognition
of new developments in financial products by focusing on the fundamentals behind risk rather than on static product categories.
?. Be!!e- a+ignen! $7 a*i!a+ an, $*e-a!i$na+ -isk an, en$5-ages (anking $-gania!i$ns !$ i!iga!e $*e-a!i$na+ -isk: Introducing an e!plicit capital calculation for operational risk
eliminates the implicit and imprecise (buffer) that covers operational risk under current capital rules.
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. En&ane, s5*e-)is$-6 7ee,(ak: all three pillars of the proposed rule aim to enhance
supervisory feedback from federal banking agencies to managers of banks and thrifts.
. En&ane, ,is+$s5-e *-$$!es a-ke! ,isi*+ine: The proposed rule seeks to aid market
discipline through the regulatory framework by reuiring specific disclosures relating to risk measurement and risk management.
1. P-ese-)es !&e (ene7i!s $7 in!e-na!i$na+ $nsis!en6 an, $$-,ina!i$n a&ie)e, %i!& !&e 1 Base+ A$-,: /n important objective of the 78;; /ccord was competitive consistency of
capital reuirements for banking organizations competing in global markets. +asel II continues to pursue this objective.
2.11 #IMITATIONS OF BASE# II:
1. #ak $7 s577iien! *5(+i kn$%+e,ge 0 knowledge about banks& portfolios and their future
riskweight, since this will also depend on whether banks will use the standardized or IR+ approaches.
2. #ak $7 *-eise kn$%+e,ge: as to how operational risk costs will be charged. The banks are
e!pected to benefit from sharpening up some aspects of their risk management practices preparation and for the introduction of the operational risk charge.
". #ak $7 $nsis!en6: at least at this stage, as to how insurance activities will be accounted for.
Ane treatment outlined in the 1apital /ccord is that banks deduct euity and other regulatory capital investments in insurance subsidiaries and significant minority investments in insurance entities. /n alternative to this treatment is to apply a risk weight age to insurance investments.
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2.12 CHA##ENGES FOR INDIAN BANKING SYSTEM UNDER BASE# II •
C$s!+6 Da!a(ase C-ea!i$n an, Main!enane P-$ess:
The most obvious impact of
+/$<3 II is the need for improved risk management and measurement. It aims to give impetus to the use of internal rating system by the international banks.
•
A,,i!i$na+ Ca*i!a+ Re85i-een!: 2ere is a worrying aspect that some of the banks will not
be able to put up the additional capital to comply with the new regulation and they may be isolated from the global banking system.
•
#a-ge P-$*$-!i$n $7 NPAs: / large number of Indian banks have significant proportion of
E4/s in their assets. /long with that a large proportion of loans of banks are of poor uality. There is a danger that a large number of banks will not be able to restructure and survive in the new environment. This may lead to forced mergers of many defunct banks with the e!isting ones and a loss of capital to the banking system as a whole.
•
In-ease, P-$;C6+ia+i!6: The increased importance to credit ratings under +asel II could
actually imply that the minimum reuirements could become procyclical as banks are reuired to raise capital levels for loans in times of economic crises.
•
#$% Deg-ee $7 C$-*$-a!e Ra!ing Pene!-a!i$n: India has as few as three established rating
agencies and the level of rating penetration is not very significant as, so far, ratings are restricted to issues and not issuers. 'hile +asel II gives some scope to e!tend the rating of issues to issuers, this would only be an appro!imation and it would be necessary for the system to move to ratings of issuers.
C-$ss B$-,e- Iss5es 7$- F$-eign Banks: In India, foreign banks are statutorily reuired to
maintain local capital and the following issues are reuired to be resolved 7. Jalidation of the internal models approved by their head offices and home country supervisor adopted by the Indian branches of foreign banks. >. *ate history maintained and used by the bank should be distinct for the Indian branches compared to the global data used by the head office ?. capital for operational risk should be maintained separately for the Indian branches in India
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2.10 IMPACT OF BASE# II IMP#EMENTATION ON THE INDIAN BANKING INDUSTRY 1. C&anges in Ca*i!a+ Risk 4eig&!e, Asse!s Ra!i$ @CRAR: #ost of the banks are already
adhering to the +asel II guidelines. 2owever, the Dovernment has indicated that a cushion should be maintained by the public sector banks and therefore their 1R/R should be above 7>@. +asel I focused largely on credit risk, whereas +asel II has ? risks to be considered, viz., credit risk, operational risk and market risks. /s +asel II considers all these ? risks, there are chances of a decline in the 1apital /deuacy Ratio.
2. Hig& $s!s 7$- 5*;g-a,a!i$n $7 !e&n$+$g6: Full implementation of the +asel II framework
would reuire upgradation of the bankwide information systems through better branch connectivity, which would entail huge costs and may raise ITsecurity issues. The implementation of +asel II can also raise issues relating to development of 2R skills and database management. $mall and medium sized banks may have to incur enormous costs to acuire reuired technology, as well as to train staff in terms of the risk management activities. There will be a need for technological up gradation and access to information like historical data etc.
". Ra!ing -isks: 4roblems embedded in +asel II norms include rating of risks by rating agencies.
'hether the country has adeuate number of rating agencies to discharge the functions in a +asel II compliant banking system, is a uestion for consideration. Further, to what e!tent the rating agencies can be relied upon is also a matter of debate.
0. I*-$)e, Risk Manageen! > Ca*i!a+ A,e85a6: Ane aspect that hold back the critics of
+asel II is the fact that it will tighten the risk management process, improve capital adeuacy and strengthen the banking system.
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RISK MANAGEMENT IN BANKING SECTOR 3. C5-!ai+en! $7 C-e,i! !$ In7-as!-5!5-e P-$e!s: The norms reuire a higher weight age
for project finance, curtailing credit to this is very crucial sector. The longterm impacts for this could be disastrous.
=. P-e7e-ene 7$- M$-!gage C-e,i! !$ C$ns5e- C-e,i! #$%e- Risk 4eig&!s !$ M$-!gage -e,i!: 4reference for #ortgage 1redit to 1onsumer 1redit 3ower Risk 'eights to #ortgage
credit would accentuate bankers& preference towards it visKvis consumer credit.
?. Base+ II: A,)an!age Big Banks: It would be far easier for the larger banks to implement the
norms, raising their uality of risk management and capital adeuacy. This combined with the higher cost of capital for smaller players would ueer the pitch in favour of the former. The larger banks would also have a distinct advantage in raising capital in euity markets.
. IT s*en,ing: A,)an!age !$ In,ian IT $*anies: An the flipside, Indian IT companies,
which have considerable e!pertise in the +F$I segment, stand to gain. #ajor Indian IT companies such as Ifle! and Infosys already have the products, which could help them develop an edge over their rivals from the developed countries.
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CHAPTER III: PROECT TASK
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".1 INTRODUCTION
The reason for conducting this survey was to establish how these new regulations were perceived in terms of priority, urgency and interest within the banks. In addition, aim is to provide a view on strategic issues and to report on key trends related to many aspects of compliance within the +asel II regulatory framework. Finally, to make recommendations on the opportunities offered by the new regulations for the risk management process.
".2 STUDY PROB#EM +asel II norms came as an attempt to reduce the gap in point of views between conflict practices. Therefore, the difference of bank implementation of those resolutions emerges. $tudy problem can be stated as follows0
T$ %&a! e'!en! (anks &a)e i*+een!e, Base+ II n$-s -e+a!e, !$ en&aning in!e-na+ $n!-$+ in !&e (anks/
"." OBECTIES
1overing different aspects of risk assessment
Identifying keys for effective risk management
To understand the challenges and impact of Implementing +asel II
To analyze the current progress of +asel II in 2ubli.
".".1 DATA CO##ECTION
4rimary information0 4ersonal interview" 5uestionnaire
$econdary information0 Through internet, #anuals, 6ournals, /udit"/nnual reports BABASAB PATIL
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".0 STUDY COERAGE AND SAMP#E
$tudy coverage consists of all bank employees within internal control, risk management, operations department, and credit department. 7G uestionnaires were distributed over 7G banks in 2ubli, selected on random sampling techniue.
The survey assesses the readiness of the banking industry for implementing the +asel II regulatory framework and provides a view of the strategic issues and key trends related to the many aspects of compliance within this framework.
".3 SCOPE OF THE SUREY The +anking Industry has been assessed the readiness in seven areas0
/wareness of regulations
Arganizational structure
Reporting ability
1ompliance with +asel II
1apital allocation
+asel II action plan
Technology
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CHAPTER I: ANA#YSIS > INTERPRETATION
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0.1 A4ARENESS OF REGU#ATIONS S$5-e: A++ !&e (e+$% ana+6sis an, in!e-*-e!a!i$n is ,$ne 7-$ !&e s5-)e6 $n,5!e, in Banks.
7. 'hat is your assessment of your readiness for the new +asel proposals with respect to capital reuirementsL Table :.7.70 Readiness for the new +asel proposal FC33N 4R<4/R<* 4/RTI/33N 4R<4/R<* EAT N
1R<*T RI$M ; >
#/RM
A4
Figure :.7.7 Readiness for the new +asel proposal
>. 2ave you done a gap analysis between current risk management practice and new capital reuirementsL Table :.7.>0 Dap analysis
N<$ EA
1R<*T RI$M
#/RM
A4
8 7
H H
8 7
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Figure :.7.> Dap analysis ?. 'hat degree of priority do you address to the new +asel regulatory frameworkL Table :.7.?0 4riority to new +asel regulatory framework J
1R<*T RI$M 8 7
#/RM
A4
Figure :.7.? 4riority to new +asel regulatory framework :. 2ow do you view +asel II regulation0 as an opportunity to enhance the risk management process, or as a regulatory constraintL
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Table :.7.:0 Jiew of +asel II regulation
1R<*T
#/RM
A4
A44ARTCEITN
RI$M 7G
;
7G
1AE$TR/IET
>
Figure :.7.:0 Jiew of +asel II regulation OBSERATIONS
•
The majority of banks consider themselves to be fully prepared.
•
/ majority of banks have performed a gap analysis between their current risk management practice and the new capital reuirements.
•
Anly one bank does not view +asel II implementation as a high priority project.
•
The banks largely believe that +asel II will provide them an opportunity to enhance risk management.
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RISK MANAGEMENT IN BANKING SECTOR INTERPRETATION •
/lthough the +asel II regulations are considered important to very important by a strong majority of banks, some are only partly prepared for implementation.
•
The banks aim to look beyond the regulatory aspects and aim to benefit from the new regulations as a means to enhanced risk management.
0.2 ORGANISTIONA# STRUCTURE 7. *o you have an assigned 1redit risk, #arket risk and Aperational risk manager in your bankL Table :.>.70 /ssignment of risk manager
N<$ EA
1R<*T RI$M
#/RM
A4
7G
8 7
8 7
Figure :.>.70 /ssignment of risk manager
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>. To whom does the Risk manager reportL Table :.>.>0 'hom does risk manager report 12I
1R<*T
#/RM
A4
RI$M :
RI$M P
RI$M P
>
7
7
:
>
>
Figure :.>.>0 'hom does risk manager reportL
?. 'hat is the assigned manager&s time dedicated to this activityL Table :.>.?0 Time dedication
G>G@ >GHG@ QHG@
1R<*T RI$M
#/RM
A4
> > P
: 7 H
> > P
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Figure :.>.?0 Time dedication :. 2ow many people work in these departmentsL Table :.>.:0 Eumber of people work
7 ? ? H H 7G Q 7G
1R<*T RI$M
#/RM
A4
> P 7 7
: : 7 7
7 H 7 ?
Figure :.>.:0 Eumber of people work H. *o you have a Risk 1ommitteeL
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Table :.>.H0 Risk 1ommittee
N<$ EA
1R<*T RI$M
#/RM
A4
P :
H H
P :
Figure :.>.H0 Risk 1ommittee OBSERATIONS •
/lmost all of the participating banks have a risk management departemnt.
•
#ost of the industry&s risk managers& report to the 1hief
•
$lightly more attention is paid to credit and operational risk than to #arket risk, as :G @ of the banks operating do not have risk committee.
INTERPRETATION
•
*espite the relatively small size of banks, they are generally well aware of the risk management function, and for this purpose, risk managers spend over half their time performing these functions.
0." REPORTING ABI#ITY
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7. /re you producing reporting for Table :.?.70 Reports produced for
1R<*T
RI$M R
#/RM
A4
: ; :
: ; :
4CR4A$<
Figure :.?.70 Reports produced for >. *oes e!ternal reporting drive your internal reportingL Table :.?.>0
: H 7
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#/RM
A4
H : 7
RI$M : H 7
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RISK MANAGEMENT IN BANKING SECTOR
Figure :.?.>0
#/RM
A4
$IDEIFI1/ET3N
Figure :.?.?0
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:. 2ow freuent is your internal reportingL Table :.?.:0 Freuency of internal reporting 1R<*T RI$M *aily 'eekly #onthly /nnually
#/RM
A4
7 ; 7
7 7 9 7
7 ; 7
Figure :.?.:0 Freuency of internal reporting
H. 'ill you produce specific internal reporting for 1redit, #arket and Aperational RiskL Table :.?.H0 4roduction of specific internal reporting
N<$ EA
1R<*T RI$M
#/RM
A4
7G
7G
7G
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Figure :.?.H0 4roduction of specific internal reporting OBSERATIONS
•
/ll risk reporting is compiled largely for monitoring and *ecision making purposes than Regulatory purpose.
•
/ll the +anks produce internal report.
•
#ost of the +anks produce Internal Report monthly.
•
#ost of the banks said
INTERPRETATION
•
Reporting for all risk still needs to be developed.
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0.0 COMP#IACE 4ITH BASE# II 7. 'hich approach will best suit your organizationL Table :.:.70 /pproach that best suit organization $T/E*/R* FACE*/TIAE /*J/E1<* *AE&T MEA'
1R<*T
#/RM
A4
RI$M ;
8
9
>
7
?
Figure :.:.70 /pproach that best suit organization
>. 2ave you performed a 1ost"+enefit analysis for each approach proposed by +asel IIL Table :.:.>0 1ost"+enefit analysis
N<$ EA
1R<*T RI$M
#/RM
A4
7G
; >
8 7
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Figure :.:.>0 1ost"+enefit analysis ?. In your situation, could regulatory capital consumption be motivation for0 Table :.:.?0 Regulatory capital consumption be motivation $TA44IED /1TIJITI<$ *
1R<*T RI$M #/RM 7 H 9
/1TIJITI<$ /15CIRIED
7
/1TIJITI<$ EAE<
7
7
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7
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RISK MANAGEMENT IN BANKING SECTOR
Figure :.:.?0 Regulatory capital consumption b e motivation OBSERATIONS
•
#ost of the banks believe that the standard approach is most appropriate for their purposes.
•
An the whole, a cost"benefit analysis has been done for each approach. It appears that the banks have completed their cost"benefit analysis only for their elected approach.
•
Regulatory capital consumption is motivated for developing activities.
INTERPRETATION
•
#ost of the banks would prefer to adopt the standard approach, but only few of those who would like to implement the advanced approach and they will implement.
•
The banks that would prefer to adopt the standard approach should try to adopt advanced approach.
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0.3 CAPITA# A##OCATION 7. 2ave you estimated the regulatory capital consumption for each of your individual businessesL Table :.H.70
N<$ EA
1R<*T RI$M
#/RM
A4
7G
8 7
7G
Figure :.H.70
>. 'ill you outsource activities with high capital consumptionL Table :.H.>0 Autsource activities for high capital con sumption
N<$ EA
1R<*T RI$M
#/RM
A4
: P
? 9
H 9
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Figure :.H.>0 Autsource activities for high capital consumption ?. 'ill you insure selected RiskL Table :.H.?0 Insure Risk
N<$ EA
1R<*T RI$M
#/RM
A4
9 ?
H H
P :
Figure :.H.?0 Insure Risk :. *o you intend allocating economic capital by +usiness linesL
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Table :.H.:0 /llocation of economic capital 1R<*T RI$M
#/RM
A4
N<$
;
9
;
EA
7
>
7
Figure :.H.:0 /llocation of economic capital
H. 'ill you make use of +asel II reuirements to implement an economic capital allocation throughout your business linesL Table :.H.H0 Cse of +asel II reuirements
N<$ EA
1R<*T RI$M
#/RM
A4
8
; 7
; 7
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Figure :.H.H0 Cse of +asel II reuirements OBSERATIONS
•
#ost of the banks do not outsource activities with high capital consumption.
•
2alf of the banks insure selected Risk.
•
+anks with less sophisticated approaches are likely to use regulatory capital as the basis for internal capital allocation.
INTERPRETATION
•
Jery few banks plan to outsource activities with high capital consumption, but the majority will insure their credit risks, while nearly half will plan to insure their market and operational risks.
•
/ strong majority of local banks will allocate economic capital according to business lines, while a stronger majority will use the +asel II reuirements to implement that capital allocation process.
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0.= BASE# II ACTION P#AN 7. 2ave you established an action plan to achieve the +asel II reuirementsL Table :.P.70
N<$ EA
1R<*T RI$M
#/RM
A4
7G
7G
7G
Figure :.P.70
>. 2ow will you e!ecute this action planL Table :.P.>0
IET
1R<*T RI$M
#/RM
A4
9
H
;
7
:
7
:
?
?
R<$ACR1<$
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Figure :.P.>0
1R<*T
#/RM
A4
T<12EA3ADN
RI$M ;
RI$M 9
;
1A##CEI1/TIAE
7
:
7
AT2
Figure :.P.?0 3argest spending area
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:. 2ow far are you in the implementation of your action planL Table :.P.:0 1urrent progress 1R<*T RI$M
#/RM
A4
H
9
H
H
?
H
EAT R33I$<* 4/RTI/33N R33I$<* FC33N R33I$<*
Figure :.P.:0 1urrent progress OBSERATIONS
•
/ll the banks established by an action plan to achieve the +asel II reuirements.
•
#ost of the banks e!ecute the action plan with internal resources than e!ternal resources.
•
3argest spending area is technology.
•
2alf of the bank&s implementation of action plan is partially realized and half fully realized.
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RISK MANAGEMENT IN BANKING SECTOR INTERPRETATION
•
The banks have generally determined an action plan to help them to meet +asel II reuirements. They have partially completed the actions reuired, and will continue with these action plans.
•
Those banks that have not yet begun implementation tend to be the smaller banks, with simpler business models, which reuire less time and resources to meet the +asel II reuirements.
0.? TECHNO#OGY 7. *oes your current IT infrastructure allow you to meet the +asel II reuirementsL Table :.9.70 IT infrastructure
N<$ EA
1R<*T RI$M
#/RM
A4
7G
; >
8 7
Figure :.9.70 IT infrastructure
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>. 'ill you develop an IT solution for Risk managementL Table :.9.>0 IT solution for Risk management
N<$ EA
1R<*T RI$M
#/RM
A4
9 ?
9 ?
9 ?
Figure :.9.>0 IT solution for Risk management
?. 2ave you completed a review of potential IT solutions availableL Table :.9.?0 Review of potential IT solutions available
T<12EA3ADN 1AE$C3TIED
1R<*T RI$M
#/RM
A4
H :
? P
: H
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Figure :.9.?0 Review of potential IT solutions available
:. 'hat difficulties do you foreseeL Table :.9.:0 *ifficulties that you foresee
1R<*T
#/RM
A4
IET
RI$M ?
7
7
1/4/+I3ITI<$ */T/+/$< *<$IDE #A*<3$ +C*D
7 7
7
: ?
P ?
7 7 : ?
AT2
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Figure :.9.:0 *ifficulties that you foresee OBSERATIONS
•
#ore than half of the +anking industry will use their IT infrastructure in its current format.
•
*ifficulties that banks foresee are more on *ata Dathering and 2uman Resource.
INTERPRETATION
•
The banks should train their employees, in order to overcome the difficulties in implementing the +asel II norms.
•
The banks should develop sufficient infrastructure to gather the reuired data.
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CHAPTER : FINDINGS AND SUGGESTIONS
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3.1 FINDINGS
•
1redit risk is generally well contained, but there are still problems associated with loan classification, loan loss provisioning, and the absence of c onsolidated accounts.
•
#arket risk and Aperational risk are clear challenge, as they are relatively new to the areas that were not well developed under the original +asel 1apital /ccord.
•
The new regulations will allow banks to introduce substantial improvements in their overall risk management capabilities, improving risk based performance measurement, capital allocation as portfolio management techniues.
•
Future comple!ity is e!pected because banks diversify their operations. It is e!pected that banks will diversify their operations to generate additional income sources, particularly feebased income i.e. non interest income, to improve returns.
•
+asel II leads to increase in *ata collection and maintenance of privacy and security in various issues.
•
The banks that would prefer to adopt the $tandard /pproach should try to adopt /dvanced /pproach.
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3.2 SUGGESTIONS
•
The +anks should review +asel II components and develop a vision, strategy and action plan for what is e!pected to be a suitable framework based on how the banking system evolves over time.
•
The +anks need regular engagement for sustained support. / ualified longterm advisor would be preferable.
•
/ workshop should be planned to produce a road map to +asel II 1ompliance.
•
Training and additional assistance to make it easier for the banking system to comply with new guidelines on market and operational risk.
•
*ata 4rivacy and security needs more attention
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CHAPTER I: CONC#USION
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=.1 CONC#USION
Implementation of +asel II has been described as a long journey rather than a destination by itself. Cndoubtedly, it would reuire commitment of substantial capital and human resources on the part of both banks and the supervisors. R+I has decided to follow a consultative process while implementing +asel II norms and move in a gradual, seuential and coordinate manner. For this purpose, dialogue has already been initiated with the stakeholders. /s envisaged by the +asel 1ommittee, the accounting profession too, will make a positive contribution in this respect to make Indian banking system still stronger.
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CHAPTER II: APPENDI
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?.1 UESTIONNAIRE studying :th semester #+/ in +<1 *A#$ . I am working on a
I am +/+/$/+ 4/TI3
project titled ( RISK MANAGEMENT IN BANKING SECTOR. In this regard I reuest you to spend your valuable time in filling this uestionnaire @Tik !&e a**-$*-ia!e ($'. This information will be used only for academic purpose and will be kept confidential.
INSTITUTIONA# INFORMATION
7. Eame of your bank0 >. 4lease indicate the name of the contact Eame0 person for this uestionnaire and his"her position in the +ank. 4osition0 ?. To which of the following types of o 4ublic sector banks does your bank belongL o 4rivate sector o Foreign +ank
:. 'here is your parent"head office locatedL Tik !&e a**-$*-ia!e ($' A4ARENESS OF REGU#ATIONS
7. 'hat is your assessment of your readiness for the new +asel proposals with respect to capital reuirementsL 1R<*T RI$M
#/RM
A4
FC33N 4R<4/R<* 4/RTI/33N 4R<4/R<* EAT
N
4R<4/R<* >. 2ave you done a gap analysis between current risk management practice and new capital reuirementsL BABASAB PATIL
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1R<*T RI$M
#/RM
A4
N<$ EA ?. 'hat degree of priority do you address to the new +asel regulatory frameworkL 1R<*T RI$M
#/RM
A4
J
#/RM
A4
A44ARTCEITN 1AE$TR/IET ORGANISTIONA# STRUCTURE
7. *o you have an assigned 1redit risk, #arket risk and Aperational risk manager in your bankL 1R<*T RI$M
#/RM
A4
N<$ EA
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>. To whom does the Risk manager reportL 1R<*T RI$M
#/RM
A4
12I
/E*
3I/+3ITN #/E/D
RI$M
AFFI1
#/RM
A4
G>G@ >GHG@ QHG@ :. 2ow many people work in these departmentsL 1R<*T RI$M
#/RM
A4
7 ? ? H H 7G Q 7G
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H. *o you have a Risk 1ommitteeL 1R<*T RI$M
#/RM
A4
N<$ EA REPORTING ABI#ITY
7. /re you producing reporting for 1R<*T RI$M
#/RM
A4
R. *oes e!ternal reporting drive your internal reportingL 1R<*T RI$M
#/RM
A4
J
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?. *oes e!ternal reporting affect your decision making processL 1R<*T RI$M
#/RM
A4
#/RM
A4
J
#/RM
A4
N<$ EA COMP#IACE 4ITH BASE# II
7. 'hich approach will best suit your organizationL 1R<*T RI$M
#/RM
A4
$T/E*/R* FACE*/TIAE /*J/E1<* *AE&T MEA'
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>. 2ave you performed a 1ost"+enefit analysis for each approach proposed by +asel IIL 1R<*T RI$M
#/RM
A4
N<$ EA ?. In your situation, could regulatory capital consumption be motivation for0 1R<*T RI$M
#/RM
A4
$TA44IED /1TIJITI<$ *
7. 2ave you estimated the regulatory capital consumption for each of your individual businessesL 1R<*T RI$M
#/RM
A4
N<$ EA >. 'ill you outsource activities with high capital consumptionL 1R<*T RI$M
#/RM
A4
N<$ EA
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?. 'ill you insure selected RiskL 1R<*T RI$M
#/RM
A4
N<$ EA :. *o you intend allocating economic capital by +usiness linesL 1R<*T RI$M
#/RM
A4
N<$ EA H. 'ill you make use of +asel II reuirements to implement an economic capital allocation throughout your business linesL 1R<*T RI$M
#/RM
A4
N<$ EA BASE# II ACTION P#AN
7. 2ave you established an action plan to achieve the +asel II reuirementsL 1R<*T RI$M
#/RM
A4
N<$ EA
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>. 2ow will you e!ecute this action planL 1R<*T RI$M
#/RM
A4
#/RM
A4
IET
#/RM
A4
EAT R33I$<* 4/RTI/33N R33I$<* FC33N R33I$<* TECHNO#OGY
7. *oes your current IT infrastructure allow you to meet the +asel II reuirementsL 1R<*T RI$M
#/RM
A4
N<$ EA
>. 'ill you develop an IT solution for Risk managementL 1R<*T RI$M
#/RM
A4
N<$ EA ?. 2ave you completed a review of potential IT solutions availableL
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1R<*T RI$M
#/RM
A4
T<12EA3ADN 1AE$C3TIED :. 'hat difficulties do you foreseeL 1R<*T RI$M
#/RM
A4
IET
43/1<0
SSSSSSSSSSSSSSSSSS
*/T<0
$ignature.
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RISK MANAGEMENT IN BANKING SECTOR
REFFERENCE 4EB SITES
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www.bis.org
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www.rbi.org
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www.kpmg.com
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www.cognizant.com
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www.google.com
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www.yahoo.com
BOOKS
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2and +ook on Risk management B +asel II norms
ARTICA#S
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Risk #anagement in +anks. R $ Raghavan 1hartered /ccountant.
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+asel Eorms challenges in India $wapan +akshi
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'hite 4aper The Ripple
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Risk #anagement Duidelines for 1ommercial +anks B *FIs.
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+/$<3 II /re Indian +anks Doing to DainL $antosh E. Dambhire 6amanalal, +ajaj Institute of #anagement $tudies #umbai
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+asel II and Indias banking structure 1. 4. 1handrasekhar and 6ayati Dhosh
REPORTS
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Report on Implementing +asel II0 Impact on
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