Overview of Risk Management Laxmikant Gupta Sr.V.P. Risk Management & Compliance 1
5 Basic Risks : Credit Risk the most centralised risk mgt Market Risk / Portfolio Risk Settlement Risk / Counterparty Risk Liquidity Risk Operational Risk the most decentralised risk mgt 2
Credit Risk Normally with all kinds of financial services entities, primarily in lending business. Capital Adequacy norms for Banks and NBFCs based on probability of default. Risk Mitigants : Requires operational procedures like authorization matrix and mid-office structure / independent structure of limit monitoring. Limit structures to be flexible enough depending upon type of instruments (structured / non-structured / repo lending / secured etc.) and depend upon maturities. Group level limits (e.g. sectorwise, AAA rated per entity, AA rated total etc). Risk Transfers : Spread Trading, Gaurantees against lending, default swap. Credit risk pricing on overall portfolio basis.
Market Risk / Portfolio Risk As capital adequacy norm for own proprietary funds. Portfolio risk of underperformance for mutual funds and VCFs. VaR based capital adequacy rules for Market Risk on normal basis. Stress Testing to check survival issue / capital adequacy Interest Rate Risk (duration / maturity aspect) Equity market risk deviation, correlation, sentiment, beta aspects Forex risks, Commodity price risk, Deviation from benchmarks, Spread risks etc. Portfolio risk ratios : Sharpe Ratio, Information Ratio, Standard Deviation, Tracking Error. Difference in Beta and Correlation Risk. Portfolio Risks : Attribution of return, Attribution of Risk, identifying research alpha v/s fund managers alpha etc.
Market Risk / Portfolio Risk Market Risk by manufacturing entity : Long on Finished Goods, Short on Raw Materials. Exporters : Long on USD, hence, can borrow in USD. Importers : Short on USD & hence, can invest in USD. Long Term Market risk on floating inventory stocks Hedging v/s new speculation in manufacturing? How to increase shareholders wealth? Risk Transfers : Options & various structures thereof. Accounting aspects for HTM, HFT, AFS.
Settlement Risk / Counterparty Risk Settlement Risk relates to failure of exchanging, resulting in market risk arising out of failure of trades. Majorly taken care in organized markets as it guarantees settlements. However, risk still prevails for Exchanges which requires to have adequacy of Net Worth and Margin Collection system. Margin : A proxy of market risk in case of settlement failure. Risks exist in fixed income segment and any unorganized market segment. Risk Mitigant : Margin system, DVP system, list of approved counterparties, empanelled list of brokers etc.
Operational Risk Defination : Risk of loss resulting from inadequate or failed internal process, people, system or external factors. All organization affected in some or the other way. Disaster Recovery & Business Continuity Risk 3 levels. 3rd Party claims while organization acting in professional capacity. Information Risk System failures Legal and Compliance Risk Reputation Risk Internal Frauds including mis-selling and mis-representation (specially in insurance and distributors segment). External Frauds Errors / omissions due to lack of effective control and monitoring resulting in financial loss. Money Laundering and lack of appropriate KYC framework
HIGH RISK SEVERITY -- FREQUENCY RISK FREQUENCY (Descending order) Operations, Settlement, Payment, Delivery - Back office External Frauds Products, Sales and Distribution Internal Frauds Admin and HR Related RISK SEVERITY (Descending order) Internal Frauds External Frauds Products, Sales and Distribution Operations, Settlement, Payment Delivery - Back office Admin and HR Related
Pillars of Operational Risk Control and Self Risk Assessment Heat Map structure and Mitigation Plan Key Risk Indicators Loss Data Collection Policy Framework NPAP system Process review by risk management independent of that by internal auditors. Scenario Analysis Stress Testing Internal and Concurrent Audit Insurances FA, Keyman & professional indemnity cover Governance Framework : Risk Committee
BASEL Norms Capital Adequacy 8%, as per RBI 9%. Tier 2 is limited to 100% of Tier I. Credit Risk : Standard Approach, Internal Rating Based Approach. IRB has 2 approaches Foundation and Advanced approach. Op Risk : Basic Indicator Approach, TSA, Advanced Mgt Approach IRB Approach to have internal data for PD, LGD etc. EL = PD x LGD. It should be priced. Under Foundation approach of IRB, LGD is either 45% or 75%. BASEL III norms under implementation Liquidity Coverage Ratio (LCR) and Net Stable Fund Ratio (NSFR) More Liquidity related.
Other risks specific to certain businesses Lapse of policies or increased claim levels for insurance companies. Product and pricing defects in insurance companies. Claims arising out of clinical trial related cases in Pharma R&D. Engineering contracts related issues including issues relating to safety norms pollution control norms etc. Exit related risks in venture funds including risks arising out of various due diligences.
12 Any questions??