Risk Management

A PROJECT REPORT
ON
STUDY OF RISK MANAGEMENT IN BANKS

SUBMITTED BY
LAD NETRA CHANDRAKANT
T.Y.B.Com (B&I) [Semester V]
PADMASHREE ANNASAHEB JADHAV BHARTIYA SAMAJ UNNATI

MANDALS
B.N.N. COLLEGE
DHAMANKAR NAKA, BHIWANDI, 421302
SUBMITTED TO
UNIVERSITY OF MUMBAI
ACADEMIC YEAR
2016-2017
UNDER THE GUIDANCE OF

Ms. URVI GADA
A PROJECT REPORT
ON
STUDY OF RISK MANAGEMENT IN BANKS

SUBMITTED BY
T.Y.B.Com (B&I) [Semester V]
PADMASHREE ANNASAHEB JADHAV BHARTIYA SAMAJ UNNATI

MANDALS
B.N.N. COLLEGE
DHAMANKAR NAKA, BHIWANDI, 421302
SUBMITTED TO
UNIVERSITY OF MUMBAI
ACADEMIC YEAR
2016-2017
UNDER THE GUIDANCE OF

Ms. URVI GADA
Padmashree Annasaheb Jadhav Bhartiya Samaj Unnati Mandals

B.N.N.College, Bhiwandi.
(Arts, Science & Commerce) Dist.Thane 421 305
SELF FUNDED COURSES
Est. June 1966
Bachelor of Banking and Insurance (B.B.I.)
CERTIFICATE
This is to certify that, MISS. LAD NETRA CHANDRAKANT.

(Roll No.05) of T.Y.B Com (B&I), B.N.N College, Semester V (Academic
Year 2016 - 2017) has successfully completed the project entitled STUDY
OF RISK MANAGEMENT IN BANKS and submitted the Project Report
in partial fulfillment of the requirement for the award of the Degree of
B.Com (Banking & Insurance sem.-V) of University of Mumbai.
Ms. URVI GADA

(Project Guide)
Examiner: -
Dr. Suvarna T. Rawal

(Co-ordinator)
Dr.Ashok D.Wagh
(Principal)
1._______________________
College Seal
DECLARATION
I, Miss LAD NETRA CHANDRAKANT (Roll No.05) of
TY.B.Com.(Banking and Insurance) Semester V, studying in
B.N.N. College, Bhiwandi, hereby declare that the information
contained
in
the
project
titled
STUDY
OF
RISK
MANAGEMENT IN BANKS is true and correct to the best of

my knowledge and belief.
________________________
T.Y.B Com (B&I)
PLACE: BHIWANDI
DATE:
ACKNOWLEDGEMENT
I am deeply indebted to my project guide, my family and friends who have supported me
all through my project by encouraging and inspiring me. They have also contributed to
the quality of the material presented in the project. I would like to acknowledge all those
whom I owe a debt of gratitude. It is my foremost duty to express my sincere gratitude
towards my mentor, guru and guide, Miss Urvi Gada ,Assistant Professor, B.N.N.
College, Bhiwandi, Dist.Thane, Maharashtra for her constant encouragement, support
and generous attitude which helped me with new insights not only in understanding
different aspects of my project but also the intricacies of life. It was truly an enriching
experience working under her guidance.
I must thank the Management of B.N.N. College, Dist.Thane, Maharashtra and our
Principal Dr. Ashok D. Wagh for constantly encouraging me. I also thank our coordinator
Dr. Suvarna T. Rawal, and all Vice-Principal of B.N.N. College for their constant support
and cooperation.
I express my deep sense of gratitude to all my teachers, friends and all well
wishers who were always concerned about my project and contributed directly or
indirectly for the successful completion of my project work.
INDEX
CHAPTERS
CONTENTS
PAGE NO.
Introduction
1-3
Profile
4-6
Review of literature
Data Analysis and interpretation
Observations and Conclusions
Suggestions
Bibliography
RISK
MANAGEMENT
IN
BANKS
INTRODUCTION
Risk is defined as anything that can create hindrances in the way of achievement of
certain objectives. It can be because of either internal factors or external factors,
depending upon the type of risk that exists within a particular situation. Exposure to that
risk can make a situation more critical. A better way to deal with such a situation; is to
take certain proactive measures to identify any kind of risk that can result in undesirable
outcomes. In simple terms, it can be said that managing a risk in advance is far better
than waiting for its occurrence.
Risk management is a measure to identifying, analyzing and then responding to a
particular risk. It is a process that is continuous in nature and a helpful tool in decision
making process .According to the Higher Education Funding Council (HEFC). Risk
management is not just used for ensuring the reduction of the probability of bad
happenings but it also covers the increase in likeliness of occurring good things .A model
called prospect theory states that a person is more likely to take on the risk than to suffer
a sure loss .
The Banking sector has a pivotal role in the development of an economy. It is the key
driver of economic growth of the country and has a dynamic role to play in converting
the idle capital resources for their optimum utilization so as to attain maximum
productivity. In fact, the foundation of a sound economy depends on how sound the
banking sector is and vice versa.
In India, the banking sector is considerably strong at present but at the same time,
banking is considered to be very risky business .Financial institutions must take risk, but
they must do so consciously. However, it should be borne in mind that banks are very
fragile institutions which are built on customers trust, brand reputation and above all
dangerous leverage. In case of something goes wrong, banks can collapse and failure of
one bank is sufficient to send shock waves right through the economy. Therefore, bank
management must take utmost care in identifying the type as well as degree of its risk
exposure and tackle those effectively. Moreover, bankers must see risk management as an
ongoing and valued activity with the board setting the example.
As risk is directly proportionate to return, the more risk a bank takes, it can expect to
make more money. However greater risk also increases the danger that the bank may
incur huge losses and be forced out of business .In fact, today a bank must its operations
with two goals in mind to generate profit and to stay in business. Banks therefore, try to
ensure that their risk taking is informed and prudent. Thus maintaining a trade-off
between risk and return is the business of risk management. Moreover, risk management
in the banking sector is a key issue linked financial stability. Unsound risk management
practices governing bank often plays a central role in risk for the purpose of risk
management in banks.
The Banking sector has a pivotal role in the development of an economy. It is the key
driver of economic growth of the country and has a dynamic role to play in converting
the idle capital resources for their optimum utilisation so as to attain maximum
productivity (Sharma, 2003). In fact, the foundation of a sound economy depends on how
sound the Banking sector is and vice versa.
banking is considered to be a very risky business. Financial institutions must take risk,
but they must do so consciously (Carey, 2001). However, it should be borne in mind that
banks are very fragile institutions which are built on customers trust, brand reputation
and above all dangerous leverage. In case something goes wrong, banks can collapse and
failure of one bank is sufficient to send shock waves right through the economy
(Rajadhyaksha, 2004). Therefore, bank management must take utmost care in identifying
the type as well as the degree of its risk exposure and tackle those effectively. Moreover,
bankers must see risk management as an ongoing and valued activity with the board
setting the example.
make more money. However, greater risk also increases the danger that the bank may
incur huge losses and be forced out of business. In fact, today, a bank must run its
operations with two goals in mind to generate profit and to stay in business (Morrison,
2005). Banks, therefore, try to ensure that their risk taking is informed and prudent. Thus,
maintaining a trade-off between risk and return is the business of risk management.
Moreover, risk management in the banking sector is a key issue linked to financial system
stability.
Unsound risk management practices governing bank lending often plays a central role in
1980-1990 Formulation and monitoring of the risk appetite, Integration of the risk culture
throughout the Group, analysis of scenarios using advanced models and driven by senior
management and with remuneration metrics, establishing a framework of control,
reporting frameworks aligned with the risk appetite. And scaled that identifies the risks.
Definition of Risk Management

A risk can be defined as an unplanned event with financial consequences resulting in loss
or reduced earnings. An activity which may give profits or results in loss may be called
risky proposition due to uncertainty or unpredictability of the activity of trade in future.
In other words, it can be defined as the uncertainty of the income.
Risk refers to a condition where there is a possibility of undesirable occurrence of a

particular result which is known or best quantifiable and therefore insurable Risk may
mean that there is a possibility of loss or damage which, may or may not happen.
Risk may be defined as a uncertainties resulting in adverse outcome. Adverse in relation
to planned objective or expectations .In the simple words, risk may be defined as
possibility of loss. It may be financial loss or loss to the reputation image.
Although the term and uncertainty are often used synonymously, there is difference
between the two Uncertainties in the case when the decision maker knows all the possible
outcomes of a particular act but does not have an idea of the probabilities of the
outcomes. On the country, risk is related to a situation in which the decision maker knows
the probabilities of the various outcomes. In short risk is quantifiable uncertainty.
PURPOSE OF THE RESEARCH

Risk Analysis and Risk Management has got much importance in the Indian economy
during this liberalization period. The foremost among the challenges faced by the banking
sector today is the challenge of understanding and managing the risk. The very nature of
the banking business is having the threat of risk imbibed in it. Banks main role is
intermediation between having resources and those requiring resources. For management
of risk at corporate level.
Various risk, like credit risk, market risk or operational risks have to be converted into
one composite measure. Therefore, it is necessary that measurement of operational risk
should be tandem with other measurements of credit risk and market risk so that the
requisite composite estimate can be worked out. So, regarding to international banking
rule and RBI guidelines the investigation of risk analysis and risk management in
banking sector is being most important.
Risk management is the application of proactive strategy to plan, lead organize, and
control the wide variety of risk that are rushed into the fabric of an organizations daily
and long term functioning . Like it or not, risk has a say in the achievement of our goals
and in the overall success of an organization.
LITERATURE REVIEW OF RISK MANAGEMENT

AARATHI KALYANRAMAN
Aarathi kalyanraman have summarized the core principles of Enterprise wide Risk
management. As per the authors risk management culture should percolate from the
Board level to the lowest level employee. Firms will be required to make significant
investment necessary to comply with the latest best practices in the new generation of
Risk regulation and Management. Corporate Governance regulation with the advent of
Sarbanes-Oxley Act in India and several other legislations in various countries also
provide the frame work for sound Risk management structures. Hitherto, Enterprise wide
risk management existed only for name sake. Generally firms did not institute a truly
integrated set of Risk measures, methodologies or Risk management Architecture. The
ensuing decades will usher in a new set of Risk Management.
The integrated Risk Management infrastructure would covers areas like Corporate
Compliance, Corporate Governance, Capital management etc. Areas like business risk
reputation risk and strategy risk also will be incorporated in the overall Risk Architecture
more formally. As always it will be the banks and the Financial Services firms which will
lead the way in this evolutionary process. The compliance requirements of Basel II and
III accords will also oblige Banks and Financial institutions to put in place robust Risk
Management methodologies.
The authors felt that it is generally felt that Risk Management concerns largely with
activities within the firm. However, during the next decade Governments in different
countries would desire to have innovatively drawn Risk management system for the
whole country. The authors draw reference to the suggestions that a country with
exposure to a few concentrated industries should be obliged to diversify its excessive
exposures by arranging appropriate swaps with other potential macro applications to
improve the management of their social security measures etc. They draw references to
the spread of Risk Management Education worldwide.
SUMAN KALANI
Felt that the insolvency for banks becomes true when current losses exhaust capital
completely. It also occurs when the return on assets (ROA) is less than the negative
capital asset ratio. The probability of insolvency is explained in terms of an equation.
OBJECTIVES OF THE STUDY

The following of risk management for any organization can be summarized as under:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
Survival of the Organization

Efficiency in Operations
Identifying and achieving acceptable levels of worry ,
Earnings stability,
Uninterrupted operations
Continued growth
Preservation of reputation
To identify the risks faced by the banking industry
To trace out the process and system of risk management
RESEARCH METHODOLOGY
This paper is theoretical modal based on the extensive research for which the secondary
source of information gathered. The sources include online publications, books and
journals.
COMPONENTS OF RISK MANAGEMENT

Risk management may be defined as the process of identifying and controlling risk. It is
also described at times as the responsibility of the management to identify measure,
monitor and control various items of risks associated with banks position and
transaction. The process of risk management has three clearly identifiable steps, viz., and
Risk identification. Risk measurement and Risk control.
RISK MANAGEMENT SYSTEMS IN BANKS:

Risk is inherent and absolutely unavoidable in banking. Risk is the potential loss an
assets or a portfolio is likely to suffer due to a variety of reasons. As a financial
intermediary, bank assumes or restructures risks for its clients. A Simple example for this
would be acceptance of deposits. A more sophisticated example is an interest rate swap. A
bank while operating on behalf of the customers as well as in its own behalf has to face
various types of risk associated with those transactions. Prudent banking lies in
identifying, assessing and minimizing these risks. In a competitive market environment, a
banks rate of return will be greatly influenced by its risk management skills.
In short, the two most important developments that have made it imperative for Indian
commercial banks to give emphasize on risk management discussed below(a)Deregulation
The era of financial sector reforms which started in early 1990s has culminated in
deregulation in a phased manner. Deregulation has given banks more autonomy in areas
like lending, investment, interest rate structure etc. As results of these developments,
banks are required to manage their own business themselves and at the same time
maintain liquidity and profitability. This has made it imperative for banks to pay more
attention to risk management.
(b)Technological Innovation
Technological innovations have provided a platform to the banks for creating an
environment for efficient customer services as also for designing products. In fact, it is
technological innovation that has helped banks to manage the assets and liabilities in a
better way. Providing various delivery channels, reducing processing time of transactions,
reducing manual intervention in bank office function. However, all these developments
have also increased the diversity and complexity of risks. Which need to be managed
professionally so that the opportunities provided by the technology are not negative
Role of RBI in Risk Management in Banks

The Reserve Bank of India has been using CAMELS rating to evaluate the financial
soundness of the Banks. The CAMELS Model consists of six components namely Capital
Adequacy, Asset Quality, Management, Earnings Quality, Liquidity and Sensitivity to
Market risk
In 1988, The Basel Committee on Banking Supervision of the Bank for International
Settlements (BIS) has recommended using capital adequacy, assets quality, management
quality, earnings and liquidity (CAMEL) as criteria for assessing a Financial Institution.
The sixth component, sensitivity to market risk (S) was added to CAMEL in 1997
(Gilbert, Meyer & Vaughan, 2000). However, most of the developing countries are using
CAMEL instead of CAMELS in the performance evaluation of the FIs. The Central
Banks in some of the countries like Nepal, Kenya use CAEL instead of CAMELS (Baral,
2005). CAMELS 92 frameworks are a common method for evaluating the soundness of
Financial Institutions.
In India, the focus of the statutory regulation of commercial banks by RBI until the early
1990s was mainly on licensing, administration of minimum capital requirements, pricing
of services including administration of interest rates on deposits as well as credit.
Reserves and liquid asset requirements (Kannan, 2004). In these circumstances, the
supervision had to focus essentially on solvency issues. After the evolution of the BIS
prudential norms in 1988, the RBI took a series of measures to realign its supervisory and
regulatory standards and bring it at par with international best practices. At the same time,
it also took care to keep in view the socio-economic conditions of the country, the
business practices, payment systems prevalent in the country and the predominantly
agrarian nature of the economy, and ensured that the prudential norms were applied over
the period and across different segments of the financial sector in a phased manner.
Finally, it was in the year 1999 that RBI recognised the need of an appropriate risk
management and issued guidelines to banks regarding assets liability management,
management of credit, market and operational risks. The entire supervisory mechanism
has been realigned since 1994 under the directions of a newly constituted Board for
Financial Supervision (BFS), which functions under the aegis of the RBI, to suit the
demanding needs of a strong and stable financial system.
The supervisory jurisdiction of the BFS now extends to the entire financial system
barring the capital market institutions and the insurance sector. The periodical on-site
inspections, and also the targeted appraisals by the Reserve Bank, are now supplemented
by off-site surveillance which particularly focuses on the risk profile of the supervised
institution. A process of rating of banks on the basis of CAMELS in respect of Indian
banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in respect
of foreign banks has been put in place from 1999.
Framework is a common method for evaluating the soundness of Financial Institutions.
In India, the focus of the statutory regulation of commercial banks by RBI until the early
1990s was mainly on licensing, administration of minimum capital requirements, pricing of
services including administration of interest rates on deposits as well as credit, reserves and
liquid asset requirements (Kannan, 2004). In these circumstances, the supervision had to
focus essentially on solvency issues. After the evolution of the BIS prudential norms in 1988,
the RBI took a series of measures to realign its supervisory and regulatory standards and
bring it at par with international best practices. At the same time, it also took care to keep in
view the socio-economic conditions of the country, the business practices, payment systems
prevalent in the country and the predominantly agrarian nature of the economy, and ensured
that the prudential norms were applied over the period and across different segments of the
financial sector in a phased manner.
Finally, it was in the year 1999 that RBI recognised the need of an appropriate risk
management and issued guidelines to banks regarding assets liability management,
management of credit, market and operational risks.
The entire supervisory mechanism has been realigned since 1994 under the directions of a
newly constituted Board for Financial Supervision (BFS), which functions under the aegis of
the RBI, to suit the demanding needs of a strong and stable financial system. The supervisory
jurisdiction of the BFS now extends to the entire financial system barring the capital market
institutions and the insurance sector.
The periodical on-site inspections, and also the targeted appraisals by the Reserve Bank, are
now supplemented by off-site surveillance which particularly focuses on the risk profile of
the supervised institution. A process of rating of banks on the basis of CAMELS in respect of
Indian banks and CACS (Capital, Asset Quality, Compliance and Systems & Control) in
respect of foreign banks has been put in place from 1999.
Since then, the RBI has moved towards more stringent capital adequacy norms and adopted
the CAMEL (Capital adequacy, Asset quality, Management, Earnings, Liquidity) based
rating system for evaluating the soundness of Indian banks. The Reserve Banks regulatory
and supervisory responsibility has been widened to include financial institutions and nonbanking financial companies. As a result, considering the changes in the Banking industry,
the thrust lies upon Risk - Based Supervision (RBS). The main supervisory issues addressed
by Board for Financial Supervision (BFS) relate to on-site and off-site supervision of banks.
The on-site supervision system for banks is on an annual cycle and is based on the
CAMEL model. It focuses on core assessments in accordance with the statutory
mandate, i.e., solvency, liquidity, operational soundness and management prudence. Thus,
banks are rated on this basis.
Moreover, in view of the recent trends towards financial integration, competition,
globalization, it has become necessary for the BFS to supplement on-site supervision
with off-site surveillance so as to capture early warning signals from off-site monitoring
that would be helpful to avert the likes of East Asian financial crisis (Sireesha, 2008). The
off-site monitoring system consists of capital adequacy, asset quality, large credit and
concentration, connected lending, earnings and risk exposures viz., currency, liquidity
and interest rate risks. Apart from this, the fundamental and technical analysis of stock of
banks in the secondary market will serve as a supplementary indicator of financial
performance of banks.
Thus, on the basis of RBS, a risk profile of individual Bank will be prepared. A high-risk
sensitive bank will be subjected to more intensive supervision by shorter periodicity with
greater use of supervisory tools aimed on structural meetings, additional off site
surveillance, regular on-site inspection etc. This will be undertaken in order to ensure the
stability of the Indian Financial System.
Risk Management Practices in India

Risk Management, according to the knowledge theorists, is actually a combination of
management of uncertainty, risk, equivocality and error (Mohan, 2003). Uncertainty
where outcome cannot be estimated even randomly, arises due to lack of information and
this uncertainty gets transformed into risk (where estimation of outcome is possible) as
information gathering progresses.
As information about markets and knowledge about possible outcomes increases, risk
management provides solution for controlling risk. Equivocality arises due to conflicting
interpretations and the resultant lack of judgment.
This happens despite adequate knowledge of the situation. That is why; banking as well
as other institutions develops control systems to reduce errors, information systems to
reduce uncertainty, incentive system to manage agency problems in risk-reward
framework and cultural systems to deal with equivocality.
Initially, the Indian banks have used risk control systems that kept pace with legal
environment and Indian accounting standards. But with the growing pace of deregulation
and associated changes in the customers behavior, banks are exposed to mark-to-market
accounting (Mishra, 1997).
Therefore, the challenge of Indian banks is to establish a coherent framework for
measuring and managing risk consistent with corporate goals and responsive to the
developments in the market. As the market is dynamic, banks should maintain vigil on
the convergence of regulatory frameworks in the country.
Changes in the international accounting standards and finally and most importantly
changes in the clients business practices. Therefore, the need of the hour is to follow
certain risk management norms suggested by the RBI and BIS.
banking is considered to be a very risky business. Financial institutions must take risk,
but they must do so consciously (Carey, 2001). However, it should be borne in mind that
banks are very fragile institutions which are built on customers trust, brand reputation
and above all dangerous leverage. In case something goes wrong, banks can collapse and
failure of one bank is sufficient to send shock waves right through the economy
(Rajadhyaksha, 2004). Therefore, bank management must take utmost care in identifying
the type as well as the degree of its risk exposure and tackle those effectively. Moreover,
bankers must see risk management as an ongoing and valued activity with the board
setting the example.
make more money. However, greater risk also increases the danger that the bank may
incur huge losses and be forced out of business. In fact, today, a bank must run its
operations with two goals in mind to generate profit and to stay in business (Marrison,
2005). Banks, therefore, try to ensure that their risk taking is informed and prudent. Thus,
maintaining a trade-off between risk and return is the business of risk management.
PROCESS OF RISK MANAGEMENT

To overcome the risk and to make banking function well, there is a need to manage all
kinds of risks associated with the banking. Risk management becomes one of the main
functions of any banking services for risk management.
These levels differ from institution to institution and country to country.
Risk origination within the Banks
Credit Risk
Market Risk
Operational Risk
Risk Control
Recommendations for Risk Control
Risk Mitigation through Control Techniques
Deputation of Competent Officers to Deal with the Risks
Risk identification
Identify Risks
Understand and Analyze Risks
Risk Monitoring
Supervise the Risks
Reporting on progress
Compliance with Regulations Follow-up
Risk Return Trade off

Balancing of Risk against Return
(1)Identification
Risk can be defined as the potential that events expected or anticipated may any adverse
impact on the banks capital or earnings. Therefore, proper identification of existing risks
and risks that may arise from new business is crucial to the risk management process.
(2)Measurement
Accurate and timely measurement of risk enables a bank to quantify the risk for
controlling and monitoring risks levels. It involves sophisticated tools including modeling
and use of technology.
(3) Control
Control is administered by establishment and communication of limits for risk taking
units through policies, standards and procedures. There should be a laid down system to
exemptions in controlling the risk.
(4) Monitoring
Monitoring is affected through risk reporting to ensure timely review of risk positions
and exceptions. Monitoring reports should be concise, frequent, timely and reasonably
accurate. The purpose of monitoring is to present right information to the right people.
Type of Risks
Risk may be defined as possibility of loss, which may be financial loss or loss to the
image or reputation. Banks like any other commercial organization also intend to take
risk, which is inherent in any business. Higher the risk taken, higher the gain would be.
But higher risks may also result into higher losses. However, banks are prudent enough to
identify measure and price risk, and maintain appropriate capital to take care of any
eventuality. The major risks in banking business or banking risks, as commonly
referred, are listed below
Liquidity Risk
Interest Rate Risk
Market Risk
Credit or Default Risk
Operational Risk
Types of
Risk
Liquidity
Risk
Interes
t Risk
Credit or
Default
Risk
Market
Risk
Operation
al
Liquidity
Risk
Funding
Risk
Time
Risk
Call Risk
Interest
Risk
Gap
Risk
Yield
curve
Basis
Risk
Embedd
ed
Risk
Reinveste
d
Risk
Market Risk
Forex Risk
Market liquidity
Risk
Credit Risk
Counterparty Risk
Country Risk
Operational Risk
Transaction Risk
Transaction Risk
Compliance Risk
Compliance Risk
Liquidity Risk
The liquidity risk of banks arises from funding of long-term assets by short-term
liabilities, thereby making the liabilities subject to rollover or refinancing risk (Kumar et
al., 2005). It can be also defined as the possibility that an institution may be unable to
meet its maturing commitments or may do so only by borrowing funds at prohibitive
costs or by disposing assets at rock bottom prices. The liquidity risk in banks manifest in
different dimensions
(a) Funding Risk:

Funding Liquidity Risk is defined as the inability to obtain funds to meet cash flow
obligations. For banks, funding liquidity risk is crucial. This arises from the need to
replace net outflows due to unanticipated withdrawal/ non-renewal of deposits (wholesale
and retail).
(b)Time Risk:
Time risk arises from the need to compensate for non-receipt of expected inflows
of funds i.e., performing assets turning into non-performing assets.
(c)Call Risk:
Call risk arises due to crystallization of contingent liabilities. It may also arise
when a bank may not be able to undertake profitable business opportunities when
it arises.
Liquidity risk refers to multiple dimensions such as
Inability to raise funds at normal cost
Market liquidity risk
Assets liquidity risk
Following an introduction to the liquidity risk and funding concept in Group Santander
(page 245), we present the liquidity management framework set by the Group, including
monitoring and control of liquidity risk (pages 246-250). We then look at the funding
strategy developed by the Group and its subsidiaries over the last few years (pages 250253), with particular attention to the liquidity evolution in 2014. The evolution of the
liquidity management ratios in 2014 and business and market trends that gave rise to it
(pages 253-258). The section ends with a qualitative description of the prospects for
funding in 2015 for the Group and its main countries
There are challenges to liquidity risk management. The practices rely on imperial and
continuous observations of market liquidity. Liquidity risk models appear too theoretical
to permit instrumental applications. The times profiles of projected uses and sources of
funds, and their gaps or liquidity mismatches, captures the liquidity position of a bank
Balance sheet analysis and measurement of liquidity risk

Decision-making on funding and liquidity is based on a deep understanding of the
Groups current situation (environment, strategy, balance sheet and state of liquidity), of
the future liquidity needs of the various units and businesses (projection of liquidity), as
well as access to and the situation of funding sources in the wholesale markets.
The objective is to ensure the Group maintains optimum levels of liquidity to cover its
short and long-term needs with stable funding sources, optimizing the impact of its cost
on the income statement.
This requires monitoring of the structure of balance sheets, forecasting short and
medium-term liquidity and establishing the basic metrics
At the same time, various analyses of scenarios are conducted which take into account
the additional that needs could arise from various extreme, unlikely but possible, events.
These could affect the various items of the balance sheet and/funding sources differently
(degree of renewal of wholesale funding, deposit outflows, deterioration in the value of
liquid assets, etc), whether for global market reasons or specific ones of the Group.
Analysis of the balance sheet and measurement of liquidity risk

The inputs for drawing up the Groups various contingency plans are obtained from the
results of the analysis of balance sheets, forecasts and scenarios, which, in turn, enable a
whole spectrum of potential adverse circumstances to be anticipated.
All these actions are in line with the practices being fostered by the Basel Committee and
the various regulators in the European Union and the European Banking Authority to
strengthen the liquidity of banks. Their objective is to define a framework of principles
and metrics that, in some cases, are close to being implemented and, in others, still being
developed.
Greater detail on the measures, metrics and analysis used by the Group and its
subsidiaries to manage and control liquidity risk is set out below:
Methodology for monitoring and controlling liquidity risk
The Groups liquidity risk metrics aim to:
Achieve greater efficiency in measuring and controlling liquidity risk.
Support financial management, with measures adapted to the form of managing the
Groups liquidity.
Alignment with the regulatory requirements derived from the transposition of Basel
III in the European Union (basically CRDIV in EU and others), in order to avoid conflicts
between limits and facilitate management.
Serve as an early warning system, anticipating potential risk situations by monitoring
certain indicators.
Attain the involvement of countries. The metrics are developed on the basis of
common and homogeneous concepts that affect liquidity, but they require analysis and
adaptation by each unit.
Interest Rate Risk

Interest Rate Risk arises when the Net Interest Margin or the Market Value of Equity
(MVE) of an institution is affected due to changes in the interest rates. In other words, the
risk of an adverse impact on Net Interest Income (NII) due to variations of interest rate
may be called Interest Rate Risk (Sharma, 2003). It is the exposure of a Banks financial
condition to adverse movements in interest rates.
IRR can be viewed in two ways its impact is on the earnings of the bank or its impact
on the economic value of the banks assets, liabilities and Off-Balance Sheet (OBS)
positions. Interest rate Risk can take different forms. The following are the types of
Interest Rate Risk
(a) Gap or Mismatch Risk:

A gap or mismatch risk arises from holding assets and liabilities and Off-Balance
Sheet items with different principal amounts, maturity dates or re-pricing dates,
thereby creating exposure to unexpected changes in the level of market interest
rates.
(b)Yield Curve Risk:

Banks, in a floating interest scenario, may price their assets and liabilities based
on different benchmarks, i.e., treasury bills yields, fixed deposit rates, call market
rates, MIBOR etc. In case the banks use two different instruments maturing at
different time horizon for pricing their assets and liabilities then any non-parallel
movements in the yield curves, which is rather frequent, would affect the NII.
Thus, banks should evaluate the movement in yield curves and the impact of that
on the portfolio values and income.
.
An example would be when a liability raised at a rate linked to say 91 days T Bill is used
to fund an asset linked to 364 days T Bills. In a raising rate scenario both, 91 days and
364 days T Bills may increase but not identically due to non-parallel movement of yield
curve creating a variation in net interest earned (Kumar et al., 2005).
(c) Basis Risk:

Basis Risk is the risk that arises when the interest rate of different assets,
liabilities and off-balance sheet items may change in different magnitude. For
example, in a rising interest rate scenario, asset interest rate may rise in different
magnitude than the interest rate on corresponding liability, thereby creating
variation in net interest income.
The degree of basis risk is fairly high in respect of banks that create composite assets out of
composite liabilities. The loan book in India is funded out of a composite liability portfolio
and is exposed to a considerable degree of basis risk. The basis risk is quite visible in volatile
interest rate scenarios (Kumar et al., 2005). When the variation in market interest rate causes
the NII to expand the banks have experienced favorable basis shifts and if the interest rate
movement causes the NII to contract, the basis has moved against the banks.
Accrual or reported earnings in the near term. This is measured by measuring the changes
in the Net Interest Income (NII) equivalent to the difference between total interest income
and total interest expense.
Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to
the vulnerability of an institutions financial condition to the movement in interest rates.
Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and
cash flow. 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) equivalent to the difference between total interest income and
total interest expense.
Effects of interest rate risk

The interest rates variations can have an unfavorable impact on the bank's income and
Economic value. That creates two separate, but supplementing perspectives for assessing
the bank's exposure to interest rate risk.
Yield perspective:
It is focused on analyzing the influence of interest rate variations on
The accrued and reported income. This is the traditional approach for interest rate risk
Assessment adopted by many banks. The income variability is an important and central
Point of the interest rate risk analysis, because decreased incomes or direct losses can
suddenly jeopardize the institution's financial stability. Decreasing the market
confidence and reducing its liquidity. In this respect, the income Component, which
traditionally is subject to greatest attention, is the net interest income (The difference
between total interest incomes and total interest expenses). However, as Banks constantly
expand their activities that generate other non-interest related income and income based
on fees and other non-interest related revenues.
The non-interest related income, originating from many activities such as credit servicing
and different programs for assets' securitization, can be very sensitive to the market
interest rates
Economic value perspective:

The market interest rates variations also affect the economic Value of the bank's incomes,
liabilities and off-balance items. A given instrument's Economic value is the estimation of
the present value of its expected net cash flows discounted.
Viewed in broader sense, the bank's economic value is the present value of the expected net cash
flows defined as the expected cash flows from the assets minus the expected net cash flows from
liabilities plus the expected net cash flows from off-balance items. In that sense, the economic
value perspective represents the bank's own capital's (net value) sensitivity to interest rates
fluctuations. In view of the fact that economic value perspective examines the possible
influence of interest rates' variations on the present value of all future cash flows, it offers
a broader view of the potential long-term effect from the interest rate variations rather
than the yield perspective.
Methods for interest rate risk measurement

Banks use different methods for the calculation of interest rate risk, but none is
appropriate for all banks simultaneously. Regardless of the diversity, all methods require
solid Accounting information which is the basis for adequate information necessary for
monitoring and timely reporting of exposures to interest rate risk.
The three most frequently used methods for interest rate risk measurement are the
discrepancy Analysis, the simulation method and the duration method. The application of
each individual method depends on the bank's size, the complexity of its activity
organization And the level of interest rate risk.
Discrepancy analysis
The discrepancy analysis is the most frequently used method for interest rate risk
assessment. Discrepancy is the difference between interest sensitive assets and interest
sensitive Liabilities (including off-balance items) over a particular period of time. The
discrepancy Analysis includes both assets and liabilities with fixed and with floating
interest Rate. Under the discrepancy analysis the bank's assets and liabilities are grouped
in different Time periods depending on their maturity (in case of fixed interest rate) or on
the time Interest rates movements, and should never be speculative. The most frequently
used discrepancy
Coefficient is the following:
Interest sensitive assets - Interest sensitive liabilities Profitable assets
Interest sensitive assets- Interest sensitive liabilities Profitable assets
In some cases, the total assets indicator can be used instead of profitable assets, but that
can lead to underestimating the interest rate risk.
Duration analysis
One of the discrepancy analysis' limitations is its inability to show the portfolio value Or
their changes as a consequence from interest rates change. For tackling with this
problem, another analytical method for measuring risk in portfolios of interest sensitive
securities has been developed.The duration is a measure for the percentage deviation of
the economic value of an Individual position which will occur at a small change of the
interest rates. It shows the Time and amount of cash flows which are received before the
instruments contractually agreed
Maturity.
On principle, the longer the maturity period and the period for the next
Change in the instrument's price is, or the smaller the payments received prior to maturity
are (for example, coupon payments), the longer the duration is. The longer duration
means that a certain change in interest rates levels will have a greater impact on the
economic Value. The modified duration is a variety of the simple duration which
calculates the interest Rate risk sensitivity of the instrument's price. The difference
between the simple and modified duration is that the first one is expressed in time units,
while the second one is a ratio. In the financial circles the term duration usually refers to
modified duration.
Market Risk
The risk of adverse deviations of the mark-to-market value of the trading portfolio, due to
market movements, during the period required to liquidate the transactions is termed as
Market Risk (Kumar et al., 2005). This risk results from adverse movements in the level
or volatility of the market prices of interest rate instruments, equities, commodities, and
currencies. It is also referred to as Price Risk.
Price risk occurs when assets are sold before their stated maturities. In the financial
market, bond prices and yields are inversely related. The price risk is closely associated
with the trading book, which is created for making profit out of short-term movements in
interest rates
Market Risk may be defined as the possibility of loss to bank caused by the changes in
the market variables. It is the risk that the value of on-/off-balance sheet positions will be
adversely affected by movements in equity and interest rate markets, currency exchange
rates and commodity prices. Market risk is the risk to the banks 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 prices.
The term Market risk applies to (i) that part of IRR which affects the price of interest rate
instruments, (ii) Pricing risk for all other assets/ portfolio that are held in the trading book
of the bank and (iii) Foreign Currency Risk.
(a) Forex Risk:

Forex risk is 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.
Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse
exchange rate movement during a period in which it has an open position, either spot or
forward or both in same foreign currency. Even in case where spot or forward positions in
individual currencies are balanced the maturity pattern of forward transactions may
produce mismatches. There is also a settlement risk arising out of default of the counter
party and out of time lag in settlement of one currency in one center and the settlement of
another currency in another time zone. Banks are also exposed to interest rate risk, which
arises from the maturity mismatch of foreign currency position.
(b) Market Liquidity Risk:
Bank Deposits generally have a much shorter contractual maturity than loans and
liquidity management needs to provide a cushion to cover anticipated deposit
withdrawals. Liquidity is the ability to efficiently accommodate deposit as also
reduction in liabilities and to fund the loan growth and possible funding of the offbalance sheet claims. The cash flows are placed in different time buckets based on
future likely behavior of assets, liabilities and off-balance sheet items. Liquidity
risk consists of Funding Risk, Time Risk & Call Risk.
Market liquidity risk arises when a bank is unable to conclude a large transaction in a
particular instrument near the current market price. Market risk is the risk that the
financial instrument's value will fluctuate as a result from market price changes,
regardless of whether these changes are caused by factors Typical for individual
instruments or their issuer (counterparty), or by factors pertaining to
All the instruments traded on the market 1. The four most common factors connected
with Market risk is interest rates, currency exchange rates, costs of investments in trade
portfolio (Regardless of the instruments' character debt or capital), prices of exchange
commodities And other market variables related to the bank's activity.
The market risk pertaining to both individual financial instruments and portfolio
instruments can be a function of one, several or all these factors, and in many cases it can
be very complicated. In general, market risk can be defined as a risk arising from market
movements of prices, interest rates and currency exchange rate
The policy for market risk control and management should be subordinated to several
Main aims:
To protect the bank against unexpected losses and to contribute to income stability via
independent identification, assessment and understanding of business market risks;
to contribute to bringing the bank's organizational structure and management process
in line with the best international practices and to set minimum standards for market risks
control;
to create transparent, objective and consistent information system of the market risks
as a base for reasonable decision-making;
To establish a structure that will help the bank to realize the connection between the
business strategy and the operations on one hand, and between the purposes of risk
control and monitoring, on the other.
The admissible threshold of market risk is the amount of potential unexpected loss which
the bank is willing to assume because of unexpected and unfavorable changes in the
market variables. The admissible threshold of market risk should not exceed the losses
which the bank can assume without disturbing its financial stability. The bank's ability to
overcome losses caused by market risk depends on its capital and reserves, on the
potential losses originating from other non-market risks and on the regulatory capital
required for maintaining the business activity.
Risk monitoring is the fundament for effective management process. That is the reason
why the banking institutions should have adequate internal reporting systems reflecting
their exposure to market risk. Sufficiently detailed regular reports should be submitted to
the top management and to the various management levels.
Modified duration analysis

The modified duration is the calculation of given instrument's price sensitivity (elasticity)
to small changes in the market interest rates. Elasticity shows the percentage increase or
decrease in the particular factor as a result from changes in another factor. Like all types
of elasticity, modified duration can also be calculated by using a mathematical formula.
Using these methods, banks take into consideration the market value of every debt
instrument with a fixed interest rate, and then they calculate the instrument's profitability
until it matures, which represents the internal discount rate of that instrument. In cases of
instruments with a floating interest rate, banks use the market value of every instrument
and then they calculate its profitability based on the assumption that principal is due at
the next change of the interest rate. Banks calculate the modified duration for each debt
instrument using the following formula:
D=
1
(1+I)
Where:
D= modified duration;
D= simple duration;
I = profitability.
The duration analysis as a whole is an excellent conception for the measurement of risks
pertaining to a securities portfolio with fixed income. With other portfolios, however, the
duration method is inappropriate because it measures only the interest rate risk
sensitivity. Along with all these factors for some time now, the bond traders keep a short
position over fixed rate periods of 2 years for example, and at the same time they occupy
a long position over fixing periods of 10 years (they take the yield curve spreads in an
exceptionally big range), thus speculating with the non-similar movements of interest
rates over different periods. Since the duration analysis presupposes identical movement
of interest rates, in such cases as the above it does not work
All these factors have created the need for a new risk measurement method. Such a
method would be suitable for various portfolio types and at the same time would use
simple principles. Value at Risk is such a method, namely.
Analysis of the type 'simulation analysis'

Simulation methods work on the fact that interest rates changes are not static, but
dynamic.
Simulation includes a process of generating several interest rate scenarios over a time
period and discounting of supposed cash flows in each individual interest rate scenario in
order to calculate the present value for every scenario. As a result from the simulation, we
obtain a range of probable risk exposures which reflect both the current and expected
risk. The main advantage of the simulation methods is that they are dynamic and forwardoriented. Banks can change their interest rate scenarios depending on many factors such
as pricing and structure of assets and liabilities.
The models also take into account the fact that interest rates do not change similarly in
the various maturity groups, so risk caused by unparalleled changes in the yield curve can
be identified through using a simulation method. The accuracy of those models depends
on the validity of the used output data. If output data is incorrect, the results cannot
accurately reflect the interest rate risk to which the bank is exposed. Another weakness of
those models is that they
Require technical experience for their development and detailed information about
maturities and interest rates.
Default or Credit Risk

Credit risk is more simply defined as the potential of a bank borrower or counterparty to
fail to meet its obligations in accordance with the agreed terms. In other words, credit risk
can be defined as the risk that the interest or principal or both will not be paid as
promised and is estimated by observing the proportion of assets that are below standard.
Credit risk is borne by all lenders and will lead to serious problems, if excessive. For
most banks, loans are the largest and most obvious source of credit risk. It is the most
significant risk, more so in the Indian scenario where the NPA level of the banking
system is significantly high (Sharma, 2003). The Asian Financial crisis, which emerged
due to rise in NPAs to over 30% of the total assets of the financial system of Indonesia,
Malaysia, South Korea and Thailand, highlights the importance of management of credit
risk.
The management of credit risk includes
a) Measurement through credit rating/ scoring,
b) Quantification through estimate of expected loan losses,
c) Pricing on a scientific basis and
d) Controlling through effective Loan Review Mechanism and Portfolio Management
There are two variants of credit risk which are discussed below
(a)Counterparty Risk:
This is a variant of Credit risk and is related to non-performance of the trading
partners due to counterpartys refusal and or inability to perform. The
counterparty risk is generally viewed as a transient financial risk associated with
trading rather than standard credit risk.
b) Country Risk
This is the risk that arises due to cross border transactions that are growing dramatically
in the recent years owing to economic liberalization and globalization. It is the possibility
that a country will be unable to service or repay debts to foreign lenders in time. It
comprises of Transfer Risk arising on account of possibility of losses due to restrictions
on external remittances; Sovereign Risk associated with lending to government of a
sovereign nation or taking government guarantees;
Political Risk when political environment or legislative process of country leads to

government taking over the assets of the financial entity (like nationalization, etc.) and
preventing discharge of liabilities in a manner that had been agreed to earlier;
Cross border risk arising on account of the borrower being a resident of a country other
than the country where the cross border asset is booked; Currency Risk, a possibility that
exchange rate change will alter the expected amount of principal and return on the
lending or investment.
This is also a type of credit risk where non-performance of a borrower or counterparty
arises due to constraints or restrictions imposed by a country. Here, the reason of nonperformance is external factors on which the borrower or the counterparty has no control.
Credit risk is the most fundamental of all the risks faced by the bank. The lenders always
faced the risk of counter party not repaying the loan or not making due payments in time.
Banks are in the business of taking credit risk in exchange for a certain return above the
risk free rate. The credit risk can be measured by using the ratios.
1.
2.
3.
4.
5.
Ratio of non-performing advance to total advances.

Ratio of loan losses to bad debts reserve.
Ratio of loan-loss provision to impired credit.
Ratio of loan losses to capital and reserve.
Ratio of loan-loss provisions to total income.
Credit Risk depends on both external and internal factors. The internal
factors include
1. Deficiency in credit policy and administration of loan portfolio.
2. Deficiency in appraising borrowers financial position prior to lending.
3. Excessive dependence on collaterals.
4. Banks failure in post-sanction follow-up, etc.
The major external factors

1. The state of economy
2. Swings in commodity price, foreign exchange rates and interest rates, etc.
TOOLS OF CREDIT RISK MANAGEMENT.

The instruments and tools, through which credit risk management is carried out, are
detailed below:
a) Exposure Ceilings:
Prudential Limit is linked to Capital Funds say 15% for individual borrower
entity, 40% for a group with additional 10% for infrastructure projects undertaken
by the group, Threshold limit is fixed at a level lower than Prudential Exposure;
Substantial Exposure, which is the sum total of the exposures beyond threshold
limit should not exceed 600% to 800% of the Capital Funds of the bank (i.e. six to
eight times).
b) Review/Renewal:
Multi-tier Credit Approving Authority, constitution wise delegation of powers,
Higher delegated powers for better-rated customers; discriminatory time schedule
for review/renewal, Hurdle rates and Bench marks for fresh exposures and
periodicity for renewal based on risk rating, etc. are formulated.
c) Risk Rating Model:
Set up comprehensive risk scoring system on a six to nine point scale. Clearly
define rating thresholds and review the ratings periodically preferably at half
yearly intervals. Rating migration is to be mapped to estimate the expected loss.
d) Risk based scientific pricing:
Link loan pricing to expected loss. High-risk category borrowers are to be priced
high. Build historical data on default losses. Allocate capital to absorb the
unexpected loss. Adopt the RAROC framework.
e) Portfolio Management
The need for credit portfolio management emanates from the necessity to
optimize the benefits associated with diversification and to reduce the potential
adverse impact of concentration of exposures to a particular borrower, sector or
industry. Stipulate quantitative ceiling on aggregate exposure on specific rating
categories, distribution of borrowers in various industry, business group and
conduct rapid portfolio reviews.
f) Loan Review Mechanism
This should be done independent of credit operations. It is also referred as Credit
Audit covering review of sanction process, compliance status, and review of risk
rating, pickup of warning signals and recommendation of corrective action with
the objective of improving credit quality.
OPERATIONAL RISK
Basel Committee for Banking Supervision has defined operational risk as the risk
of loss resulting from inadequate or failed internal processes, people and systems
or from external events. Thus, operational loss has mainly three exposure classes
namely people, processes and systems
Managing operational risk has become important for banks due to the following
reasons1. Higher level of automation in rendering banking and financial services
2. Increase in global financial inter-linkages
Scope of operational risk is very wide because of the above mentioned reasons.
Two of the most common operational risks are discussed below
(a) Transaction Risk:
Transaction risk is the risk arising from fraud, both internal and external, failed
business processes and the inability to maintain business continuity and manage
information.
(b) Compliance Risk:
Compliance risk is the risk of legal or regulatory sanction, financial loss or
reputation loss that a bank may suffer as a result of its failure to comply with any
or all of the applicable laws, regulations, and codes of conduct and standards of
good practice. It is also called integrity risk since a banks reputation is closely
linked to its adherence to principles of integrity and fair dealing
Always banks live with the risks arising out of human error, financial fraud and
natural disasters. The recent happenings such as WTC tragedy, Barings debacle
etc. has highlighted the potential losses on account of operational risk.
Exponential growth in the
Use of technology and increase in global financial inter-linkages are the two
primary changes that contributed to such risks. Operational risk, though defined
as any risk that is not categorized as market or credit risk, is the risk of loss
arising from inadequate or failed internal processes, people and systems or from
external events. In order to mitigate this, internal control and internal audit
systems are used as the primary means.
Risk education for familiarizing the complex operations at all levels of staff can
also reduce operational risk. Insurance cover is one of the important mitigations
of operational risk. Operational risk events are associated with weak links in
internal control procedures. The key to management of operational risk lies in the
banks ability to assess its process for vulnerability and establish controls as well
as safeguards while providing for unanticipated worst-case scenarios.
Operational risk involves breakdown in internal controls and corporate
governance leading to error, fraud, performance failure, compromise on the
interest of the bank resulting in financial loss. Putting in place proper corporate
governance practices by itself would serve as an effective risk management tool.
Bank should strive to promote a shared understanding of operational risk within
the organization, especially since operational risk is often intertwined with market
or credit risk and it is difficult to isolate.
Definition and objectives

Group Santander defines operational risk (OR) as the risk of losses from defects
or failures in its internal processes, employees or systems, or those arising from
unforeseen circumstances
Operational risk is inherent to all products, activities, processes and systems and
is generated in all business and support areas. For this reason, all employees are
responsible for managing and controlling the operational risks generated in their
sphere of action.
The Groups objective in control and management of operational risk is to
identify, measure/valuate, control/mitigate, monitor and communicate this risk.
The Groups objective in control and management of operational risk is to
identify, measure/valuate, control/mitigate, monitor and communicate this risk.
The Groups priority is to identify and eliminate risk focuses, regardless of whether
they produce losses or not. Measurement also helps to establish priorities in management
of operational risk.
Group Santander has been using the standard method envisaged in BIS II rules for
calculating regulatory capital by operational risk. During 2014, however, the Group
started a project to evolve toward a focus of advanced models (AMAs), for which it
already has met most of the regulatory requirements. It is important to note that the
priority in operational risk management continues to center on its mitigation.
The report on Prudential Significance/Pillar III in section 5 includes information on
calculating the equity requirements by operational risk.
Management model and control of operational risk

The Groups operational risk management incorporates the following elements:
The various phases of the operational risk management and control model are:
Identify the operational risk inherent in all the Groups activities, products, processes
and systems.
Define the target profile of operational risk, specifying the strategies by unit and time
frame, the OR appetite and tolerance and monitoring.
Promote the involvement of all employees in the operational risk culture, through
adequate training at all spheres and levels.
Measure and assess the operational risk objectively, continuously and coherent with the
regulatory standards (Basel, Bank of Spain) and the sector.
Continuously monitor the exposure of operational risk, implement control procedures,
improve internal knowledge and mitigate losses.
Establish mitigation measures that eliminate or minimize operational risk.
Produce regular reports on the exposure to operational risk and the level of control for
senior management and the Groups areas/units, as well as inform the market and
regulatory bodies.
Define and implement the methodology needed to calculate the capital in terms of
expected and unexpected loss.
For each of the aforementioned processes, the following are needed:
Define and implement systems that enable operational risk exposure, integrated into the
Groups daily management, to be monitored and controlled, taking advantage of the
existing technology and achieving the maximum computerisation of applications.
Define and document the policies for managing and controlling operational risk, and
install management tools for this risk in accordance with the rules and best practices.
Group Santanders operational risk management model contributes the following
advantages:
Promotes development of an operational risk culture.
Implementation of the model and initiatives in Operational

Risk
Almost all the Groups units are incorporated to the model and with a high degree of
uniformity. However, due to the different pace of implementation, phases, schedules and
the historical depth of the respective databases, the degree of progress varies from
country to country.
As indicated in section 9.1., the Group started a transformation project toward an AMA
focus. During 2014, the state of the pillars of the OR model was analyzed, both at the
corporate level as well as in the relevant units, and a series of actions was planned in
order to cover the management and regulatory expectations in the management and
control of OR.
The main functions, activities and global initiatives adopted seek to ensure effective
management of operational risk are:
Define and implement the operational risk framework.
Designate OR coordinators and create operational risk departments in the local units.
Training and interchange of experiences: continuation of best practices within the
Group.
Foster mitigation plans: ensure control of implementation of corrective measures as
well as ongoing projects.
Define policies and structures to minimize the impact on the Group of big disasters.
Maintain adequate control of activities carried out by third parties in order to meet
potential critical situations.
Supply adequate information on this type of risk.
Develop a methodology to calculate the capital based on VAR models with a confidence
interval of 99.9%.
The corporate function enhances management of technological risk, strengthening the
following aspects among others:
Protection against and prevention of cyber-attacks and in general aspects related to the
security of information systems.
Foster contingency and business continuity plans.

Management of risk associated with the use of technologies (development and
maintenance of applications, design, implementation and maintenance of technology
platforms, output of computer processes, etc.).
Following the approval in 2013 of the corporate framework for agreements with third
parties and control of suppliers, applied to all the institutions where Group Santander has
affective control, in 2014 work was begun on drawing up a model developing this
framework and formulating the policies of homologation of suppliers, identifying the
detail of the principles that will govern relations of the Groups entities with suppliers,
from the beginning to their termination, and paying particular attention to:
The decision to outsource new activities and services.
The selection of the supplier.
Establishing the rights and obligations of each of the parties.
Control of service and regular review of agreements made with suppliers.
The ending of agreements established.
The Group is in the process of implementing the model, analyzing the current processes
of the institutions in matters of control of suppliers, standardizing certain controls and
verifying compliance with the aspects defined in the model.
System of operational risk information

The Group has a corporate information system that supports the operational risk
management tools and facilitates information and reporting functions and needs at both
the local and corporate levels.
This system has modules to register events, risks and assessment map, indicators,
mitigation and reporting systems, and is applied to all the Groups units.
Other aspects of control and monitoring of operational risk

Analysis and monitoring of controls in market operations
Due to the specific nature and complexity of financial markets, the Group considers it
necessary to strengthen continuously operational control procedures of this activity. In
2014, it continued to improve the control model of this business, attaching particular
importance to the following points:
Analyze the individual operations of each Treasury operator in order to detect possible
anomalous behavior.
Implementation of a new tool that enables compliance with the new requirements in
recording and control of listening in to operations.
Strengthen controls on cancelling and modifying operations.
Strengthen controls on the contributions of prices to market indexes.
Develop extra controls to detect and prevent irregular operations.
Develop extra controls on access to systems registering front office operations (for
example, with the purpose of detecting shared users)
.
The business is also undergoing a global transformation that involves modernizing the
technology platforms and operational processes which incorporate a robust control
model, enabling the operational risk associated with business to be reduced.
Corporate information
The function of operational risk control has an operational risk management information
system that provides data on the Groups main elements of risk. The information
available for each country/unit is the operational risk sphere is consolidated in such a way
as to obtain a global vision with the following features:
Two levels of information: corporate with consolidated information and the other
individualized for each country/unit.
TECHNIQUES OF RISK MANAGEMENT

a) GAP Analysis
It is an interest rate risk management tool based on the balance sheet which
focuses on the potential variability of net-interest income over specific time
intervals. In this method a maturity/ re-pricing schedule that distributes interestsensitive assets, liabilities, and off-balance sheet positions into time bands
according to their maturity (if fixed rate) or time remaining to their next re-pricing
(if floating rate), is prepared. These schedules are then used to generate indicators
of interest-rate sensitivity of both earnings and economic value to changing
interest rates. After choosing the time intervals, assets and liabilities are grouped
into these time buckets according to maturity (for fixed rates) or first possible repricing time (for flexible rate s). The assets and liabilities that can be re-priced are
called rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs)
respectively. Interest sensitive gap (DGAP) reflects the differences between the
volume of rate sensitive asset and the volume of rate sensitive liability and given
by,
GAP = RSAs RSLs
The information on GAP gives the management an idea about the effects on netincome due to changes in the interest rate. Positive GAP indicates that an increase
in future interest rate would increase the net interest income as the change in
interest income is greater than the change in interest expenses and vice versa.
(Cumming and Beverly, 2001)
Duration-GAP Analysis
It is another measure of interest rate risk and managing net interest income
derived by taking into consideration all individual cash inflows and outflows.
Duration is value and time weighted measure of maturity of all cash flows and
represents the average time needed to recover the invested funds. Duration
analysis can be viewed as the elasticity of the market value of an instrument with
respect to interest rate. Duration gap (DGAP) reflects the differences in the timing
of asset and liability cash flows and given by, DGAP = DA - u DL. Where DA is
the average duration of the assets, DL is the average duration of liabilities, and u
is the liabilities/assets ratio. When interest rate increases by comparable amounts,
the market value of assets decrease more than that of liabilities resulting in the
decrease in the market value of equities and expected net-interest income and vice
versa. (Cumming and Beverly, 2001).
b) Value at Risk (VaR)

It is one of the newer risk management tools. The Value at Risk (VaR) indicates
how much a firm can lose or make with a certain probability in a given time
horizon. VaR summarizes financial risk inherent in portfolios into a simple

number. Though VaR is used to measure market risk in general, it incorporates
many other risks like foreign currency, commodities, and equities (Jorion, 2001)
Methods for Evaluating Value-at-Risk Estimates

I. CURRENT REGULATORY FRAMEWORK
In August 1996, the U.S. bank regulatory agencies adopted the market risk
amendment (MRA) to the 1988 Basle Capital Accord. The MRA, which became
effective in January 1998, requires that commercial banks with significant trading
activities set aside capital to cover the market risk exposure in their trading accounts. (For
further details on the market risk amendment, see Federal Register [1996].) The market
risk capital requirements are to be based on the value-at-risk (VaR) estimates generated
by the Banks own risk management models.
In general, such risk management, or VaR, models forecast the distributions of future
portfolio returns. To fix notation, let YT denote the log of portfolio value at time t. The kperiod-ahead portfolio return is t + k = yt + k yt Conditional on the information
available at time t + k is a random variable with distribution ft + k Thus, VaR model m
is characterized by fmt + k its forecast of the distribution of the k-period-ahead portfolio
return.
VaR estimates are the most common type of forecast generated by VaR models. A VaR
estimate is simply a fmt + k The VaR estimate at time t derived from model m for a kperiod-ahead return, denoted specified quintile (or critical value) of the forecasted.
The critical value that corresponds to the lower a percent tail of fmt + k In other words,
VaR estimates are forecasts of the maximum portfolio loss that could occur over a given
holding period with a specified confidence level.
Under the internal models approach embodied in the MRA, regulatory capital against
market risk exposure is based on VaR estimates generated by banks own VaR models
using the standardizing parameters of a ten-day holding period (k = 10) and 99 percent
coverage
A banks market risk capital charge is thus based on its own estimate of the potential loss
that would not be exceeded with 1 percent certainty over the subsequent two week
period. The market risk capital that bank m must hold for time t + 1 denoted MCRmt + 1
is set as the larger of VaRmt (10,1) or a multiple of the average of the previous sixty
VaRmt (10,1) estimates, that is,
MRCmt + 1 max VaRmt = (10, 1);
Where is smt a multiplication factor and is an additional capital charge for the portfolios
idiosyncratic credit risk. Note that under the current framework the multiplier explicitly
links the accuracy of a banks VaR model to its capital charge by varying over time. Is set
according to the accuracy of model ms VaR
II. ALTERNATIVE EVALUATION METHODS

Given the obvious importance of VaR estimates to banks and now their regulators,
evaluating the accuracy of the models underlying them is a necessary exercise. To date,
two hypothesis-testing methods for evaluating VaR estimates have been proposed: the
binomial method, currently the quantitative standard embodied in the MRA, and the
interval forecast method proposed by Christoffersen (forthcoming). For these tests, the
null hypothesis is that the
VaR estimates in question exhibit a specified property
characteristic of accurate VaR estimates. If the null hypothesis is rejected, the VaR
estimates do not exhibit the specified property, and the underlying VaR model can be said
to be inaccurate. If the null hypothesis is not rejected, then
The model can be said to be acceptably accurate.
However, for these evaluation methods, as with any hypothesis test, a key issue is their
statistical power, that is, their ability to reject the null hypothesis when it is incorrect.
If the hypothesis tests exhibit low power, then the probability of misclassifying an
inaccurate VaR model as acceptably accurate will be high. This paper examines the
power of these tests within the context of a simulation exercise
In addition, an alternative evaluation method that is not based on a hypothesis-testing
framework, but instead uses standard forecast evaluation techniques, is proposed. That is,
the accuracy of VaR estimates is gauged by how well they minimize a loss function that
represents Regulators concerns. Although statistical power is not relevant for this
evaluation method, the related issues of comparative accuracy and model
misclassification are examined within the context of a simulation exercise. The
simulation results are presented below, after the three evaluation methods are described.
(See Lopez [1998] for a More complete discussion.)
(b)Risk Adjusted Rate of Return on Capital (RAROC)

It gives an economic basis to measure all the relevant risks consistently and gives
managers tools to make the efficient decisions regarding risk/return tradeoff in different
assets. As economic capital protects financial institutions against unexpected losses, it is
vital to allocate capital for various risks that these institutions face. Risk Adjusted Rate of
Return on Capital (RAROC) analysis shows how much economic capital different
products and businesses need and determines the total return on capital of a firm. Though
Risk Adjusted Rate of Return can be. Used to estimate the capital requirements for
market, credit and operational risks, it is used as an integrated risk management tool
(Croupy and Robert, 2001)
b) Securitization
It is a procedure studied under the systems of structured finance or credit linked
notes. Securitization of a banks assets and loans is a device for raising new
funds and reducing banks risk exposures. The bank pools a group of incomeearning assets (like mortgages) and sells securities against these in the open
market, thereby transforming illiquid assets into tradable asset backed securities.
As the returns from these securities depend on the cash flows of the underlying
assets, the burden of repayment is transferred from the originator to these pooled
assets
c) Sensitivity Analysis
It is very useful when attempting to determine the impact, the actual outcome of a
particular variable will have if it differs from what was previously assumed. By
creating a given set of scenarios, the analyst can determine how changes in one
variable(s) will impact the target variable.
d) Internal Rating System

An internal rating system helps financial institutions manage and control credit
risks they face through lending and other operations by grouping and managing
the credit-worthiness of borrowers and the quality of credit transactions.
Financial risk refers to those risks that may affect a bank's business growth,
marketability of its product and services, likely failure of its strategies aimed at
business growth etc. These risks may arise on account of management failures,
competition, non- availability of suitable products/services, external factors etc. In
these risk operational and strategic risk have a great need of consideration.
The need for credit portfolio management emanates from the necessity to
optimize the benefits associated with diversification and to reduce the potential
adverse impact of concentration of exposures to a particular borrower, sector or
industry. Stipulate quantitative ceiling on aggregate exposure on specific rating
categories, distribution of borrowers in various industry, business group and
conduct rapid portfolio reviews.
Risk environment
As a result of the environment in which Banco Santander operates, there are different
potential risks that could threaten the development of business and meeting the Groups
strategic objectives. The risk division identifies and assesses these risks and presents
them regularly for analysis to senior management and the board, which take the
opportune measures to mitigate and control them. The main focuses of risk are:
Macroeconomic environment: at the end of 2014, the main sources of macroeconomic
uncertainty were:
Economic slowdown in Europe.
The adjustment to the Chinese economy, which could impact emerging as well and
developed markets.
Change in the US interest rate scenario and its possible impact on emerging markets
(flight to quality).
Evolution of commodity prices and their possible impact on various economies.
Banco Santanders business model, based on geographic diversification and a customerfocused bank, strengthens the stability of results in the face of macroeconomic
uncertainty, ensuring a medium-low profile.
The Group uses techniques of scenario analysis and stress tests to analyses the possible
evolution of macroeconomic indicators and their impact on the income statement, capital
and liquidity. These analyses are incorporated to risk management when planning capital
(section 12.3), risk appetite (section 4.4) and risk management of the different types of
risk (section 6.5.2 on credit, 7.2.1.6. on market and 8.2.2. on liquidity).
Competitive environment:
The financial industry has undergone in the last few years a process of restructuring and
consolidation that could still continue in the coming years. These movements are
changing the competitive environment, as a result of which senior management
continuously monitors the competitive environment, reviewing the Banks business and
strategic plan. The risk division ensures that the changes in the plans are compatible with
the risk appetite limits
Regulatory environment:
a regulatory environment for the financial industry more demanding in capital and
liquidity has been shaped in the last few years, as well as a greater supervisory focus on
risk management and business processes.
In this line the Single Supervisory Mechanism came into force in November 2014.
Previously, during 2014, the European Central Bank, in coordination with the European
Banking Authority, conducted a global evaluation to enhance the transparency; control
and credibility of European banks (see more detail in section 1 of this chapter). This
context will mark the regulatory environment of the coming months. Of note are the
following aspects:
The entry into force of joint supervisory teams, formed from teams from the relevant
national authorities and the European Central Bank.
The gradual harmonization of criteria, concepts, authorization procedures, etc., seeking
an homogenization that equals the regulation and supervision that affects European
banks.
In the same line, supervision of all European banks under a common methodology: the
Supervisory Review and Evaluation Process (SREP).
The importance of the relations established between the Single Supervisory Mechanism
and the rest of supervisors in countries where the Group operates, through supervisory
colleges and the signing of memories of understanding with them
The Bank is attaching greater priority to these issues by permanently monitoring the
changes in the regulatory environment, which enables it to rapidly adapt to the new
requirements. The Group is strengthening teams in all spheres of its activity in order to
comply with the supervisors requirements.
The Group also has a coordination mechanism, fostered and backed by the board and
senior management, among the different management areas and countries, in order to
ensure a consistent response at Group level and implement the best practices in managing
projects with regulatory impact.
Of note, among others, are the projects in order to adjust to:
The requirements of the Basel capital regulations which have been transposed in most
countries where the Group operates, particularly in Europe via the CRR/CRD IV
. The international standards on risk data aggregation (RDA).
The US Volcker rule that limits the own account operations that banks can carry out
. The European investor protection rule (MIFID II) which strengthens the requirements
related to the functioning of securities markets and marketing of financial products.
Non-financial and transversal risks

(operational, conduct, reputational, strategic, etc.): these risks are assuming increasing
importance because of the attention paid to them by regulators and supervisors, which see
in them a reflection of the way banks behave toward their stakeholders (employees,
clients, shareholders, investors and social agents). Of particular note in the financial
industry are
With operational risk, cyber risk or the risk of suffering attacks by third parties on the
Banks IT systems, which could alter the integrity of the information or normal
development of operations.
He Bank has been strengthening in the last few years its computer security system and
continues to invest in this area in the face of potential threats (for more detail sees section
9).
Conduct risk:
in the last few years there has been a growing tightening of regulations regarding the
treatment that banks must provide to their customers, These changes in regulations and
their application could entail an impact for banks involving potential judicial demands or
fines by supervisors as well as the necessary changes to processes and structure that must
be carried out to comply with the new standards
Banco Santander is strengthening control of this risk and has launched a global plan to
improve the marketing of investment products and analysis of the costs incurred (paid or
provisioned) as a result of compensation to clients and sanctions.
In line with the regulatory recommendations in the corporate governance sphere, the
board agreed to appoint an executive vice-chairman to whom the compliance function
reports.
More information is available in the section on compliance, conduct and reputational risk
in this report.
There are also specific risk development programs for all the Groups executives and a
strategy of risk training and auditing for these divisions through the corporate schools of
risks and auditing, which have global and local programs and disseminate the culture of
prudence in risks and control throughout the Group.
The BASEL Committee on Banking Supervision

At the end of 1974, the Central Bank Governors of the Group of Ten countries formed a
Committee of banking supervisory authorities. As this Committee usually meets at the
Bank of International Settlement (BIS) in Basel, Switzerland, this Committee came to be
known as the Basel Committee. The Committees members came from Belgium, Canada,
France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, United Kingdoms and the United States. Countries are represented by their
central banks and also by the authority with formal responsibility for the prudential
supervision of banking business where this is not the central bank.
The Basel Committee does not possess any formal supra-national supervisory authority,
and its conclusions do not, and were never intended to, have legal force. Rather, it
formulates broad supervisory standards and guidelines and recommends the statements of
best practice in the expectation that individual authorities will take steps to implement
them through detailed arrangements statutory or otherwise which are best suited to
their own national systems (NEDfi Databank Quarterly, 2004). In this way, the
Committee encourages convergence towards common approaches and common standards
without attempting detailed harmonization of member countries supervisory techniques.
The Committee reports to the central bank Governors of the Group of Ten countries and
seeks the Governors endorsement for its major initiatives. In addition, however, since the
Committee contains representatives from institutions, which are not central banks, the
decision involves the commitment of many national authorities outside the central
banking fraternity. These decisions cover a very wide range of financial issues.
One important objective of the Committees work has been to close gaps in international
supervisory coverage in pursuit of two basic principles that no foreign banking
establishment should escape supervision and the supervision should be adequate. To
achieve this, the Committee has issued a long series of documents since 1975
BASEL I
.
In 1988, the BASEL Committee decided to introduce a capital measurement system
(BASEL I) commonly referred to as the Basel Capital Accord. Since 1988, this
framework has been progressively introduced not only in member countries but also in
virtually all other countries with active international banks. Towards the end of 1992, this
system provided for the implementation of a credit risk measurement framework with
minimum capital standard of 8%.
The basic achievement of Basel I has been to define bank capital and the so-called bank
capital ratio. Basel I is a ratio of capital to risk-weighted assets. The numerator, Capital,
is divided into Tier 1 (equity capital plus disclosed reserves minus goodwill) and Tier 2
(asset revaluation reserves, undisclosed reserves, general loan loss reserves, hybrid
capital instrument and subordinated term debt).
BASEL II (Revised International Capital Framework)

Central bank Governors and the heads of bank supervisory authorities in the Group of
Ten (G10) countries endorsed the publication of International Convergence of Capital
Measurement and Capital Standards: a Revised Framework, the new capital adequacy
framework commonly known as Basel II. The Committee intends that the revised
framework would be implemented by the end of year 2006.
In principle, the new approach (Basel II) is not intended to raise or lower the overall level
of regulatory capital currently held by banks, but to make it more risk sensitive. The spirit
of the new Accord is to encourage the use of internal systems for measuring risks and
allocating capital. The new Accord also wishes to align regulatory capital more closely
with economic capital. The proposed capital framework consists of three pillars
Pillar 1 - Minimum capital requirements
Pillar 2 - Supervisory review process
Pillar 3 - Market discipline
Pillar 1: Minimum Capital Requirements

Pillar 1 of the new capital framework revises the 1988 Accords guidelines by aligning
the minimum capital requirements more closely to each banks actual risk of economic
loss. The minimum capital adequacy ratio would continue to be 8% of the risk-weighted
assets (as per RBI, it is 9%), which will cover capital requirements for credit, market and
operational risks.
Estimating Capital required for Credit Risks

For estimating the capital required for credit risks, a range of approaches such as
Standardized, Foundation Internal Rating Based (IRB) and Advanced IRB are suggested.
Pillar 2: Supervisory Review Process

Pillar 2 of the new capital framework recognizes the necessity of exercising effective
supervisory review of banks internal assessments of their overall risks to ensure that
bank management is exercising sound judgment and had set aside adequate capital for
these risks. To be more specific Supervisors will evaluate the activities and risk profiles of individual banks to
determine whether those organizations should hold higher levels of capital than the
minimum requirements in Pillar 1 would specify and to see whether there is any need for
remedial actions.
Pillar 3: Market Discipline

Pillar 3 leverages the ability of market discipline to motivate prudent management by
enhancing the degree of transparency in banks public reporting. It sets out the public
disclosures that banks must make that lend greater insight into the adequacy of their
capitalization. The Committee believes that, when market place participants have a
sufficient understanding of a banks activities and the controls it has in place to manage
its exposures, they are better able to distinguish between banking organizations so that
they can reward those that manage their risks prudently and penalize those that do not
(NEDfi Databank Quarterly, 2004).
BASEL III
Thus, under BASEL III, the denominator of the minimum capital ratio will consist of
three parts the sum of all risk weighted assets for credit risk, plus 12.5 times (reciprocal
of 8 % minimum risk based capital ratio) the sum of the capital charges for market risk
and operational risk. The multiplicatory factor of 12.5 has been introduced in order to
enable banks to create a numerical link between the calculation of capital requirement for
credit risk and the capital requirement for operational and market risks. In case of capital
requirement for credit risk, calculation of capital is based on the risk weighted assets.
However, for calculating capital requirement for operational and market risk, the capital
charge itself is calculated directly.
The standardized approach builds on the basic indicator approach. It divides the banks
activities into 8 business lines corporate finance, trading and sales, retail banking,
commercial banking, payment and settlement, agency services, asset management and
retail brokerage. The capital charge for operational risk is arrived at based on fixed
percentage for each business line.
The Impact of Basel III on Risk Management in banks

Over the past decade, banks and banking systems globally have dealt with the challenges
of implementing Basel II. During the next several years, they will be intensifying efforts
to meet the requirements of Basel III, encompassing the most recent reforms by The
Basel Committee (Committee) to the Basel Accord. Basel III represents the next phase in
the Committees ongoing efforts to strengthen global capital and liquidity rules to achieve
a more resilient banking sector. The significance and comprehensiveness of reforms set
forth by the Committee aim to incorporate lessons learned from the recent financial crisis,
especially related to the loss of confidence in the solvency, capital adequacy, and liquidity
of banking institutions, which extended quickly not only throughout the financial system,
but also ultimately through the economy at large, resulting in a contraction of liquidity
and credit availability.
The implementation of Basel II has been a key driver for the refinement and maturation
of risk management frameworks in financial institutions worldwide. However, the arrival
of Basel III signals an unprecedented rising of the bar for risk management practices to
support the comprehensive nature of the new requirements. The stakes could not be
higher, with capital events such as the payment of dividends, contingent on meeting Basel
III capital requirements by January 1, 2013.
This article summarizes key aspects of Basel III and its evolution. Its focus is on the
significant elements that banks must consider as they approach key risk-management
requirements and challenges posed by the reforms, as well as major components of a
solution framework, key success factors, and types of implementation actions to be
considered.
Reforms and Timelines

Basel III introduces new capital, leverage, and liquidity standards to reinforce regulation,
supervision, and risk management of the financial sector. It reinforces the three Basel II
pillars -- pertaining to Minimum Capital Requirements (Pillar 1), Supervisory Review
(Pillar 2), and Market Discipline (Pillar 3) -- through Rules that must become laws and
regulations in each participating country by January 1, 2013. These complex and
comprehensive Basel III Rules are best summarized in the following list of regulatory
changes, each of which is discussed in subsequent paragraphs:
raising the quality of capital by re-defining predominant components of Tier 1 capital
enhancing the risk coverage of the capital framework to include off-balance sheet risks
and risk-management incentives
Increasing capital requirements such as:
o Core Tier 1 (common equity)
o Tier 1 (surplus, instruments issued by consolidated subsidiaries and held by third parties
and not included in Core Tier 1)
o Conservation buffer (new in Basel III, to build up adequate buffers above the minimum
that can be drawn down during times of stress)
o Countercyclical buffer (to build up adequate buffers to protect the banking sector in
period of excess credit growth)
Introducing an internationally standardized leverage ratio, consistently calculated
across country jurisdictions, and employing consistent definitions of capital components
Raising standards for the supervisory review process under Pillar 2 and for public
disclosures under Pillar 3
Introducing minimum global liquidity standards and ratios

Raising the quality of capital The Committee designed both qualitative and quantitative
measures to ensure that the banking sector can retain and attract adequate levels of capital
under Basel III while remaining capable of supporting economic growth.
New qualitative measures place an increasing emphasis on common equity capital,
including paid-in common shares and retained earnings, which will constitute the
predominant form of Tier 1 capital under Basel III. The inconsistencies in capital
definition and lack of disclosures, both of which became apparent during the recent
financial crisis, limited the ability of markets to make qualitative assessments of capital
across institutions and jurisdictions. In response, Basel III incorporates internationallystandardized regulatory deductions to create, across country boundaries, more resilient
regulatory capital comprised of instruments: 1) without maturity or redemption features,
2) that are subordinated, and 3) for which the payment of dividends must be
discretionary. The new regulatory deductions will phase out hybrid capital instruments
that offer redemption incentives and may comprise up to 15 percent of the Tier 1 capital
base under Basel II. Regulatory deductions extend to Tier 2 and eliminate Tier 3 capital
instruments, such as those created to cover market risks. Over time this will result in a
strengthened capital base and a higher common equity component of that capital base.
Increasing the risk coverage of the capital framework
During the recent financial crisis, the disruption to the financial markets was exacerbated
by off-balance sheet derivatives and related exposures. In response, the Committee set
forth reforms to the Basel II framework designed to raise capital requirements for the
trading book and complex securitization exposures, including a stressed value-at-risk
(VaR) capital requirement. The Committee also introduced measures that include riskmanagement incentives, including incentives to move over-the-counter derivative
contracts to central counterparties, to reduce systemic risk across the financial system
from counterparty exposures
Increasing capital ratios

Transitional arrangements for implementing new standards specify levels of Common
Equity Tier 1, Tier 1, and Total Capital as a percentage of risk weighted assets as of
January 1, 2013, with phased-in increases occurring through January 1, 2015. As of
January 1, 2013 banks are required to achieve the following new minimum requirements
in relation to risk-weighted assets (RWAs):
Common Equity Tier 1/RWAs: 3.5%
Tier 1 capital/RWAs: 4.5%
Total capital/RWAs: 8%
By January 1, 2018, defined regulatory adjustments will be fully deducted from Common
Equity Tier 1 capital. Further, the Committee hopes to increase the resiliency of the
banking sector during strong economic periods through measures such as promoting
more forward-looking provisions toward an Expected Loss (EL) approach, building
buffers and establishing protection from excess growth. This will require changes to
current accounting standards for certain mark-to-market assets and margining practices.
Introducing an internationally standardized leverage ratio

Until the risk management maturity of the banking sector achieves a level of precision
that consistently supports each Basel Pillar, especially the transparency and market
disclosures under Pillar 3, risk-based capital requirements will be supplemented with a
leverage ratio that represents a base percentage of regulatory capital across the board as a
backstop mechanism. The capital measure will be based on the new definition of Tier 1
capital in the Basel III framework, plus findings from data collected during a transition
period to understand the impact of using total regulatory capital and Common Equity Tier
1. The transition period for the leverage ratio began on January 1, 2011, with a parallel
run period (using risk-based capital) beginning January 1, 2013 and continuing until
January 1, 2017. Bank-level disclosure of the leverage ratio and its components will
begin January 1, 2015.
Raising standards for the supervisory review process

Reforms to the Basel II framework completed by the Committee in July 2009 raised
capital requirements for trading book and securitization exposures (Pillar 1). The reforms
also raised the standards for the Pillar 2 supervisory review process and strengthened
Pillar 3 disclosures. Pillar 1 and 3 enhancements were to be implemented by the end of
2011, with Pillar 2 standards becoming effective when introduced in 2009.
Introducing minimum global liquidity standards

The loss of liquidity throughout the financial system during the recent financial crisis
highlighted for the Committee liquiditys importance to banking sector stability and led to
the development of liquidity standards in Basel III. The standards have been developed to
achieve the objectives of:
ensuring that sufficient high-quality liquid resources are available to meet an acute
stress scenario lasting for one month
highlighting funding sources with one year stability
The measures used to assess these two objectives are known respectively as the Liquidity
Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). The LCR is to be
introduced January 1, 2015; the minimum standards for the NSFR are to be established
by January 1, 2018.
Defining a Solution Set in the Risk Management Framework

The critical risk management challenges posed by the need to implement Basel III require
the support and engagement of multiple competencies across the organization to address
impacts on people, process and technology. However, the laws and regulations being
written to implement Basel III will not distinguish size, structure, risk profile, complexity,
or economic significance of a banking organization. Yet, these factors must be taken into
consideration in developing, maintaining, and continuously improving an appropriate risk
management framework that serves an individual institution well. In a recent On
Financial Services article that I authored on risk management, published in Q3 of 2011, I
noted that: unlike accounting, regulatory, tax, and other well-defined governance
structures that exist throughout financial institutions, there is not a single standard for an
enterprise risk management framework. This is important to keep in mind as banking
organizations plan and position for Basel III.
Given that not all risk management organizations look or function alike, how can banks
effectively approach implementing the comprehensive and complex regulations that will
arise from Basel III? Experience in implementing Basel II has shown that an
implementation approach for a Basel III program that is integrated with risk management
and that also is connected to the banks Program Management Office (PMO) is optimal.
Such an integrated program will:
Coordinate all Basel III initiatives enterprise-wide
Help ensure that major work streams in risk management and the PMO that identify
requirements, solution sets and projects fully address Basel III implementation
requirements
Taken together, these two components ensure that the people and capital employed in
implementing Basel III are moving strategically and tactically in the desired direction not
only to meet the requirements of Basel III, but also to align the organizations risk
management capabilities with the implementation of Basel initiatives at a project level.
Even though the Basel III PMO may organizationally be part of an enterprise-wide PMO,
a key to successful implementation is to ensure that risk management is effectively
incorporated into each major project initiative or related groups of projects (which may
take the form, for example, of providing subject matter expertise or actually managing
certain project initiatives).
As banks assess the major components of a risk management or Basel III program, we
propose that four work streams could potentially be used to organize various project
initiatives within the Program:
1. Corporate Risk Governance:

The Basel Committee requires targeted supervisory guidance, as high-profile
incidents related to corporate governance have continued to attract adverse
attention around the globe. A key success factor in implementing Basel II and
furthering risk management was gaining buy-in and support at the highest levels
of banking organizations, including not only various levels of management, but
the board as well. Corporate governance not only sets the tone for, but also directs
the organization toward key risk management and Basel solution.
2. Financial Analytics:
The Rules that will become laws and regulations by the end of 2012 extend the
capabilities required by Basel II to perform calculations and analytics around data.
Achieving these required improvements in modeling and reporting will require rigorous
effort. Examples of key risk management and Basel solutions include:
internal model and estimation development for measuring risk factors such as
Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EAD)
Capital forecasting and sensitivity analysis
Stress-testing methodology
Methodologies for economic capital and optimization of regulatory capital
calculations under the new Rules
Design and generation of new regulatory liquidity risk reports
Adjustment of risk-weighted assets (RWA) calculations
Introduction of funding and liquidity metrics
2. Processes and Procedures:
Some changes needed, by the end of 2012, to develop risk-management
processes supporting laws and regulations that extend beyond Basel II rules will
likely be:
Review, redesign, and updating of risk functions and procedure
CONCLUSION
The following are the conclusions 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 ensure that the risks are consciously taken with full knowledge, clear purpose and
understanding so that it can be measured and mitigated.
Functions of risk management should actually be bank specific dictated by the size
and quality of balance sheet, complexity of functions, technical/ professional manpower
and the status of MIS in place in that bank.
Risk Management Committee, Credit Policy Committee, Asset Liability Committee,
etc. are such committees that handle the risk management aspects.
The banks can take risk more consciously, anticipates adverse changes and hedges
accordingly; it becomes a source of competitive advantage, as it can offer its products at a
better price than its competitors.
Regarding use of risk management techniques, it is found that internal rating system
and risk adjusted rate of return on capital are important.
the effectiveness of risk measurement in banks depends on efficient Management
Information System, computerization and net working of the branch activities.
CASE STUDY
Risk is the fundamental element that drives financial behavior without risk the financial
system would be vastly simplified. However risk is omnipresent in the real words.
Financial institutions therefore should manage the risk efficiently to survive in this highly
uncertain world. The future of banking will undoubtedly rest on risk management
dynamics. Only those banks that have efficient management of credit risk is a critical
component of comprehensive risk management essentials for long term success of
banking institutions.
We are proud of our customers project Risk management case studies and the success
they have achieved. Active Risk helps to drive business performance by allowing our
customers to take more risk. Every day our customers benefit from the visibility and
competitive advantage that active delivers. With active risk manager our customers have
a singular, central view of all risk information across their organization. High quality
timely data enables risk to be actively managed and leveraged transforming risk from a
challenge to overcome into an opportunity for competitive advantage.
Bibliography
Websites
www.scribd.com
Www. Google.com
www.yahoo.com
www.bis.org
Www. Rbi.org
www.kpmg.com
Www. Cognizant.com
Books
Hand book on risk management & Basel III Norms.

Risk Management

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A PROJECT REPORT

STUDY OF RISK MANAGEMENT IN BANKS

PADMASHREE ANNASAHEB JADHAV BHARTIYA SAMAJ UNNATI

UNDER THE GUIDANCE OF

STUDY OF RISK MANAGEMENT IN BANKS

PADMASHREE ANNASAHEB JADHAV BHARTIYA SAMAJ UNNATI

UNDER THE GUIDANCE OF

Padmashree Annasaheb Jadhav Bhartiya Samaj Unnati Mandals

Bachelor of Banking and Insurance (B.B.I.)

This is to certify that, MISS. LAD NETRA CHANDRAKANT.

Ms. URVI GADA

Dr. Suvarna T. Rawal

MANAGEMENT IN BANKS is true and correct to the best of

LAD NETRA CHANDRAKANT

Data Analysis and interpretation

Observations and Conclusions

Definition of Risk Management

Risk refers to a condition where there is a possibility of undesirable occurrence of a

PURPOSE OF THE RESEARCH

LITERATURE REVIEW OF RISK MANAGEMENT

OBJECTIVES OF THE STUDY

Survival of the Organization

COMPONENTS OF RISK MANAGEMENT

RISK MANAGEMENT SYSTEMS IN BANKS:

Role of RBI in Risk Management in Banks

Risk Management Practices in India

PROCESS OF RISK MANAGEMENT

Risk Return Trade off

Interest Rate Risk

Credit or Default Risk

(a) Funding Risk:

Balance sheet analysis and measurement of liquidity risk

Analysis of the balance sheet and measurement of liquidity risk

Interest Rate Risk

(a) Gap or Mismatch Risk:

(b)Yield Curve Risk:

(c) Basis Risk:

Effects of interest rate risk

Economic value perspective:

Methods for interest rate risk measurement

(a) Forex Risk:

Modified duration analysis

Analysis of the type 'simulation analysis'

Default or Credit Risk

Political Risk when political environment or legislative process of country leads to

Ratio of non-performing advance to total advances.

The major external factors

TOOLS OF CREDIT RISK MANAGEMENT.

Definition and objectives

Management model and control of operational risk

Implementation of the model and initiatives in Operational

Foster contingency and business continuity plans.

System of operational risk information

Other aspects of control and monitoring of operational risk

TECHNIQUES OF RISK MANAGEMENT

b) Value at Risk (VaR)

horizon. VaR summarizes financial risk inherent in portfolios into a simple

Methods for Evaluating Value-at-Risk Estimates

II. ALTERNATIVE EVALUATION METHODS

(b)Risk Adjusted Rate of Return on Capital (RAROC)

d) Internal Rating System

Non-financial and transversal risks

The BASEL Committee on Banking Supervision

BASEL II (Revised International Capital Framework)