Managing Risks in Commercial and Retail Banking

AMALENDU GHOSH worked for the Reserve Bank of India (RBI) for thirty-six years and has extensive exposure to bank regulation, risk management, risk-based bank supervision, and the New Basel Capital Accord. He was the chief of RBI's banking regulation department. After retirement, he worked with RBI on a contractual basis as the head of a risk-based bank supervision project implementation group, and was involved in drawing the road map, developing a supervision model, and writing a bank examination manual for actual conduct of bank inspection for the switch to the risk-based bank supervision system. Ghosh was also the risk management consultant to two nationalized commercial banks in India. He has hands-on experience in the formulation and implementation of risk management practices and procedures including development of models for counterparty rating.

Preface xv

Part One Risk Management Approaches and Systems

Chapter 1 Business Risk in Banking 3

1.1 Concept of Risk 3

1.2 Broad Categories of Risks 3

1.3 Credit Risk 5

1.4 Market Risk 7

1.5 Operational Risk 8

1.6 Operating Environment Risk 10

1.7 Reputation Risk 11

1.8 Legal Risk 12

1.9 Money Laundering Risk 12

1.10 Offshore Banking Risk 14

1.11 Impact of Risk 15

1.12 Summary 16

Notes 18

Chapter 2 Control Risk in Banking 19

2.1 How Control Risk Arises 19

2.2 External Control and Internal Control Risks 19

2.3 Internal Control Objectives 21

2.4 Internal Control Framework 21

2.5 Tasks in Establishing a Control Framework 28

2.6 Business Risk and Control Risk Relationship 34

2.7 Summary 35

Chapter 3 Technology Risk in Banking 37

3.1 What Is Technology Risk? 37

3.2 Risks in Electronic Banking 37

3.3 Sources of Technology Risk 38

3.4 Management of Technology Risk 42

3.5 Summary 43

Chapter 4 Fundamentals of Risk Management 45

4.1 Risk Management Concept 45

4.2 Risk Management Approach 45

4.3 Risk Identification Approach 47

4.4 Risk Management Architecture 47

4.5 Risk Management Organizational Structure 48

4.6 Summary 53

Chapter 5 Risk Management Systems and Processes 55

5.1 Risk Management Policy 55

5.2 Risk Appetite 56

5.3 Risk Limits 57

5.4 Risk Management Systems 59

5.5 Management Information System 67

5.6 Verification of Risk Assessment 72

5.7 Human Resource Development 72

5.8 Top Management Commitment 73

5.9 Capital Adequacy Assessment and Disclosure Requirement 74

5.10 Risk Prioritization 75

5.11 Summary 76

Notes 77

Part Two Credit Risk Management

Chapter 6 Credit Problems and Credit Risk 81

6.1 Genesis of Credit Problems 81

6.2 Causes of Credit Risk 92

6.3 Summary 93

Notes 94

Chapter 7 Identification of Credit Risk 95

7.1 Market Risk and Credit Risk Relationship 95

7.2 Credit Risk Identification Approach 96

7.3 Credit Risk Identification Process 100

7.4 Summary 109

Notes 110

Chapter 8 Credit Risk Rating Concept and Uses 111

8.1 Credit Risk Rating Concept 111

8.2 Credit Risk Rating Uses 113

8.3 Credit Risk Rating Principles 122

8.4 Summary 127

Notes 128

Chapter 9 Credit Risk Rating Issues 129

9.1 Rating Practices in Banks 129

9.2 Design of the Rating Framework 130

9.3 Conceptual Issues 131

9.4 Developmental Issues 136

9.5 Implementation Issues 140

9.6 Rating Framework Overview 147

9.7 Summary 147

Notes 151

Chapter 10 Credit Risk Rating Models 153

10.1 Internal Rating Systems in Banks 153

10.2 Need for Different Rating Models 154

10.3 Need for New and Old Borrower Rating Models 155

10.4 Types of Rating Models 157

10.5 New Capital Accord Options 158

10.6 Asset Categorization 159

10.7 Identification of Model Inputs 160

10.8 Assessment of Component Risk 161

10.9 Summary 172

Notes 172

Chapter 11 Credit Risk Rating Methodology 173

11.1 Rating Methodology Development Process 173

11.2 Derivation of Component Rating 189

11.3 Derivation of Counterparty Rating 195

11.4 Summary 197

Chapter 12 Credit Risk Measurement Model 199

12.1 Risk Rating and Risk Measurement Models 199

12.2 Credit Loss Estimation—Conceptual Issues 200

12.3 Quantification of Risk Components 204

12.4 Credit Risk Measurement Models 215

12.5 Back-Testing of Credit Risk Models 219

12.6 Stress Testing of Credit Portfolios 220

12.7 Summary 222

Notes 223

Chapter 13 Credit Risk Management 225

13.1 General Aspects 225

13.2 Credit Management and Credit Risk Management 225

13.3 Credit Risk Management Approach 226

13.4 Credit Risk Management Principles 227

13.5 Organizational Structure for Credit Risk Management 232

13.6 Credit Risk Appetite 234

13.7 Credit Risk Policies and Strategies 234

13.8 Early Warning Signal Indicators 242

13.9 Credit Audit Mechanism 244

13.10 Credit Risk Mitigation Techniques 248

13.11 Summary 253

Note 254

Chapter 14 Credit Portfolio Review Methodology 255

14.1 Portfolio Classification 255

14.2 Portfolio Management Objectives 256

14.3 Portfolio Management Issues 256

14.4 Portfolio Analysis Technique 261

14.5 Portfolio Risk Mitigation Techniques 266

14.6 Summary 269

Chapter 15 Risk-Based Loan Pricing 271

15.1 Loan Pricing Concept 271

15.2 Loan Pricing Principles 271

15.3 Loan Pricing Issues 272

15.4 Loan Price Computation 275

15.5 Summary 280

Part Three Market Risk Management

Chapter 16 Market Risk Framework 283

16.1 Market Risk Concept 283

16.2 Market Risk Types 283

16.3 Market Risk Management Framework 285

16.4 Organizational Setup 286

16.5 Market Risk Policy 288

16.6 Market Risk Vision 289

16.7 Summary 290

Chapter 17 Liquidity Risk Management 293

17.1 Liquidity Risk Causes 293

17.2 Liquidity Risk Management Activities 294

17.3 Liquidity Risk Management Policies and Strategies 296

17.4 Liquidity Risk Identification 297

17.5 Liquidity Risk Measurement 299

17.6 Liquidity Management Structure and Approaches 306

17.7 Liquidity Management under Alternate Scenarios 310

17.8 Liquidity Contingency Planning 313

17.9 Stress Testing of Liquidity Funding Risk 314

17.10 Liquidity Risk Monitoring and Control 321

17.11 Summary 325

Notes 326

Chapter 18 Interest Rate Risk Management 327

18.1 Interest Rate Risk in Trading and Banking Books 327

18.2 Interest Rate Risk Causes 328

18.3 Interest Rate Risk Measurement 332

18.4 Maturity Gap Analysis 334

18.5 Duration Gap Analysis 336

18.6 Simulation Analysis 341

18.7 Value-at-Risk 342

18.8 Earnings at Risk 347

18.9 Interest Rate Risk Management 351

18.10 Interest Income Stress Testing 353

18.11 Interest Rate Risk Control 354

18.12 Summary 355

Notes 356

Chapter 19 Foreign Exchange Risk Management 357

19.1 Exchange Risk Implication 357

19.2 Exchange Risk Types 358

19.3 Foreign Currency Exposure Measurement 361

19.4 Exchange Risk Quantification 364

19.5 Exchange Risk Management 366

19.6 Exchange Risk Hedging 370

19.7 Summary 371

Notes 372

Chapter 20 Equity Exposure Risk Management 373

20.1 Equity Exposure Identification 373

20.2 Equity Exposure Management Framework 374

20.3 Equity Exposure Risk Measurement 375

20.4 Summary 376

Chapter 21 Asset Liability Management Review Process 379

21.1 Asset-Liability Review 379

21.2 Liquidity Risk Review 380

21.3 Interest Rate Risk Review 383

21.4 Foreign Exchange Risk Review 384

21.5 Equity Price Risk Review 385

21.6 Value-at-Risk Review 385

21.7 Summary 386

Part Four Operational Risk Management

Chapter 22 Operational Risk Management Framework 389

22.1 Operational Risk Concept 389

22.2 Operational Risk Sources 390

22.3 Operational Risk Causes 393

22.4 Operational Risk Policy Objectives 397

22.5 Operational Risk Policy Contents 398

22.6 Operational Risk Management Framework 399

22.7 Summary 401

Note 408

Chapter 23 Operational Risk Identification, Measurement, and Control 409

23.1 Operational Risk Identification Approach 409

23.2 Operational Risk Identification Process 410

23.3 Business Line Identification 411

23.4 Operational Risk Assessment Methods 414

23.5 Operational Risk Measurement Methodology 421

23.6 Operational Risk Measurement Process 425

23.7 Operational Risk Monitoring 429

23.8 Operational Risk Control and Mitigation 430

23.9 High-Intensity Operational Risk Events—Business Continuity Planning 431

23.10 Business Continuity Plan Support Requirements 433

23.11 Business Continuity Planning Methodology 434

23.12 Operational Risk Management Organizational Structure 436

23.13 Summary 437

Notes 438

Part Five Risk-Based Internal Audit

Chapter 24 Risk-Based Internal Audit—Scope, Rationale, and Function 443

24.1 Internal Audit Scope and Rationale 443

24.2 Risk-Based Internal Audit Policy 449

24.3 Internal Audit Department Structure 450

24.4 Summary 452

Chapter 25 Risk-Based Internal Audit Methodology and Procedure 453

25.1 Risk-Based Internal Audit Methodology 453

25.2 Risk-Based Audit Planning and Scope 468

25.3 Risk-Based Audit Process 471

25.4 Summary 484

Part Six Corporate Governance

Chapter 26 Corporate Governance 489

26.1 Corporate Governance Concept 489

26.2 Corporate Governance Objectives 490

26.3 Corporate Governance Foundation 492

26.4 Corporate Governance Elements 493

26.5 Corporate Governance in Banks 500

26.6 Toward Better Corporate Governance in Banks 505

26.7 Summary 509

Note 510

Part Seven Lessons from the Asian and the United States’ Financial Crises

Chapter 27 The Causes and Impact of the Asian and the United States’ Financial Crises 513

27.1 The Asian Financial Crisis Causes and Impact 514

27.2 Risks Emerging from the Asian Financial Crisis 515

27.3 The Impact of the U.S. Financial Crisis 519

27.4 The U.S. Financial Crisis Causes and the Concomitant Risks 520

27.5 Basel Committee on Banking Supervision Response (Basel III) 534

27.6 Summary 535

Notes 537

About the Author 539

Index 541