Chapter 5: Risk Management in Banks

Chapter 5: Risk Management in Banks • Sourcing of banking risks: • Credit risk • Exchange risk • Interest rate risk: it is the exposure of a bank’s financial condition to adverse movements in interest rates • Liquidity risk: risk that the bank may not be able to fund increases in assets or meet liability obligations as they fall due without incurring unacceptable losses. • Country risk • Other non-financial risks • What is required? • Better understanding of the types of risk and the inter-relationships between various types of risk. • Better understanding of the drivers and dynamics of each type of risk • Evolution of tools to model and manage risk • Evolution of innovative instruments and markets to support risk mitigation, through allocation and transfer, such as securitisation and derivative products • Dealing with changes in the organisation of financial systems such as more efficient management of very large banks, new kinds of institutions such as hedge funds and securitisation companies, a blurring of traditional classification of types of financial institutions • Developing the appropriate regulatory and legal structures to support the risk management environment

Risk management is uniquely important for financial institutions because, in contrast to firms in other industries, their liabilities are a source of wealth creation for their shareholders. • Banks have started focusing on ‘asset-liability risk’ to mitigate the balance sheet weaknesses. • The problem is not that market value of assets might fall or that the value of liabilities might rise. • It is that capital might be depleted by narrowing of the difference between assets and liabilities, since the values of assets and liabilities may not always move together, in the same direction. • Asset-liability risk is a leveraged risk. • To reduce interest rate risk: • Selling fixed rate, long-term assets • By obtaining matching fixed-rate, long-term liabilities to fund fixed rate, long-term assets, • Extend maturities in the investment portfolio • Increase floating rate deposits and short-term borrowings • Increase long-term and fixed rate lending • Use of interest rate derivatives (IRDs)

Interest Rate Derivatives: • Banks can use IRDs to transform some of its fixed rate investments into floating rate assets. It can also use IRDs to transform floating rate liabilities into fixed rate liabilities. • They are contracts used to hedge other positions that expose them to risk, or speculate on anticipated price moves. • They are financial instruments whose value depends on the value of other underlying instruments (such as price of underlying fixed rate securities) or indices (such as interest rate indices). • The most widely used contracts are swaps, financial futures, forward rate agreements (FRAs), options, caps/floors/collars and swaptions. • A swap is an agreement in which two parties agree to exchange periodic payments. The monetary value of the payments exchanged is based on a notional amount. There are four prevalent types-interest rate swaps, currency swaps, commodity swaps and equity swaps. • Interest rate futures: a futures contract is a legal agreement between a buyer (or seller) and an established exchange in which the buyer (or seller) agrees to take (or make) delivery of something at a predetermined price at the end of a predetermined period of time. When the underlying asset is an interest-bearing security, the contract is termed as interest rate futures. • FRA: a forward rate agreement is one type of forward contract, based on interest rates. Here, two counterparties agree to a notional principal amount to serve as a reference for determining cash flows. • Interest rate options: they provide protection against adverse market moves, while enabling the holder to still benefit from favourable shifts in the market. • Caplets and floorlets: caplet-call option-protects the bank against large increase in interest rates -it effectively has set a cap on the bank’s interest outgo and floorlets-put option-ensures that drops in interest rate donot eat into the bank’s earnings-it has effectively guaranteed a minimum level of income floor for the bank. • Interest rate collars: when a bank purchases a collar, it is actually simultaneously buying an interest rate cap and selling an interest rate floor- the notional amount, maturity and index being the same. • Swaptions: it is an options on a swap. The holder of a swaption has the option of entering into a swap contract at a predetermined fixed rate during the agreed period.

How do interest rate swaps work? (illustration) • Firm A, with credit rating less than investment grade, requires rs 100 crore fixed rate funding for a term of 7 years. • the firm has two alternatives-borrow 7 year fixed rate funds at a sizeable premium, 12%p.a or borrow floating rate funds for the 7 year period at a small premium, market determined prime rate (equivalent to LIBOR) plus 2% p.a. • Bank B, which enjoys investment grade credit rating requires floating rate funds. Moreover, it can issue 7 year fixed rate bonds in the same currency at 10% p.a. • It can also acquire floating rate funds for an equivalent term at the market-determined prime rate-LIBOR plus 50 bps p.a. • The rate offered to the firms can be represented as follows: • firm A: fixed rate:12% and floating rate: LIBOR + 2% • Bank B: fixed rate:10% and floating rate:LIBOR +0.5% • Assume that firm A wants to borrow funds at a fixed rate and Bank B prefers to acquire funds at a floating rate linked to LIBOR. • Firm A seems to have a comparative advantage in floating rate markets, since the additional premium it pays over the amount paid by bank B is less in this marekt(2-0.5=1.5) than in fixed rate market (12-10=2). • Similarly Bank B appears to have a comparative advantage in the fixed rate market.

The fact that the difference between two fixed rates is greater than the difference between the two floating rates, allows a profitable swap to be negotiated. • This is done as follows: • Firm A would raise floating rate funds at LIBOR+2% and Bank B would raise an identical amount of fixed rate funds at 10%. Next A and B enter into a swap directly without an intermediary as follows: • Firm A agrees to pay Bank B fixed interest rate at 9.75% and Bank B agrees to pay A the floating rate of interest at LIBOR percent p.a. • Bank B has 3 sets of cash flows: • a-It pays 10% to outside lenders • b-It receives 9.75% p.a. from A • c-It pays the LIBOR to A • The net effect of cashflows a and b is a cost of 0.25% p.a. to B. the net effect of all three cash flows is that Bank B pays LIBOR+0.25% or 0.25% less than what it would have had to pay to the floating rate markets if accessed directly. • Firm A also has three sets of cash flows: • A-it pays LIBOR+2% to outside lenders. • B-it receives LIBOR from B • C-it pays 9.75% p.a. to B • The first two cash flows aggregate to a cost of 2%, and all three taken together implies that A pays 11.75% p.a. for obtaining fixed rate funds or 0.25% less than if if had gone directly to the fixed rate markets. • Therefore it is evident that an interest rate swap benefits both A and B by 25 bps each, that is an aggregate of 50 bps p.a.

Managing Liquidity risk: • Banks should have a practice of formulating liquidity policy • Asset management and liability management • Project sources and uses of funds over the planning horizon • Cash flow or funding gap report • Ratio analysis • Working capital approach • Rating the bank’s liquidity by regulator • Sources of liquidity risk: factors that can influence bank liquidity: • Access to financial markets • Financial health of the bank • Balance-sheet structure • Liability and asset mix • Timing of funds flow • Impact of other risks

Chapter 6: High-tech Banking: E-payment Systems and Electronic Banking • Traditionally transfer of bank credits have taken place through debit instruments like cheques, demand drafts and payment orders. • The recent past has, however, seen an increasing plethora of choices for making payments such as following: • Internet/phone/mobile banking • Electronic clearing system • Electronic fund transfer • Debit cards • Payments through Real Time Gross Settlement (RTGS) • Information technology based retail financial services being offered by the banking industry to its clientele has contributed to the broadening of product lines for retail banking as well as delivery channels. • These e-channels allow financial transactions to be carried out anywhere and anytime.

RBI has actively involved and has taken a lead role to create e-payment infrastructure for smooth and efficient functioning of payment and settlement system. Some of the e-payment infrastructures are as follows: • Electronic clearing system • Electronic fund transfer (EFT): Electronic funds transfer or EFT refers to the computer-based systems used to perform financial transactions electronically. • Centralised Funds Management Systems (CFMS): The Centralised Funds Management System (CFMS), is a system set up, operated and maintained by the Reserve Bank of India (hereinafter referred to as the ‘Bank’) to enable operations on current accounts maintained at various offices of the Bank, through standard message formats in a secure manner. • Negotiated Dealing System (NDS) for screen-based trading in government securities: Negotiated Dealing System (NDS) is an electronic platform for facilitating dealing in Government Securities and Money Market Instruments. • Real Time Gross Settlement (RTGS): RTGS is a large value funds transfer system whereby financial intermediaries can settle interbank transfers for their own account as well as for their customers. RTGS system is a funds transfer mechanism where transfer of money takes place from one bank to another on a “real time” and on “gross” basis. This is the fastest possible money transfer system through the banking channel. • All these systems have a positive impact on quick, safe and electronic movement of money for various sectors of the economy.

Internet/phone/mobile banking-the age of electronic banking • Electronic banking refers to banking online, through computer and over the internet or through telephones. • Benefits of electronic banking: • For Banks: • Price: in the long run, a bank can save on money by not paying for tellers or for managing branches. It is cheaper to make transactions over the internet. • Customer base: the internet allows the bank to reach a whole new market as there are no geographic boundaries with the internet. The internet also widens the limit for small banks who want to add to their customer base. • Efficiency: banks can become more efficient than they already are by providing internet access for their customers. The internet provides the bank with an almost paperless system. • Customer service and satisfaction: banking on the internet not only allows the customer to access full range of available services but it also allows them some services not offered at any of the branches. The person does not have to go to a branch for some service. A person can print information, forms, and applications via the internet and search information efficiently instead of waiting in line and asking a teller. With better and faster options, a bank would be able to create better customer relations and satisfaction. • Image: a bank is more preferred if it offers internet banking.

For customers: • Bill Pay: this is a service offered through electronic banking that allows the customers to set up bill payments to just about anyone. The customer can select the person or company whom he wants to make a payment, and bill pay will withdraw the money from his account and send the payee a paper cheque or an electronic payment. • Other important facilities: electronic banking gives customer the control over nearly every aspect of managing his bank accounts. The customer can buy, sell securities, check balances, verify about the cheques cleared or money transferred, view transaction history and avoid going actually to the bank. • Customers need not go physically to a bank for some information which they can obtain via internet. This saves their time, money and energy. Moreover they are relieved of the day-to-day hassles at banks eg waiting in lines etc. • The best benefit is that electronic banking is free. • Problems/concerns with electronic banking: • One of the first problems that banks have to worry about is customer support. Banks will have to create a whole new customer relations department to help customers and ensure that customers receive assistance quickly if they need help. • Another major issue is the software that would be used in order to support the network. The first major concern is with laws. While electronic banking does not have national or state boundaries, the law does. It has to be ensured that they have software in place that can detect when an interstate law is being violated. • Security is a huge issue with banks. Along with security, encryption and managerial issues, a bank has to worry about becoming too cold and distant to the customer. Electronic banking makes the banks impersonal with respect to the customer.

ECS • This is a method of payment whereby institutions and corporates having to make a large number of payments such as interest or dividend can directly deposit the amount electronically into the banks accounts of the investors without having to issue paper instruments. • Benefits to an organisation: • Savings in administrative cost incurred for printing of paper instruments and dispatching them by registered post. • Loss of instruments in transit or fraudulent encashment totally eliminated. • Reconciliation of transaction is made automatic. • Cash management becomes easier as arrangement for funds is required to be made only on the specified date. • Ensuring better customer/investor service. • Benefits to the customer: • Payment on due date • Effortless receipt-no need for visit to the bank for depositing the divdend/interest warrant • Probability of loss of instrument in transit or fraudulent encashment thereof and consequent correspondence with the company are completely eliminated.

Debit cards • Debit cards can be defined as a plastic card with which a customer may withdraw funds on deposit in the customer’s account using an ATM. • Benefits to customers: • Payment convenience and safety: the customer does not have to carry a cheque-book or large sums of money • Wide acceptance • Easier qualification: since debit cards use the customer’s own money, not his credit, they are often easier to get than credit cards • Benefits to merchants: • Fast approvals • Fraud prevention: purchase amounts are 100% authorised at the point-of-sale reducing losses due to fraudulent checks • Increased dales • Minimum investment: involves adding a low-cost PIN pad that works with the existing equipment • Security: online debit transactions are encrypted to protect the integrity of the cardholder’s personal banking information • Cash management: funds are available sooner than with personal cheques.

Chapter 7: Cash Management and Demand Forecasting in ATMs • All retail banks are competing for a larger share of customers’ financial transactions. • Their efforts are directed towards attracting and retaining customers by offering them a basket of tailor-made schemes supported by a state-of-the-art distribution system-the ATMs. • ATMs offer hassle free cash movement and withdrawal. No need to going to the bank and waiting and requesting the teller for fresh notes or for change of notes. • Cash management service is a new product which facilitates the banks to source cheaper funds and serve its clients more effeciently. • The product in this chain is cash. • The various aspects involved are the logistics involved in ATM operations, role of forecasting in retail outlets and ATMs and the parameters that are taken into consideration, scope of network sharing, issue of having the right mix of currency denomination to be able to satisfy the demand. • The players in a retail bank’s supply chain are the RBI, the corporate branch of the bank in the city, the retail branches, the delivery channel coordinators, outsourced agents who take care of physical cash movement, ATMs and ATM vendors. • Certain demand drivers having a substantial effect on the final level of demand are: • Location of the branch/ATM • Number of current accounts • Resident accounts and their age profile • Number of salary accounts • Seasonal factors including weekends and festivals

Cash demand forecasting: • There are four steps in any market forecast undertaken by an organisation: • Defining the market of the product/basket of products • Dividing the total industry demand into its main components • Forecasting the drivers of demand in each segment and projecting how they are likely to change • Conducting sensitivity analysis to understand the most critical assumptions and to gauge risks to the baseline forecast. • The selection of a forecasting method depends on the following factors: • The context of the forecast • Relevance and availability of historical data • Time period to be forecasted • Degree of accuracy desirable • Cost benefit or value of the forecast to the bank • Time available for making the analysis. • The following are factors that are kept in mind while forecasting tools for demand of management of cash for the branches as well as the ATMs: • There is no stock-out situation in any of the branches as well as the ATMs • There is not much of idle cash lying since the opportunity cost of holding cash is quite high • The cost of delivering cash to the branches and ATMs through the outsourced agents is minimised • The lead time to deliver cash is minimised. • The nature of information flows, the lead times in every step of the chain, the relationship with the outsourced agents, the geographical location of the branches and the ATMs all play an important factor in selecting the most appropriate demand forecasting tool. • Both time series data and judgmental forecasting is used by all the retail banks to predict the demand for cash.

Chapter 8: Innovation in Products and Services • Examples: • Barclays bank: • Improved student and graduate packages • Interest and fee-free overdraft • Comprehensive mobile phone insurance • Restaurants and leisure discounts • Cardholder protection • Sports discounts

Chapter 5: Risk Management in Banks