Risk management Guidelines for Commercial Bank

RiskManagementGuidelinesforCommercialBanks&DFIs.TableofContentsPageNo.IntroductionDefiningRisk1RiskManagement1Board&SeniorManagementoversight2RiskManagementFramework3IntegrationofRisk3BusinessLineAccountability4RiskEvaluation/Measurement4IndependentReview4ContingencyPlanning4ManagingCreditRiskComponentsofCreditRiskManagement5Board&SeniorManagementoversight5OrganizationStructure7SystemsandProcedures8Creditorigination8Limitsetting9CreditAdministration9MeasuringCreditRisk10InternalRiskRating10CreditRiskMonitoring&Control13RiskReview14DelegationofAuthority15ManagingProblemCredits15ManagingMarketRiskInterestRateRisk17ForeignExchangeRisk17Equity/commoditypriceRisk18ElementofMarketRiskManagement18BoardandSeniorManagementOversight18OrganizationStructure19RiskManagementCommittee20ALCO20MiddleOffice21RiskMeasurement21RepricingGapModels21EarningatRisk&EconomicValueofEquityModels22ValueatRisk24RiskMonitoring24RiskControls24Audit25Risklimits25ManagingLiquidityRiskEarlyWarningIndicators27BoardandSeniorManagementOversight28LiquidityRiskStrategyandPolicy28ALCO/InvestmentCommittee30LiquidityRiskManagementProcess30MIS30LiquidityRiskMeasurement&Monitoring31ContingencyFundingPlan31CashFlowProjections33LiquidityRatios&Limits34InternalControls34Monitoring&ReportingRiskExposures35ManagingOperationalRiskOperationalRiskManagementPrinciples36Board&SeniorManagementOversight37OperationalRiskFunction37RiskAssessmentandQuantification38RiskManagement&Mitigation38RiskMonitoring38RiskReporting39EstablishingControlMechanism39ContingencyPlanning.39Introduction____________________________________________________________________________________________________________1IntroductionDefiningRisk:1.1.1Forthepurposeoftheseguidelinesfinancialriskinabankingorganizationispossibilitythattheoutcomeofanactionoreventcouldbringupadverseimpacts.Suchoutcomescouldeitherresultinadirectlossofearnings/capitalormayresultinimpositionofconstraintsonbank’sabilitytomeetitsbusinessobjectives.Suchconstraintsposeariskasthesecouldhinderabank'sabilitytoconductitsongoingbusinessortotakebenefitofopportunitiestoenhanceitsbusiness.1.1.2Regardlessofthesophisticationofthemeasures,banksoftendistinguishbetweenexpectedandunexpectedlosses.Expectedlossesarethosethatthebankknowswithreasonablecertaintywilloccur(e.g.,theexpecteddefaultrateofcorporateloanportfolioorcreditcardportfolio)andaretypicallyreservedforinsomemanner.Unexpectedlossesarethoseassociatedwithunforeseenevents(e.g.lossesexperiencedbybanksintheaftermathofnucleartests,Lossesduetoasuddendownturnineconomyorfallinginterestrates).Banksrelyontheircapitalasabuffertoabsorbsuchlosses.1.1.3Risksareusuallydefinedbytheadverseimpactonprofitabilityofseveraldistinctsourcesofuncertainty.Whilethetypesanddegreeofrisksanorganizationmaybeexposedtodependuponanumberoffactorssuchasitssize,complexitybusinessactivities,volumeetc,itisbelievedthatgenerallythebanksfaceCredit,Market,Liquidity,Operational,Compliance/legal/regulatoryandreputationrisks.Beforeoverarchingtheseriskcategories,givenbelowaresomebasicsaboutriskManagementandsomeguidingprinciplestomanagerisksinbankingorganization.RiskManagement.1.2.1RiskManagementisadisciplineatthecoreofeveryfinancialinstitutionandencompassesalltheactivitiesthataffectitsriskprofile.Itinvolvesidentification,measurement,monitoringandcontrollingriskstoensurethata)Theindividualswhotakeormanagerisksclearlyunderstandit.b)Theorganization’sRiskexposureiswithinthelimitsestablishedbyBoardofDirectors.c)RisktakingDecisionsareinlinewiththebusinessstrategyandobjectivessetbyBOD.d)Theexpectedpayoffscompensatefortheriskstakene)Risktakingdecisionsareexplicitandclear.f)Sufficientcapitalasabufferisavailabletotakerisk1.2.2Theacceptanceandmanagementoffinancialriskisinherenttothebusinessofbankingandbanks’rolesasfinancialintermediaries.Riskmanagementascommonlyperceiveddoesnotmeanminimizingrisk;ratherthegoalofriskmanagementistooptimizerisk-rewardtrade-off.Notwithstandingthefactthatbanksareinthebusinessoftakingrisk,itshouldberecognizedthataninstitutionneednotengageinbusinessinamannerthatunnecessarilyimposesriskuponit:noritshouldabsorbriskthatcanbetransferredtootherIntroduction____________________________________________________________________________________________________________2participants.Ratheritshouldacceptthoserisksthatareuniquelypartofthearrayofbank’sservices.1.2.3Ineveryfinancialinstitution,riskmanagementactivitiesbroadlytakeplacesimultaneouslyatfollowingdifferenthierarchylevels..a)Strategiclevel:ItencompassesriskmanagementfunctionsperformedbyseniormanagementandBOD.Forinstancedefinitionofrisks,ascertaininginstitutionsriskappetite,formulatingstrategyandpoliciesformanagingrisksandestablishadequatesystemsandcontrolstoensurethatoverallriskremainwithinacceptablelevelandtherewardcompensatefortherisktaken.b)MacroLevel:Itencompassesriskmanagementwithinabusinessareaoracrossbusinesslines.Generallytheriskmanagementactivitiesperformedbymiddlemanagementorunitsdevotedtoriskreviewsfallintothiscategory.c)MicroLevel:Itinvolves‘On-the-line’ri