1. Integrated Risk architecture: Implementation Issues FICCI - IBA conference on “Global Banking – paradigm shift” on October 5 th 2005

2. 2 1 2 Challenges in Implementing IRM 3 Components for implementing IRM What is Integrated Risk Management

3. 3 Three key imperatives for Bank’s Management  Differing requirements from various stakeholders  Employees  Borrowers  Regulators  Credit Rating agencies  Counterparty banks  Depositors  Investors  Differing requirements from various stakeholders  Employees  Borrowers  Regulators  Credit Rating agencies  Counterparty banks  Depositors  Investors Capital Adequacy Growth Profitabilit y IRM can assist in managing the three objectives proactively

4. 4 Maintenance of Regulatory/ Economic Capital is crucial to business continuity  Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.  The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.  The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.  Economic Capital is the financial cushion that a bank uses to absorb unexpected losses. The purpose of economic capital is to provide confidence to claim holders such as depositors, creditors and other stakeholders.  The development of of sophisticated risk measurement tools offers banks the capability to calculate economic capital.  The proposed New Basel Capital Accord is a major move towards aligning regulatory capital to economic capital.

5. 5 Profitability Analysis – Bank ABC  Investments offer the highest contribution p.c.age on assets  Which segment leads to high interest earnings?  The credit function has the largest contribution towards fixed expenses  Which credit segment contributes the highest?  What is the position after allocating costs?  Am I properly pricing for expected Losses?  Investments offer the highest contribution p.c.age on assets  Which segment leads to high interest earnings?  The credit function has the largest contribution towards fixed expenses  Which credit segment contributes the highest?  What is the position after allocating costs?  Am I properly pricing for expected Losses? What is the capital required for different business lines? What is the return provided by different business lines on capital invested? What is the expected impact of NPAs/ revaluation? Where should we grow? Are we generating enough internal capital to support growth?

6. 6 Risk Exposures – Bank ABC Market RiskCredit RiskLiquidity Risk The bank runs asset liability mismatches due differing maturity profiles and lending and borrowing rates for credit, investments, deposits and subordinated debentures. Borrowing/ Lending/ Investing in Foreign Currency gives rise to foreign exchange risk

7. 7 How does this affect us?  Credit Risk: Simple credit products (loans normally backed by collateral, few products)  Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)  Operational Risk: Not a major concern  Credit Risk: Simple credit products (loans normally backed by collateral, few products)  Market Risk: Simple market risk products (dealing in g-sec/ limited corporate bond market/ limited FX market)  Operational Risk: Not a major concern Increasing Complexity & Size Current EnvironmentFuture Environment  Credit Risk:  Credit Derivatives  Project Finance  Market Risk:  Multiple currencies  Investments in securities across countries  Investments in corporate bonds  Swaps/ Options other derivatives  Operational Risk:  Increasingly important with complex systems and processes, operations across time zones and markets  Credit Risk:  Credit Derivatives  Project Finance  Market Risk:  Multiple currencies  Investments in securities across countries  Investments in corporate bonds  Swaps/ Options other derivatives  Operational Risk:  Increasingly important with complex systems and processes, operations across time zones and markets

8. 8 RAROC - Base for Integrated Risk Management RAROC 22% Risk-adjusted Net income 1750 Risk-adjusted After tax income 1.75% Average Lending assets 100,000 Total capital 8000 Risk-adjusted Net income 2.20% Net Tax 0.45% Total capital 8.0 % Risk-adjusted income 5.60 % Costs 3.40 % Credit Risk Capital 4.40 % Market Risk Capital 1.60 % Operational Risk Capital 2.00 % Income 6.10 % Expected Loss 0.50 %  RAROC could be carried out for the bank as a whole or a business segment.  RAROC allows a bank to take a comprehensive risk view and forms the base for IRM

9. 9 Integrated Risk Management in a Bank What is Integrated Risk Management? Measure, monitor and manage all the risks across the bank. Bank wide integrated risk management infrastructure in terms of people, policies and systems Common and consistent risk measurement and quantification methodologies across all risk categories Aggregation of risks and estimation of economic capital to assist in risk/ return decision making Compliance Policies Culture Systems & Processes People Methodologies Integrated Risk Manageme nt Organisation Structure

10. 10 Perceived advantages of IRM  Facilitates strategic value creation  Key to regulatory compliance  Mechanism for efficient allocation of economic capital  Enables bank to maximise returns  Lower capital costs  Better decision making due to scenario analysis  Risk adjusted pricing  Loss reduction due to understanding of correlations  Elimination of unwanted exposures  Facilitates strategic value creation  Key to regulatory compliance  Mechanism for efficient allocation of economic capital  Enables bank to maximise returns  Lower capital costs  Better decision making due to scenario analysis  Risk adjusted pricing  Loss reduction due to understanding of correlations  Elimination of unwanted exposures

11. 11 1 2 Challenges in Implementing IRM 3 Components for implementing IRM What is Integrated Risk Management

12. 12 IRM Implementation – Important Facets IT Infrastructure Risk Communication and Control Centralised risk function (analytics and management) New product assessment QuantificationAggregationRisk-adjusted performance measurement Controls on Risk takers Risk reporting Risk Policy PolicyRisk ModelsPerformance Measurment MIS

13. 13 1 2 Challenges in Implementing IRM 3 Components for implementing IRM What is Integrated Risk Management

14. 14 IRM Challenges – identification of gaps in existing risk management practices  Organisation Structure  Risk Management Policies  Management Information Systems  Information Technology Systems  Top Management Oversight  Risk Analytics  Processes and Systems Reviewing and improving existing Credit Risk Market Risk Operational Risk Basel II ALM ALM Business Risk Business Risk Reputation Risk Reputation Risk Beyond Basel II

15. 15 IRM Challenges - measurement of risks  Credit Risk  Probability of Default  Loss Given Default  Exposure at Default  Market Risk  Trading Book (VaR)  Interest Rate Risk on Banking Book  Operational Risk (evolving)  Credit Risk  Probability of Default  Loss Given Default  Exposure at Default  Market Risk  Trading Book (VaR)  Interest Rate Risk on Banking Book  Operational Risk (evolving) Requires collection of data over time, development of measurement models, back testing of models

16. 16 IRM Challenges – Risk Aggregation Correlations among risk silos OVERALL ECONOMIC CAPITAL RISK CATEGORY RISK SILO CREDIT RISK Corporate I Corporate II Retail Pool Correlations Across Companies OPERATIONAL RISK Business Line 1 Business Line 2 Correlations across Businesses MARKET RISK CAPITAL Interest Rate Risk Foreign Exchange Risk Commodity Risk Correlations across Asset classes Equity Risk

17. 17 IRM Challenges - modelling of correlations across risk categories & risk silos  Modelling correlations requires data and is not easy  Fat tails in credit risk create problems  Modelling correlations requires data and is not easy  Fat tails in credit risk create problems

18. 18 IRM Challenges - Improving IT systems  Internal risk scoring models for credit  Portfolio Management Models  Models for estimating VaR for Market risk  Operational Risk databases  Asset Liability Management System  Data warehouse having interfaces for  Analytical  Modelling  Reporting  Internal risk scoring models for credit  Portfolio Management Models  Models for estimating VaR for Market risk  Operational Risk databases  Asset Liability Management System  Data warehouse having interfaces for  Analytical  Modelling  Reporting  Options for developing Risk Management Systems  In-house  Off-the-shelf  Options for developing Risk Management Systems  In-house  Off-the-shelf Sizeable investments in IT infrastructure required for implementing Basel II

19. 19 Thank you CRISIL Investment & Risk Management Services CRISIL Limited dravishankar@crisil.com dravishankar@crisil.comdravishankar@crisil.com Ph.no: 91 22 56537371