CHAPTER-3

RISK MANAGEMENT

BASIC CONCEPTS AND TECHNIQUES

In this chapter we discuss the basic hazard constructs and issues related to put on the line direction. After specifying and placing different hazards, we describe the hazard direction procedure. Risk direction procedure is a comprehensive system that includes making an appropriate hazard direction environment, keeping an efficient hazard measuring, mitigating, and monitoring procedure, and set uping an equal internal control agreement. After sketching the basic thought of the hazard direction procedure and system, we discuss the chief elements of the direction procedure for specific hazards. The latter portion of the subdivision examines the hazards involved in Islamic fiscal establishments. We review the nature of traditional hazards for Islamic fiscal establishments and point out some specific hazards that Islamic Bankss face. We so discuss the hazards built-in in different Islamic manners of funding.

3.1 Introduction

Hazard arises when there is a possibility of more than one result and the ultimate result is unknown. Hazard can be defined as the variableness or volatility of unexpected results. It is normally measured by the standard divergence of historic results. Though all concerns face uncertainness, fiscal establishments face some particular sorts of hazards given their nature of activities. The aim of fiscal establishments is to maximise net income and stockholder value-added by supplying different fiscal services chiefly by pull offing hazards. There are different ways in which hazards are classified. One manner is to separate between concern hazard and fiscal hazards. Business hazard arises from the nature of a house ‘s concern. It relates to factors impacting the merchandise market. Financial hazard arises from possible losingss in fiscal markets due to motions in fiscal variables ( Jorion and Khoury 1996, p. 2 ) . It is normally associated with purchase with the hazard that duties and liabilities can non be met with current assets ( Gleason 2000, p. 21 ) .

Another manner of break uping hazard is between systematic and unsystematic constituents. While systematic hazard is associated with the overall market or the economic system, unsystematic hazard is linked to a specific plus or house. While the asset-specific unsystematic hazard can be mitigated in a big diversified portfolio, the systematic hazard is nondiversifiable. Partss of systematic hazard, nevertheless, can be reduced through the hazard extenuation and reassigning techniques.

To understand the implicit in rule of hazard direction, we use Oldfield and Santomero ( 1997 ) categorization of hazards. Consequently, fiscal establishments face the undermentioned three types of hazards: hazards that can be eliminated, those that can be transferred to others, and the hazards that can be managed by the establishment. Fiscal mediators would avoid certain hazards by simple concern

Practices and will non take up activities that impose hazards upon them. The pattern of fiscal establishments is to take up activities in which hazards can be expeditiously managed and switch hazards that can be transferred.

Hazard turning away techniques would include the standardisation of all business-related activities and procedures, building of diversified portfolio, and execution of an incentive-compatible strategy with answerability of actions. Some hazard that Bankss face can be reduced or eliminated by reassigning or selling these in chiseled markets. Hazard reassigning techniques include, among others, usage of derived functions for fudging, merchandising or purchasing of fiscal claims, altering adoption footings, etc.

There are, nevertheless, some hazards that can non be eliminated or transferred and must be absorbed by the Bankss. The first is due to the complexness of the hazard and trouble to divide it from plus. The 2nd hazard is accepted by the fiscal establishments as these are cardinal to their concern. These hazards are accepted because the Bankss are specialized in covering with them and acquire rewarded consequently. Examples of these hazards are the recognition hazard built-in in banking book activities and market hazards in the trading book activities of Bankss.

There is a difference between hazard measuring and hazard direction. While hazard measuring trades with quantification of hazard exposures, hazard direction refers to “the overall procedure that a fiscal establishment follows to specify a concern scheme, to place the hazards to which it is exposed, to quantify those hazards, and to understand and command the nature of hazards it faces” ( Cumming and Hirtle 2001, p. 3 ) . Before we discuss the hazard direction procedure and measuring techniques, we give an overview of the hazards faced by fiscal establishments and the development of hazard direction.

3.2 RISKS FACED BY FINANCIAL INSTITUTIONS

The hazards that Bankss face can be divided into fiscal and non-financial 1s. Financial hazard can be farther partitioned into market hazard and recognition hazard. Non-financial hazards, among others, include operational hazard, regulative hazard, and legal hazard. The nature of some of these hazards is discussed below.

3.2.1 Market Hazard

Is the hazard arising in instruments and assets traded in chiseled markets? Market hazards can ensue from macro and micro beginnings. Systematic market hazard consequence from overall motion of monetary values and policies in the economic system. The unsystematic market hazard arises when the monetary value of the specific plus or instrument alterations due to events linked to the instrument or plus. Volatility of monetary values in assorted markets gives different sorts of market hazards. Therefore market hazard can be classified as equity monetary value hazard, involvement rate hazard, currency hazard, and trade good monetary value hazard. As a consequence, market hazard can happen in both banking and trading books of Bankss. While all of these hazards are of import, involvement rate hazard is one of the major hazard that Bankss have to worry approximately. The nature of this hazard is briefly explained below.

3.2.2 Interest Rate Hazard

Is the exposure of a bank ‘s fiscal status to motions in involvement rates. Interest rate hazard can originate from different beginnings. Repricing hazard arises due to clocking differences in the adulthood and re pricing of assets, liabilities and off-balance sheet points. Even with similar repricing features, footing hazard may originate if the accommodation of rates on assets and liabilities are non absolutely correlated. Yield curve hazard is the uncertainness in income due to alterations in the output curve. Finally instruments with call and set options can present extra hazards.

3.2.3 Credit Hazard

Is the hazard that counterparty will neglect to run into its duties seasonably and to the full in conformity with the agreed footings. This hazard can happen in the banking and trading books of the bank. In the banking book, loan recognition hazard arises when counterparty fails to run into its loan duties to the full in the stipulated clip. This hazard is associated with the quality of assets and the chance of default. Due to this hazard, there is uncertainness of net-income and market value of Equity originating from non-payment and delayed payment of chief and involvement.

Similarly, merchandising book recognition hazard arises due to a borrower ‘s inability or involuntariness to dispatch contractual duties in trading contracts. This can ensue in colony hazard when one party to a trade pays money or delivers assets before having its ain assets or hard currency, thereby, exposing it to possible loss. Settlement hazard in fiscal establishments peculiarly arises in foreign-exchange minutess. While a portion of the recognition hazard is diversifiable, it can non be eliminated wholly.

3.2.4 Liquidity Hazard

Arises due to deficient liquidness for normal operating demands cut downing the ability of Bankss to run into its liabilities when it falls due. This hazard may ensue from either troubles in obtaining hard currency at sensible cost from adoptions ( support or funding liquidness hazard ) or sale of assets ( plus liquidness hazard ) . One facet of asset-liability direction in the banking concern is to minimise the liquidness hazard. While funding hazard can be controlled by proper planning of cash-flow demands and seeking newer beginnings of financess to finance hard currency deficits, the plus liquidness hazard can be mitigated by variegation of assets and puting bounds of certain illiquid merchandises.

3.2.5 Operational Hazard

Is non a chiseled construct and may originate from human and proficient mistakes or accidents. It is the hazard of direct or indirect loss ensuing from inadequate or failed internal procedures, people, and engineering or from external events. While people risk may originate due to incompetence and fraud, engineering hazard may ensue from telecommunications system and plan failure. Process hazard may happen due to assorted grounds including mistakes in theoretical account specifications, inaccurate dealing executing, and go againsting operational control bounds. [ 1 ] Due to jobs originating from inaccurate processing, record maintaining, system failures, conformity with ordinances, etc. , there is a possibility that operating costs might be different from what is expected impacting the net income adversely.

3.2.6 Legal Hazards

Relate to hazards of unenforceability of fiscal contracts. This relates to legislative acts, statute law, and ordinances that affect the fulfilment of contracts and minutess. This hazard can be external in nature ( like ordinances impacting certain sort of concern activities ) or internal related to bank ‘s direction or employees ( like fraud, misdemeanors of Torahs and ordinances, etc. ) . Legal hazards can be considered as a portion of operational hazard ( BCBS, 2001a ) . Regulatory hazard arises from alterations in regulative model of the state.

3.3 RISK MANAGEMENT: BACKGROUND AND EVOLUTION

Though concern activities have been ever exposed to hazards, the formal survey of pull offing hazard started in the ulterior half of the last century. Markowitz ‘s ( 1959 ) seminal paper foremost indicated that portfolio choice was a job of maximising its expected return and minimising the hazards. A higher expected return of a portfolio ( measured by the mean ) can ensue merely from taking more hazards. Therefore, investors ‘ job was to happen the optimum risk-return combination. His analysis besides points out the systematic and unsystematic constituents of hazard. While the unsystematic constituent can be mitigated by variegation of assets, the systematic constituent has to be borne by the investor. Markowitz ‘s attack, nevertheless, faced operational jobs when a big figure of assets are involved.

Sharpe ‘s ( 1964 ) Capital Asset Pricing Model ( CAPM ) introduces the constructs of systematic and residuary hazards. Progresss in this theoretical account include Single-Factor Models of Risk that estimates the beta of an plus. While residuary ( steadfast particular ) hazard can be diversified, beta steps the sensitiveness of the portfolio to concern rhythms ( an sum index ) . The dependance of CAPM on a individual index to explicate the hazards built-in in assets is excessively simplistic. Arbitrage Pricing Theory proposed by Ross ( 1976 ) suggests

Arbitrage Pricing Theory proposed by Ross ( 1976 ) suggests that multiple factors affect the expected return of an plus. The deduction of the Multiple Factor Model is that the entire hazard is the amount of the assorted factor related hazards and residuary hazard. Therefore, a multiple of risk-premia can be associated with an plus giving the several factor-specific betas. Though the Multiple Factors Model is widely accepted, there is nevertheless, no consensus sing the factors that affect the hazard of an plus or the manner it is estimated. There are three attacks in which this theoretical account can be implemented. While the Cardinal Factors theoretical account estimates the factor specific risk- premia presuming the several factor-specific betas as given, the macroeconomic theoretical account assumes the hazard Prime Minister as given and estimates the factor-specific betas. Statistical theoretical accounts attempt to find both the risk-premia and betas at the same time.

Modern hazard direction procedures and schemes have adopted characteristics of the above mentioned theories and adopted many tools to analyse hazard. An of import component of direction of hazard is to understand the risk-return trade-off. Investors can anticipate a higher rate of return merely by increasing the hazards. As the aim of fiscal establishments is to increase the net income of the Shareholders, pull offing the ensuing hazards created to accomplish this becomes an of import map of these establishments. They do this by expeditiously diversifying the unsystematic hazards and cut downing and reassigning the systematic hazard.

There are two wide attacks to quantify hazard exposures confronting fiscal establishments. One manner is to mensurate hazards in a metameric manner ( e.g. , GAP analysis to mensurate involvement rate hazard and Value at Risk to measure market hazards ) . The other attack is to mensurate hazard exposure in a amalgamate manner by measuring the overall house degree hazard ( e.g. , Risk adjusted rate of return, RAROC for house degree aggregate hazard ) . [ 2 ]

3. 4 RISK MANAGEMENT: The Process And System

Though chief elements of hazard direction include identifying, mensurating, monitoring, and pull offing assorted hazard exposures, [ 3 ] these can non be efficaciously implemented unless there is a broader procedure and system in topographic point. The overall hazard direction procedure should be comprehensive incarnating all departments/sections of the establishment so as to make a hazard direction civilization. It should be pointed out that the particular hazard direction procedure of single fiscal establishments depends on the nature of activities and the size and edification of an establishment. The hazard direction system outlined here can be a criterion for Bankss to follow. A comprehensive hazard direction system should embrace the undermentioned three constituents. [ 4 ] We outline the basic construct of the hazard direction procedure and system in this subdivision.

3.4.1 Establishing Appropriate Risk Management Environment and Sound

Policies and Procedures

This phase deals with the overall aims and scheme of the bank towards hazard and its direction policies. The board of managers is responsible for sketching the overall aims, policies and schemes of hazard direction for any fiscal establishment. The overall hazard aims should be communicated throughout the establishment. Other than O.K.ing the overall policies of the bank sing hazard, the board of managers should guarantee that the direction takes the necessary actions to place, step, proctor, and command these hazards. The board should sporadically be informed and reexamine the position of the different hazards the bank is confronting through studies.

Senior direction is responsible to implement these wide specifications approved by the board. To make so, the direction should set up policies and processs that would be used by the establishment to pull off hazard. These include keeping a hazard direction reappraisal procedure, appropriate bounds on hazard pickings, equal systems of hazard measuring, a comprehensive coverage system, and effectual internal controls. Procedures should include appropriate blessing procedures, bounds and mechanisms designed to guarantee the bank ‘s hazard direction aims are achieved. Banks should clearly place the persons and/or commissions responsible for hazard direction and specify the line of authorization and duty. Care should be taken that there is equal separation of responsibilities of hazard measuring, monitoring and control maps.

Furthermore, clear regulations and criterions of engagement should be provided sing place bounds, exposures to counterparties, recognition and concentration. Investment guidelines and schemes should be followed to restrict the hazards involved in different activities. These guidelines should cover the construction of assets in footings of concentration and adulthood, asset-liability mismatching, hedge, securitization, etc.

3.4.2. Keeping an Appropriate Risk Measurement, Mitigating, and Monitoring Process

Banks must hold regular direction information systems for mensurating, monitoring, commanding and describing different hazard exposures. Stairss that need to be taken for hazard measuring and monitoring intents are set uping criterions for classification and reappraisal of hazards, consistent rating and evaluation of exposures. Frequent standardized hazard and audit studies within the establishment are besides of import. The actions needed in this respect are making criterions and stock lists of hazard based assets, and on a regular basis bring forthing hazard direction studies and audit studies. The bank can besides utilize external beginnings to measure hazard, by utilizing either recognition evaluations, or supervisory hazard appraisal standard like CAMELS.

Hazards that Bankss take up must be monitored and managed expeditiously. Banks should make emphasize proving to see the effects on the portfolio ensuing from different possible hereafter alterations. The countries a bank should analyze are the effects of downswing in the industry or economic system and market hazard events on default rates and liquidness conditions of the bank. Stress testing should be designed to place the conditions under which a bank ‘s places would be vulnerable and the possible responses to such state of affairss. The Bankss should hold eventuality programs that can be implemented under different scenarios.

3.4.3 Adequate Internal Controls

Banks should hold internal controls to guarantee that all policies are adhered to. An effectual system of internal control includes an equal procedure for identify and measuring different sorts of hazards and holding sufficient information systems to back up these. The system would besides set up policies and processs and their attachment are continually reviewed. These may include carry oning periodic internal audits of different procedures and bring forthing regular independent studies and ratings to place countries of failing. An of import portion of internal control is to guarantee that the responsibilities of those who measure, proctor, and control hazards are separated. Finally, an inducement and answerability construction that is compatible with decreased hazard taking on portion of the employees is besides an of import component to cut down overall hazard. A requirement of these incentive-based contracts is accurate coverage of the bank ‘s exposures and internal control system. An efficient inducement compatible construction would restrict single places to acceptable degrees and promote determination shapers to pull off hazards in a mode that is consistent with the Bankss ends and aims.

3.5 MANAGEMENT PROCESSES OF SPECIFIC RISKS

As mentioned above the entire hazard of an plus can be assigned to different beginnings. Given the general guidelines of hazard direction procedure above, in this subdivision we give inside informations of hazard direction procedures for specific hazards faced by bank

3.5.1. Credit Risk Management [ 5 ]

The board of managers should sketch the overall recognition hazard schemes by bespeaking the bank ‘s willingness to allow recognition to different sectors, geographical location, adulthood, and profitableness. In making so it should acknowledge the ends of recognition quality, net incomes, growing, and the risk-reward trade-off for its activities. The recognition hazard scheme should be communicated throughout the establishment.

The senior direction of the bank should be responsible to implement the recognition hazard scheme approved by the board of managers. This would include developing written processs that reflect the overall scheme and guarantee its execution. The processs should include policies to place, step, proctor, and command recognition hazard. Care has to be given to variegation of portfolio by puting exposure bounds on individual counterparty, groups of affiliated counterparties, industries, economic sectors, geographical parts, and single merchandises. Banks can utilize stress proving in puting bounds and monitoring by sing concern rhythms, involvement rate and other market motions. Banks engaged in international recognition demand to measure the several state hazard.

Banks should hold a system for ongoing disposal of assorted recognition risk-bearing portfolios. A proper recognition disposal by a bank would include an efficient and effectual operation related to supervising certification, contractual demands, legal compacts, collateral, etc. , accurate and seasonably describing to direction, and conformity with direction policies and Procedures and applicable regulations and ordinances.

Banks must run under sound, chiseled credit-granting standards to enable a comprehensive appraisal of the true hazard of the borrower or counterparty to minimise the inauspicious choice job. Banks need information on many factors sing the counterparty to which they want to allow recognition. These include, among others, the intent of the recognition and the beginning of refund, the hazard profile of the borrower and its sensitiveness to economic and market developments, borrower ‘s repayment history and current capacity to refund, enforceability of the collateral or warrants, etc.

Banks should hold a clear and formal rating and blessing procedure for new credits and extension of bing credits. Each recognition proposal should be capable to careful analysis by a recognition analyst so that information can be generated for internal rating and evaluation. This can be used for appropriate judgements about the acceptableness of the recognition.

Allowing recognition involves accepting hazards every bit good as bring forthing net incomes. Credit should be priced so that it suitably reflects the built-in hazards of the counterparty and the embedded costs. In sing the possible recognition, the bank needs to set up commissariats for expected loss and keep equal capital to absorb the unexpected losingss. Banks can utilize indirect and warrants to assist Mitigate hazards built-in in single minutess. Note, nevertheless, that collateral can non be a replacement for comprehensive appraisal of a borrower and strength of the refund capacity of the borrower should be given premier importance.

Banks should place and pull off recognition hazard built-in in all of its assets and activities by carefully reexamining the hazard features of the plus or activity. Particular attention is needed peculiarly when the bank embarks on new activities and assets. In this respect, equal processs and controls need to be taken to place the hazards in new plus or activity. Banks must hold analytical Techniques and information systems to mensurate recognition hazard in all on- and off balance sheet activities. The system should be able to supply information on sensitivenesss and concentrations in the recognition portfolio. Banks can pull off portfolio issues related to recognition through loan gross revenues, recognition derived functions, securitization, and engagement in secondary loan markets.

Banks must hold a system for supervising single credits, including finding the adequateness of commissariats and militias. An effectual monitoring system would supply the bank, among others, the current fiscal status of the counterparty. The system would be able to supervise jutting cash-flow and the value of the collateral to place and sort possible recognition jobs. While supervising the overall composing and quality of the portfolio, a bank should non merely take attention about the concentrations with regard to counterparty ‘s activities but besides the adulthood.

Banks should develop internal hazard evaluation systems to mange recognition hazard. A well-structured internal evaluation system can distinguish the grade of recognition hazard in different recognition exposures of a bank by categorising credits into assorted steps in hazard. Internal hazard evaluations are of import tool in monitoring and commanding recognition hazard as periodic evaluations enable Bankss to find the overall features of the recognition portfolio and indicates any impairment in recognition hazard. Deteriorating recognition can so be capable to extra monitoring and supervising.

A bank should hold independent ongoing recognition studies for the board of managers and senior direction to guarantee that the bank ‘s hazard exposures are maintained within the parametric quantities set by prudential criterions and internal bounds. Banks should hold internal controls to guarantee that recognition policies are adhered to. These may include carry oning periodic internal audits of the recognition hazard

Procedures to place the countries of failing in the recognition disposal procedure. Once the job credits are identified, Bankss should hold a clear policy and system for pull offing job credits. The Bankss should hold effectual exercise plans to pull off hazard in their portfolio.

3.5.2. Interest Rate Risk Management [ 6 ]

The board of managers should O.K. the overall aims, wide schemes and policies that govern the involvement rate hazard of a bank. Other than O.K.ing the overall policies of the bank sing involvement rate hazard the board of managers should guarantee that the direction takes the necessary actions to place, step, proctor, and command these hazards. The board should sporadically be informed and reexamine the position of involvement rate hazard the bank is confronting through studies.

Senior direction must guarantee that the bank follows policies and processs that enable the direction of involvement rate hazard. These include keeping an involvement rate hazard direction reappraisal procedure, appropriate bounds on hazard pickings, equal systems of hazard measuring, a comprehensive involvement rate hazard coverage system, and effectual internal controls. Banks should be able to place the persons and/or commissions responsible for involvement rate hazard direction and specify the line of authorization and duty.

Banks should hold clearly defined policies and processs for restricting and commanding involvement rate hazard by defining duty and answerability over involvement rate hazard direction determinations and specifying authorised instruments, fudging schemes and place taking chances. Interest rate hazard in new merchandises should be identified by carefully size uping the adulthood, re pricing or refund footings of an instrument. The board should O.K. new hedge or hazard direction schemes before these are implemented.

Banks should hold a direction information system for mensurating, monitoring, commanding and describing involvement rate exposures. Banks should hold involvement rate hazard direction systems that assess the effects of rate alterations on both the net incomes and economic value. These measurement systems should be able to use by and large accepted fiscal constructs and hazard direction.

Techniques to measure all involvement hazard associated with a bank ‘s assets, liabilities, and off-balance sheet places. Some of the techniques for mensurating a bank ‘s involvement hazard exposure are GAP analysis, continuance, and simulation. Possible emphasis trials can be undertaken to analyze the effects of alterations in the involvement rate, alterations in the incline of the output curve, alterations in the volatility of the market rates, etc. Banks should see the “worse case” scenarios and guarantee that appropriate eventuality programs are available to undertake these state of affairss.

Banks must set up and implement a system of involvement rate hazard bounds and hazard taking guidelines that can accomplish the end of maintaining the hazard exposure within some self-imposed parametric quantities over a scope of possible alterations in involvement rates. An appropriate bound system enables the control and monitoring of involvement rate hazard against predetermined tolerance factors. Any misdemeanor of bounds should be made known to senior direction for appropriate action.

Interest rate studies for the board should include sum-ups of the bank ‘s aggregative exposures, conformity with policies and bounds, consequences of emphasis trials, sum-ups of reappraisals of involvement rate hazard policies and processs, and findings of internal and external hearers. Interest rate hazard studies should be in inside informations to enable senior direction to measure the sensitiveness of the establishment to alterations in the market conditions and other hazard factors.

Banks should hold equal system of internal controls to guarantee the unity of their involvement rate hazard direction procedure and to advance effectual and efficient operations, dependable fiscal and regulative coverage, and conformity with relevant Torahs, ordinances, and institutional policies. An effectual system of internal control for involvement rate hazard includes an equal Procedure for identify and measuring hazard and holding sufficient information systems to back up these. The system would besides set up policies and processs and their attachment are continually reviewed. These periodic reappraisals would cover non merely the measure of involvement rate hazard, but besides the quality of involvement rate hazard direction. Care should be taken that there is equal separation of responsibilities of hazard measuring, monitoring and control maps

3.5.3. Liquidity Risk Management [ 7 ]

As Bankss deal with other people ‘s money that can be withdrawn, pull offing liquidness is one of the most of import maps of the bank. The senior direction and the board of managers should do certain that the bank ‘s precedences and aims for liquidness direction are clear. Senior direction should guarantee that liquidness hazard is efficaciously managed by set uping appropriate policies and processs. A bank must hold equal information system to mensurate, proctor, control and study liquidness hazard. Regular studies on liquidness should be provided to the board of managers and senior direction. These studies should include, among others, the liquidness places over peculiar clip skylines.

The kernel of liquidness direction job arises from the fact that there is a tradeoff between liquidness and profitableness and mismatch between demand and supply of liquid assets. While the bank has no control over the beginnings of financess ( sedimentations ) , it can command the usage of financess. As such, a bank ‘s liquidness place is given precedence in apportioning financess. Given the chance cost of liquid financess, Bankss should do all profitable investings after holding sufficient liquidness. Most Bankss now keep protective militias on top of planned militias. While the planned militias are derived from either regulative demands or prognosiss, the sum of the protective modesty depends on the direction ‘s attitude towards liquidness hazard.

Liquidity direction determinations have to be undertaken by sing all service countries and sections of the bank. Liquidity director must maintain path and organize the activities of all sections that raise and use financess in the bank. Decisions sing the Bankss liquidness demands must be analyzed continuously to avoid both liquidness excess and shortage. In peculiar, the liquidness director should cognize in progress when big minutess ( recognition, sedimentations, and backdowns ) would take topographic point to be after efficaciously for ensuing liquidness excesss or shortages.

A bank should set up a procedure of mensurating and monitoring cyberspace support demands by measuring the bank ‘s hard currency influxs and escapes. The bank ‘s off-balance sheet committednesss should besides be considered. It is besides of import to measure the hereafter support demands of the bank. An of import component of liquidness hazard direction is to gauge a bank ‘s liquidness needs. Several attacks have been developed to gauge the liquidness demands of Bankss. These include the beginnings and utilizations of financess attack, the construction of financess attack, and the liquidness index attack. [ 8 ] A adulthood ladder is a utile device to compare hard currency influxs and escapes for different clip periods.

The shortage or excess of net hard currency flows is a good index of liquidness deficits and surpluss at different points in clip. Unexpected hard currency flows can originate from some other beginnings. As more and more Bankss are engaged in off-balance sheet activities, Bankss should besides analyze the hard currency flows on this history. For illustration, contingent liabilities used in these histories ( like fiscal warrants and options ) can stand for significant beginnings of escapes of financess. After placing the liquidness demands, a series of worse instance scenarios can be analyzed to gauge both possible bank specific dazes and economy-wide daze. The bank should hold eventuality funding programs of managing the liquidness needs during these crises. Possible responses to these dazes would include the velocity with which assets can be liquidated and the beginnings of financess that Bankss can utilize in the crisis. If the bank is covering with foreign currency, it should hold a measuring, monitoring and control system for liquidness in active currencies.

Banks should hold equal internal controls over its liquidness hazard direction procedure that should be a portion of the overall system of internal control. An effectual system would make a strong control environment and have an equal procedure of placing and measuring liquidness hazard. It should hold equal information system that can bring forth regular independent studies and ratings to reexamine attachment to set up policies and processs.

The internal audit map should besides sporadically reexamine the liquidness direction procedure to place any jobs or failings for appropriate action by the direction.

3.5.4. Operational Risk Management [ 9 ]

The board of managers and senior direction should develop the overall policies and schemes for pull offing operational hazard. As operational hazard can originate due to failures in people, procedures, and engineering, direction of this hazard is more complex. Senior direction demands to set up the coveted criterions of hazard direction and clear guidelines for patterns that would cut down operational hazards. In making so, attention demands to be taken to include people, procedure, and engineering hazards that can originate in the establishment.

Given the different beginnings in which operational hazard can originate, a common criterion for designation and direction of these demands to be developed. Care needs to be taken to undertake operational hazard originating in different departments/organizational unit due to people, procedure, and engineering. As such a broad assortment of guidelines and regulations have to be spelled out. To make so, the Management should develop an ‘operational hazard catalogue ‘ in which concern procedure maps for each business/ section of the establishment are outlined. For illustration, the concern procedure for covering with client or investor should be laid out. This catalogue will non merely place and measure operational hazard but besides can be used for transparence by the direction and hearers.

Given the complexness of operational hazard, it is hard to quantify it. Most of the operational hazard measuring techniques are simple and experimental. The Bankss, nevertheless, can garner information of different hazards from studies and programs that are published within the establishment ( like audit studies, regulative studies, direction studies, concern programs, operations programs, mistake rates, etc. ) . A careful reappraisal of these paperss can uncover spreads that can stand for possible hazards. The information from the studies can so be categorized into internal and external factors and converted into likeliness of possible loss to the establishment. A portion of the operational hazard can besides be hedged. Tools for hazard appraisal, monitoring, and direction would include periodic reappraisals, Stress testing, and allotment of appropriate sum of economic capital.

As there are assorted beginnings of operational hazard, it needs to be handled in different ways. In peculiar, hazard arising from people demands effectual direction, monitoring, and controls. These include set uping an equal operating process. One of import component to command operational hazard is to hold clear separation of duties and to hold eventuality programs. Another important component is to do certain that describing systems are consistent, secure, and independent of concern. The internal hearers play an of import function in extenuating operational hazard.

[ 1 ] For a list of different beginnings of operational hazard see Crouhy et Al. ( 2001, p. 487 ) .

[ 2 ] For a treatment on following consolidated hazard direction from the supervisors ‘ and the Bankss positions see Cumming and Hirtle ( 2001 ) .

[ 3 ] See ( Jorion 2001, p. 3 ) for a treatment.

[ 4 ] These three constituents are derived from BCBS ‘s recommendations of pull offing specific Risks. See BCBS ( 1999 and 2001b ) .

[ 5 ] This subdivision is based on the recognition hazard direction procedure discussed in BCBS ( 1999 ) .

[ 6 ] This subdivision is based on the involvement rate hazard direction procedure discussed in BCBS ( 2001 )

[ 7 ] The treatment on Liquidity Risk Management is derived from BCBS ( 2000 ) .

[ 8 ] For a treatment on these methods see Rose ( 1999 ) .

[ 9 ] This portion is based on BCBS ( 1998 ) and Crouhy, et.al. ( 2001, Chapter 13 ) .