Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems, or from

external events.The term operational risk management (ORM) is defined as a continual cyclic process which include
risk assessment, risk decision making, and implementation of risk controls, which results in acceptance, mitigation, or
avoidance of risk. ORM is the oversight of operational risk, including the risk of loss resulting from inadequate or failed
internal processes and systems; human factors; or external events. Unlike other type of risks (market risk, credit risk,
etc.) operational risk had rarely been considered strategically significant by senior management.
Four principles--The U.S. Department of Defense summarizes the principles of ORM as follows:[2]

 Accept risk when benefits outweigh the cost.

 Accept no unnecessary risk.
 Anticipate and manage risk by planning.
 Make risk decisions in the right time at the right level.

Three levels--
In Depth-In depth risk management is used before a project is implemented, when there is plenty of time to plan and
prepare. Examples of in depth methods include training, drafting instructions and requirements, and acquiring personal
protective equipment.
Deliberate---Deliberate risk management is used at routine periods through the implementation of a project or process.
Examples include quality assurance, on-the-job training, safety briefs, performance reviews, and safety checks.
Time Critical--Time critical risk management is used during operational exercises or execution of tasks. It is defined as
the effective use of all available resources by individuals, crews, and teams to safely and effectively accomplish the
mission or task using risk management concepts when time and resources are limited. Examples of tools used includes
execution check-lists and change management. This requires a high degree of situational awareness.[2]Benefits-
1)Reduction of operational loss. 2)Lower compliance/auditing costs. 3)Early detection of unlawful activities. 4)Reduced
exposure to future risks.
Chief Operational Risk Officer--The role of the Chief Operational Risk Officer (CORO) continues to evolve and gain
importance. In addition to being responsible for setting up a robust Operational Risk Management function at
companies, the role also plays an important part in increasing awareness of the benefits of sound operational risk
management.
Most complex financial institutions have a Chief Operational Risk Officer. The position is also required for Banks that
fall into the Basel II Advanced Measurement Approach "mandatory" category.

Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to
mismatches between the assets and liabilities as part of an investment strategy in financial accounting. Asset/liability
management is the process of managing the use of assets and cash flows to reduce the firm’s risk of
loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. Th
asset/liability management process is typically applied to bank loan portfolios and pension plans. It also
involves the economic value of equity.
The concept of asset/liability management focuses on the timing of cash flows because company
managers must plan for the payment of liabilities. The process must ensure that assets are available to
pay debts as they come due and that assets or earnings can be converted into cash. The asset/liability
management process applies to different categories of assets on the balance sheet.[Important: A
company can face a mismatch between assets and liabilities because of illiquidity or change
in interest rates; asset/liability management reduces the likelihood of a mismatch.] ALM sits between risk
management and strategic planning. It is focused on a long-term perspective rather than mitigating immediate risks and is a proces
of maximising assets to meet complex liabilities that may increase profitability. ALM includes the allocation and management of
assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within
these risk frameworks for optimisation and management in the local regulatory and capital environment. Often an ALM approach
passively matches assets against liabilities (fully hedged) and leaves surplus to be actively managed. ALM objectives - ALM
encompass a broad area of risks. ----The traditional ALM programs focus on interest rate risk and liquidity risk because they
represent the most prominent risks affecting the organization balance-sheet (as they require coordination between assets and
liabilities).
But ALM also now seeks to broaden assignments such as foreign exchange risk and capital management.
The Asset Coverage Ratio--An important ratio used in managing assets and liabilities is the
asset coverage ratio which computes the value of assets available to pay a firm’s debts.
The scope of the ALM:-
Liquidity risk: the current and prospective risk arising when the bank is unable to meet its obligations as they come due
without adversely affecting the bank's financial conditions. From an ALM perspective, the focus is on the funding
liquidity risk of the bank, meaning its ability to meet its current and future cash-flow obligations and collateral needs,
both expected and unexpected. This mission thus includes the bank liquidity's benchmark price in the market.
Interest rate risk: The risk of losses resulting from movements in interest rates and their impact on future cash-flows.
Generally because a bank may have a disproportionate amount of fixed or variable rates instruments on either side of th
balance-sheet. One of the primary causes are mismatches in terms of bank deposits and loans.
Capital markets risk: The risk from movements in equity and/or credit on the balance sheet. An insurer may wish to
harvest either risk or fee premia. Risk is then mitigated by options, futures, derivative overlays which may incorporate
tactical or strategic views.
Currency risk management: The risk of losses resulting from movements in exchanges rates. To the extent that cash-flo
assets and liabilities are denominated in different currencies.
Funding and capital management: As all the mechanism to ensure the maintenance of adequate capital on a continuous
basis. It is a dynamic and ongoing process considering both short- and longer-term capital needs and is coordinated with
a bank's overall strategy and planning cycles (usually a prospective time-horizon of 2 years).
Profit planning and growth.
In addition, ALM deals with aspects related to credit risk as this function is also to manage the impact of the entire cred
portfolio (including cash, investments, and loans) on the balance sheet. The credit risk, specifically in the loan portfolio
is handled by a separate risk management function and represents one of the main data contributors to the ALM team.
The ALM function scope covers1)) management of all possible risks and rules and 2)management of funding costs,
generating results on balance sheet position. ALM intervenes in these issues of current business activities but is also
consulted to organic development and external acquisition to analyse and validate the funding terms options, conditions
of the projects and any risks (i.e., funding issues in local currencies).
Today, ALM techniques and processes have been extended and adopted by corporations other than financial institutions;
e.g., insurance.

Treasury and ALM:-

For banking institutions, treasury and ALM are strictly interrelated with each other and collaborate in managing
both liquidity, interest rate, and currency risk at solo and group level: Where ALM focuses more on risk analysis
and medium- and long-term financing needs, treasury manages short-term funding (mainly up to one year)
including intra-day liquidity management and cash clearing, crisis liquidity monitoring.
ALM governance:-The responsibility for ALM is often divided between the treasury and Chief Financial
Officer (CFO). In smaller organizations, the ALM process can be addressed by one or two key persons (Chief
Executive Officer, such as the CFO or treasurer).
To assist and supervise the ALM unit an Asset Liability Committee (ALCO), whether at the board or
management level, is established. It has the central purpose of attaining goals defined by the short- and long-term
strategic plans:
1)To ensure adequate liquidity while managing the bank's spread between the interest income and interest
expense 2)To approve a contingency plan. 3)To review and approve the liquidity and funds management policy
at least annually. 4)To link the funding policy with needs and sources via mix of liabilities or sale of assets
(fixed vs. floating rate funds, wholesale vs. retail deposit, money market vs. capital market funding, domestic vs.
foreign currency funding...)
ALM core functions-Managing gap
The objective is to measure the direction and extent of asset-liability mismatch through the funding or maturity
gap. This aspect of ALM stresses the importance of balancing maturities as well as cash-flows or interest rates
for a particular set time horizon.
 For the management of interest rate risk it may take the form of matching the 1) maturities and interest rates of loans and
investments with the 2)maturities and interest rates of deposit, equity and external credit in order to maintain adequate
profitability. In other words, it is the management of the spread between interest rate sensitive assets and interest rate
sensitive liabilities.. Liquidity risk management Liquidity is the ability of a firm, company, or even an
individual to pay its debts without suffering catastrophic losses. Key Takeaways

 Liquidity is the ability of a firm, company, or even an individual to pay its debts
without suffering catastrophic losses.
 Investors, managers, and creditors use liquidity measurement ratios when deciding
the level of risk within an organization.
 If an individual investor, business, or financial institution cannot meet its short-term
debt obligations, it is experiencing liquidity risk.

Liquidity risk occurs when an individual investor, business, or financial institution cannot
meet its short-term debt obligations. The investor or entity might be unable to convert
an asset into cash without giving up capital and income due to a lack of buyers or an
inefficient market.
The smaller the size of the security or its issuer, the larger the liquidity risk.

This aspect of liquidity risk is named funding liquidity risk and arises because of liquidity mismatch of assets and liabilities
(unbalance in the maturity term creating liquidity gap). Even if market liquidity risk is not covered into the conventional
techniques of ALM (market liquidity risk as the risk to not easily offset or eliminate a position at the prevailing market
price because of inadequate market depth or market disruption), these 2 liquidity risk types are closely interconnected. In
fact, reasons for banking cash inflows are :

 when counterparties repay their debts (loan repayments): indirect connection due to the
borrower's dependence on market liquidity to obtain the funds
 when clients place a deposit: indirect connection due to the depositor's dependence on market
liquidity to obtain the funds
 when the bank purchases assets to hold on its own account: direct connection with market
liquidity (security's market liquidity as the ease of trading it and thus potential rise in price)
 when the bank sells debts it has held on its own account: direct connection

Table below lists some internal and external factors in banks that may potentially lead to the liquidity risk
problems.

INTERNAL BANKING FACTOR EXTERNAL BANKING FACTOR

High off-balance sheet exposures. Very sensitive financial markets depositors
A gap in the maturity dates of assets and Low/slow economic performances
liabilities.
Concentration of deposits in the short term Tenor Non-economic factors

Less allocation in the liquid government Sudden and massive liquidity withdrawals from
instruments. depositors
The banks rely heavily on the short-term corporate External and internal economic shocks.
deposits.
The banks’ rapid asset expansions exceed the Decreasing depositors’ trust on the banking sector
available funds on the liability side

Liquidity gap analysis-- Measuring liquidity position via liquidity gap analysis is still one of the most common tool used
and represents the foundation for scenario analysis and stress-testing.
  Indicative maturity liquidity profile---ALM team is projecting future funding needs by tracking through maturity and
cash-flow mismatches gap risk exposure (or matching schedule). In that situation, the risk depends not only on the maturity
of asset-liabilities but also on the maturity of each intermediate cash-flow, including prepayments of loans or unforeseen
usage of credit lines. Actions to performEdit

 Determining the number or the length of each relevant time interval (time bucket)
 Defining the relevant maturities of the assets and liabilities where a maturing liability will be a
cash outflow while a maturing asset will be a cash inflow (based on effective maturities or the 'liquidity
duration': estimated time to dispose of the instruments in a crisis situation such as withdrawal from the business).
For non maturity assets (such as overdrafts, credit card balances, drawn and undrawn lines of credit or any other
off-balance sheet commitments), their movements as well as volume can be predict by making assumptions
derived from examining historic data on client's behaviour.
 Slotting every asset, liability and off-balance sheet items into corresponding time bucket based
on effective or liquidity duration maturity
In dealing with the liquidity gap, the bank main concern is to deal with a surplus of long-term assets over short-
term liabilities and thus continuously to finance the assets with the risk that required funds will not be available
or into prohibitive level.

Measuring liquidity risk--The liquidity measurement process consists of evaluating :

 Liquidity consumption (as the bank is consumed by illiquid assets and volatile liabilities)
 Liquidity provision (as the bank is provided by stable funds and by liquid assets)
For the purposes of quantitative analysis, since no single indicator can define adequate liquidity, several financial
ratios can assist in assessing the level of liquidity risk. Due to the large number of areas within the bank's
business giving rise to liquidity risk, these ratios present the simpler measures covering the major institution
concern. In order to cover short-term to long-term liquidity risk they are divided into 3 categories :
1) Indicators of operating cash-flows 2)Ratios of liquidity 3)Financial strength (leverage)

The coverage ratio computes the assets available to pay debt obligations, although the
liquidation value of some assets, such as real estate, may be difficult to calculate. There
is no rule of thumb as to what constitutes a good or poor ratio since calculations vary by
industry.

Key Takeaways

 Asset/liability management reduces the risk that a company may not meet
its obligations in the future.
 The success of bank loan portfolios and pension plans depend on
asset/liability management processes.
 Banks track the difference between the interest paid on deposits and
interest earned on loans to ensure that they can pay interest on deposits and to
determine what a rate of interest to charge on loans.

[Fast Fact: Asset/liability management is a long-term strategy to manage risks.

For example, a home-owner must ensure that they have enough money to pay
their mortgage each month by managing their income and expenses for the
duration of the loan.]
Balance Sheet DefinitionA balance sheet is a financial statement that reports a company's
assets, liabilities and shareholders' equity at a specific point in time. --How the Leverage
Ratio Works--A leverage ratio is any one of several financial measurements that look at
 how much capital comes in the form of debt, or that assesses the ability of a company to
meet financial obligations. Pension Plan--A pension plan is a retirement plan that requires
an employer to make contributions into a pool of funds set aside for a worker's future
benefit.

Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan
or meet contractual obligations. Traditionally, it refers to the risk that a lender may not
receive the owed principal and interest, which results in an interruption of cash flows and
increased costs for collection. Excess cash flows may be written to provide additional
cover for credit risk. Although it's impossible to know exactly who will default on
obligations, properly assessing and managing credit risk can lessen the severity of a loss.
Interest payments from the borrower or issuer of a debt obligation are a lender's or
investor's reward for assuming credit risk.

Key Takeaways

 Credit risk is the possibility of losing a lender takes on due to the possibility
of a borrower not paying back a loan. 
 Consumer credit risk can be measured by the five Cs: credit history,
capacity to repay, capital, the loan's conditions, and associated collateral.
 Consumers posing higher credit risks usually end up paying higher interest
rates on loans.

Understanding Credit Risk --When lenders offer mortgages, credit cards, or other
types of loans, there is a risk that the borrower may not repay the loan. Similarly, if a
company offers credit to a customer, there is a risk that the customer may not pay
their invoices. Credit risk also describes the risk that a bond issuer may fail to make
payment when requested or that an insurance company will be unable to pay a claim.
Credit risks are calculated based on the borrower's overall ability to repay a loan according to
its original terms. To assess credit risk on a consumer loan, lenders look at the five Cs: credit
history, capacity to repay, capital, the loan's conditions, and associated collateral.
Some companies have established departments solely responsible for assessing the credit
risks of their current and potential customers. Technology has afforded businesses the ability
to quickly analyze data used to assess a customer's risk profile.

Credit Risk vs. Interest Rates

If there is a higher level of perceived credit risk, investors and lenders usually demand a
higher rate of interest for their capital.
Creditors may also choose to forgo the investment or loan.
For example, because a mortgage applicant with a superior credit rating and steady income
is likely to be perceived as low credit risk, she will receive a low-interest rate on her
mortgage. In contrast, if an applicant has a poor credit history, he may have to work with a
subprime lender—a mortgage lender that offers loans with relatively high-interest rates to
high-risk borrowers—to obtain financing.

Interest Rate Risk Interest rate risk is the risk to income or capital arising from fluctuating interest rates.
Changes in interest rates affect a banking corporation’s earnings by changing its net interest income and the level
of other income (including changes in non-interest revenues/expenses). Changes in interest rates also affect the
underlying value of the banking corporation’s assets, liabilities and offbalance sheet (OBS) financial instruments
because the present value of future cash flows (and in some cases, the cash flows themselves) change when
interest rates change. Examples of Interest Rate Risk

Asset/liability management is also used in banking. A bank must pay interest on deposits and also
charge a rate of interest on loans. To manage these two variables, bankers track the net interest
margin or the difference between the interest paid on deposits and interest earned on
loans.--------------Principles for the management of interest rate risk -- (A) The board of directors in a banking
corporation should approve strategies and policies with respect to interest rate risk management and ensure that
senior management takes the steps necessary to monitor and control these risks consistent with the approved
strategies and policies. The board of directors should be informed regularly of the interest rate exposure of the
banking corporation in order to assess the monitoring and controlling of such risk against the board’s guidance
on risk appetite. (B) Senior management must ensure that the structure of the banking corporation’s business
and level of interest rate risk it assumes are effectively managed, that appropriate policies and procedures are
established to control and limit these risks, and that resources are available for evaluating and controlling interest
rate risk. (C) Banking corporations should clearly define the individuals and/or committees responsible for
managing interest rate risk and should ensure that there is adequate separation of duties in key elements of the
risk management process to avoid potential conflicts of interest.

. Banking corporations encounter interest rate risk in several ways, including repricing risk, yield curve risk,
basis risk (also known as spread risk), and optionality risk.
Repricing risk: The primary and most discussed form of interest rate risk arises from timing differences in the
maturity (for fixed-rate) and repricing (for floating rate) of banking corporation assets, liabilities and OBS
positions. Such repricing mismatches may expose a bank’s income and economic value to unanticipated
fluctuations as interest rates vary.
. Yield curve risk: Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a
banking corporation’s income or economic value. The yield curve may shift due to changing relationships
between interest rates for different maturities of the same index or market.
Basis risk: A risk arising from imperfect correlation in the changes of interest rates in different financial markets
or on different instruments with otherwise similar repricing characteristics. Differences in interest rate changes
can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS
instruments of similar maturities or repricing frequencies.
. Optionality risk: An additional source of interest rate risk arises from a change in the timing or scope of a
financial instrument’s cash flows due to changing market interest rates. This risk arises from the options
embedded in many banking corporation assets, liabilities and OBS portfolios. These options provide the holder
the right, but not the obligation, to buy, sell or in some manner alter the cash flow of the financial instrument.
While banking corporations use exchange-traded and OTC options in both trading and nontrading accounts,
instruments with embedded options are generally more important in non-trading activities. Examples of
instruments with embedded options include various types of bonds and notes with call or put provisions, loans
which give borrowers the right to prepay balances, and various types of non-maturity deposit instruments which
give depositors the right to withdraw funds at any time, often without penalties.

The change in the value of assets and the change in the value of liabilities will also differ, causing a change in
the value of stockholder’s equity.
Banks typically focus on either Net interest income or the market value of stockholders'
equity. Interest rate risk can be defined as the potential loss from unexpected changes in interest rates, which can
significantly alter a bank’s profitability and market value of equity.
INTEREST RATE RISK Is the risk of a decline in earnings due to the movements of interest rate.
Hedging
Hedging is another approach of managing interest rate risk with the use of derivative
securities like; swaps, futures and options. This approach has been found to a better approach
 in situations especially where there is a maturity mismatch. For example, when liabilities are
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mostly short-term in nature and assets are long-term, the easier method of financing the
assets, rather than trying to match the maturing periods, is by the use of derivative securities.
Sensitivity Analysis
It allows management to incorporate the impact of different spreads between asset yields and
liability interest costs when rates change by different amounts. The sensitivity of an
asset/liability can be assessed by the quantum of increase/decrease in the value of the
assets/liabilities of varying maturities due to the interest rate fluctuations. Based on the
sensitivity, all the assets/liabilities are rearranged. The sensitivity model than suggests the
assessment of the gap between the assets and liabilities having a similar sensitivity index to
the interest rate fluctuations. Further action will be taken to manage help so as to restrict the
interest rate risk.
Some of the steps for an effective sensitivity analysis are as below:  Forecast future interest rates  Identify
changes in the composition of assets and liabilities in different rate
environments  Forecast when embedded options will be exercised  Identify when specific assets and
liabilities will reprice given the rate environment  Estimate net interest income and net income 

Managing interest rate risk

Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due
to the possibility of a change in the asset's value resulting from the variability of
interest rates. Interest rate risk management has become very important, and assorted
instruments have been developed to deal with interest rate risk.
Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate.
Interest rate risk directly affects the values of fixed-income securities. Since interest rates
and bond prices are inversely related, the risk associated with a rise in interest rates
causes bond prices to fall, and vice versa. Bond investors, specifically those who invest in
long-term fixed-rate bonds, are more directly susceptible to interest rate risk.Key
Takeaways

 Interest rate risk is the risk associated with interest rate fluctuations in
assets.
 Interest rates and bond prices are inversely related.
 Certain products and options, such as forward and futures contracts, help
investors hedge interest rate risks.
 Forward contracts are agreements in which a party can purchase or sell
assets at a certain price on a specific future date.

Managing Interest Rate Risk --Interest Rate Risk Should Not Be Ignored
As with any risk-management assessment, there is always the option to do nothing, and that is
what many people do. However, in circumstances of unpredictability, sometimes not hedging is
disastrous.
Investment Products :-
Those who want to hedge their investments against interest rate risk have many products to
choose from--------Forwards:  A forward contract is the most basic interest rate management
product. The idea is simple, and many other products discussed in this article are based on this
idea of an agreement today for an exchange of something at a specific future date.------Forward
Rate Agreements (FRAs): An FRA is based on the idea of a forward contract, where the
determinant of gain or loss is an interest rate. Under this agreement, one party pays a fixed
interest rate and receives a floating interest rate equal to a reference rate. The actual payments
are calculated based on a notional principal amount and paid at intervals determined by the
parties. Only a net payment is made – the loser pays the winner, so to speak. FRAs are always
settled in cash.--FRA users are typically borrowers or lenders with a single future date on which
they are exposed to interest rate risk. A series of FRAs is similar to a swap (discussed below);
however, in a swap, all payments are at the same rate. Each FRA in a series is priced at a
different rate unless the term structure is flat.--Futures: A futures contract is similar to a forward,
but it provides the counterparties with less risk than a forward contract – namely, a lessening of
default and liquidity risk due to the inclusion of an intermediary.----Swaps:  Just like it sounds, a
swap is an exchange. More specifically, an interest rate swap looks a lot like a combination of
FRAs and involves an agreement between counterparties to exchange sets of future cash flows.
The most common type of interest rate swap is a plain vanilla swap, which involves one party
paying a fixed interest rate and receiving a floating rate, and the other party paying a floating
rate and receiving a fixed rate.-----Options: Interest rate management options are option
contracts for which the underlying security is a debt obligation. These instruments are useful in
protecting the parties involved in a floating-rate loan, such as adjustable-rate mortgages (ARMs).
A grouping of interest rate call options is referred to as an interest rate cap; a combination of
interest rate put options is referred to as an interest rate floor. In general, a cap is like a call, and
a floor is like a put.
Swaptions:  A swaption, or swap option, is simply an option to enter into a swap.
Interest-Rate DerivativeAn interest-rate derivative is a financial instrument based on an
underlying financial security whose value is affected by changes in interest rates. --Fixed Income
ForwardA fixed income forward is a contract between two parties to either buy or sell a fixed
income security in the future at a price agreed upon today. --How a Forward Rate Agreement –
FRA Hedges Interest Rates--Forward rate agreements (FRA) are over-the-counter contracts
between parties that determine the rate of interest to be paid on an agreed upon date in the
future. --Caplet Definition-A caplet is a European-style call option used by traders who want to
hedge against higher interest rates. --Interest Rate CollarAn interest rate collar is an investment
strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations.
--Interest Rate Swap DefinitionAn interest rate swap is a forward contract in which one stream of
future interest payments is exchanged for another based on a specified principal amount.