Unit 4: Risk management & bank performance
Banking Services Management notes · PTU syllabus (BCOP 521-18)
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Unit summary
Banks earn by taking risks — but must manage them carefully. This unit covers interest rate, credit, liquidity, operational and market risk management in banks, capital adequacy, investment banking and other services, and the analysis of bank balance sheets and financial performance ratios.
After this unit you can
- Explain interest rate risk and its measurement (gap analysis, duration)
- Explain credit, liquidity, operational and market risk management
- Explain capital adequacy and investment banking services
- Analyse bank balance sheets and performance ratios
PTU syllabus topics
- Interest rate risk
- credit risk
- liquidity management
- operational and market risk management in banks
- capital adequacy
- investment banking and other services
- analysis of bank balance sheets and financial performance ratios
Credit risk
Borrowers do not repay
Liquidity risk
Cannot meet withdrawals
Interest rate risk
Rate changes hurt margins
Market risk
Price movements in investments
Operational risk
Fraud, system failure
Topic 1
Interest rate risk
Interest rate risk is the risk that changes in interest rates reduce a bank's net interest income or the value of its assets and equity.
- Types: repricing (gap) risk, basis risk, yield curve risk, embedded option risk (prepayment of loans).
Repricing gap
Rate-sensitive assets (RSA) − Rate-sensitive liabilities (RSL)
Change in NII
Gap × Change in interest rate
Gap ratio
RSA ÷ RSL
Modified duration
Duration ÷ (1 + yield) — % change in value for 1% change in rates
Example
RSA ₹500 crore, RSL ₹600 crore → negative gap ₹100 crore. If rates rise by 1%, NII falls by about ₹1 crore — the bank is liability-sensitive.
- Asset-Liability Management (ALM): ALCO (Asset-Liability Committee) monitors maturity and rate gaps; tools — interest rate swaps, matching maturities, floating-rate loans (external benchmark linked rates from 2019).
Topic 2
Credit, liquidity, operational and market risk
Credit risk
Risk that a borrower fails to repay. Management: credit appraisal (5 Cs), credit rating models, exposure limits (single and group borrower limits — Large Exposures Framework), collateral, covenants, diversification, loan review, provisioning, credit derivatives.
Liquidity risk
Risk of not having enough cash to meet withdrawals and obligations.
- Basel III ratios: Liquidity Coverage Ratio (LCR) — high-quality liquid assets ≥ net cash outflows over 30 days (100%); Net Stable Funding Ratio (NSFR) — available stable funding ≥ required stable funding (100%).
- Structural liquidity statements by maturity buckets; contingency funding plans; access to RBI's LAF and MSF.
Operational risk
Risk of loss from failed internal processes, people, systems or external events — fraud, IT failures, cyber-attacks, legal risk.
- Management: internal controls, segregation of duties, audit, business continuity plans, insurance, KYC, cyber security; capital under Basel (basic indicator, standardised approaches).
Market risk
Risk of losses from movements in market prices — interest rates, equity prices, exchange rates, commodity prices — on the bank's trading book.
- Measurement: Value at Risk (VaR), stress testing; limits on positions; hedging with derivatives.
Credit risk
Borrower default — appraisal, limits, collateral
Liquidity risk
Cash shortfall — LCR, NSFR, ALM
Operational risk
Process/people/system failure — controls, BCP
Market risk
Price movements — VaR, limits, hedging
Topic 3
Capital adequacy, investment banking and other services
- Capital adequacy: CRAR ≥ 9% + CCB 2.5% (Basel III, RBI); higher buffers for Domestic Systemically Important Banks (D-SIBs) — SBI, HDFC Bank, ICICI Bank.
- Investment banking services: IPO management (merchant banking), underwriting, loan syndication, M&A advisory, private placement, project finance advisory, corporate restructuring — through subsidiaries (SBI Capital Markets, ICICI Securities).
- Other services: bancassurance (selling insurance), mutual fund distribution, wealth management, depository services, forex and trade finance, factoring, credit cards, cash management services for corporates, government business (tax collection, pension disbursement).
Topic 4
Analysis of bank balance sheets and performance ratios
Bank balance sheet (Form A)
| Liabilities | Assets |
|---|---|
| Capital and reserves | Cash and balances with RBI |
| Deposits — demand, savings, term | Balances with banks, money at call |
| Borrowings | Investments (G-secs, SLR and non-SLR) |
| Other liabilities and provisions | Advances — bills, cash credit, term loans |
| Fixed assets and other assets |
Net interest margin (NIM)
(Interest earned − Interest expended) ÷ Average earning assets × 100
Return on assets (ROA)
Net profit ÷ Average total assets × 100
Return on equity (ROE)
Net profit ÷ Average net worth × 100
Cost-to-income ratio
Operating expenses ÷ (Net interest income + Other income) × 100
Credit-deposit (CD) ratio
Advances ÷ Deposits × 100
CASA ratio
(Current + Savings deposits) ÷ Total deposits × 100
Gross NPA ratio
Gross NPAs ÷ Gross advances × 100
Provision coverage ratio
Provisions held ÷ Gross NPAs × 100
Example
Interest earned ₹1,200 crore, interest expended ₹750 crore, average earning assets ₹15,000 crore → NIM = 450 ÷ 15,000 = 3%. Net profit ₹180 crore on average assets ₹18,000 crore → ROA 1% (a healthy level for Indian banks).
- CAMELS rating used by supervisors: Capital adequacy, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk.
Exam tip
A high CASA ratio means cheaper funds; a high provision coverage ratio means the bank is better protected against bad loans.
Key terms
- Repricing gap
- Difference between rate-sensitive assets and liabilities
- Liquidity Coverage Ratio
- High-quality liquid assets relative to 30-day net cash outflows
- Value at Risk
- Maximum expected loss over a period at a given confidence level
- Net interest margin
- Net interest income as a percentage of earning assets
- CAMELS
- Supervisory rating framework for banks
Quick revision
- Interest rate risk: gap analysis, duration; ALM by ALCO.
- Credit risk: appraisal, limits, collateral; liquidity risk: LCR, NSFR.
- Operational risk: controls, BCP; market risk: VaR, stress tests.
- CRAR 9% + CCB 2.5%; D-SIBs hold extra capital.
- Ratios: NIM, ROA, ROE, cost-to-income, CD, CASA, GNPA, PCR.
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.What is interest rate risk?
- Q2.What is a repricing gap?
- Q3.Define the Liquidity Coverage Ratio.
- Q4.What is operational risk?
- Q5.What is net interest margin?
- Q6.What does CAMELS stand for?
Long-answer questions
- Q1.Explain interest rate risk and its management through ALM.
- Q2.Explain credit, liquidity, operational and market risk management in banks.
- Q3.Explain capital adequacy and the investment banking and other services of banks.
- Q4.Explain the analysis of a bank's balance sheet using performance ratios.
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