Introduction

What is Bank

Bank is a financial institution that accepts deposits from the public and creates credit. Lending
activities can be performed either directly or indirectly through capital markets. Due to their
importance in the financial stability of a country, banks are highly regulated in most countries.
Most nations have institutionalized a system known as fractional reserve banking under which
banks hold liquid assets equal to only a portion of their current liabilities. In addition to other
regulations intended to ensure liquidity, banks are generally subject to minimum capital
requirements based on an international set of capital standards, known as the Basel Accords.

Banking in its modern sense evolved in the 14th century in the prosperous cities
of Renaissance Italy but in many ways was a continuation of ideas and concepts
of credit and lending that had their roots in the ancient world. In the history of banking, a
number of banking dynasties – notably, the Medicis, the Fuggers, the Welsers,
the Berenbergs and the Rothschilds – have played a central role over many centuries.
The oldest existing retail bank is Banca Monte dei Paschi di Siena, while the oldest
existing merchant bank is Berenberg Bank.You know people earn money to meet their day-to-
day expenses on food, clothing, education of children, housing, etc. They also need money to
meet future expenses on marriage, higher education of children, house building and other social
functions. These are heavy expenses, which can be met if some money is saved out of the
present income. Saving of money is also necessary for old age and ill health when it may not
be possible for people to work and earn their living. The necessity of saving money was felt by
people even in olden days. They used to hoard money in their homes. With this practice,
savings were available for use whenever needed, but it also involved the risk of loss by theft,
robbery and other accidents. Thus, people were in need of a place where money could be saved
safely and would be available when required. Banks are such places where people can deposit
their savings with the assurance that they will be able to withdraw money from the deposits
whenever required. People who wish to borrow money for business and other purposes can
also get loans from the banks at reasonable rate of interest. Banks accept deposits from the
general public as well as from the business community. Any one who saves money for future
can deposit his savings in a bank. Businessmen have income from sales out of which they have
to make payment for expenses. They can keep their earnings from sales safely deposited in
banks to meet their expenses from time to time. Banks give two assurances to the depositors –
a. Safety of deposit, and b. Withdrawal of deposit, whenever needed on deposits, banks give
interest, which adds to the original amount of deposit. It is a great incentive to the depositor. It
promotes saving habits among the public. On the basis of deposits banks also grant loans and
advances to farmers, traders and businessmen for productive purposes. Thereby banks
contribute to the economic development of the country and well being of the people in general.
Banks also charge interest on loans. The rate of interest is generally higher than the rate of
interest allowed on deposits. Banks also charge fees for the various other services, which they
render to the business community and public in general. Interest received on loans and fees
charged for services which exceed the interest allowed on deposits are the main sources of
income for banks from which they meet their administrative expenses. The activities carried
on by banks are called banking activity. ‘Banking’ as an activity involves acceptance of
deposits and lending or investment of money. It facilitates business activities by providing
money and certain services that help in exchange of goods and services. Therefore, banking is
an important auxiliary to trade. It not only provides money for the production of goods and
services but also facilitates their exchange between the buyer and seller. You may be aware
that there are laws which regulate the banking activities in our country. Depositing money in
banks and borrowing from banks are legal transactions. Banks are also under the control of
government. Hence they enjoy the trust and confidence of people. Also banks depend a great
deal on public confidence. Without public confidence banks cannot survive

A bank is a financial institution that provides banking and other financial services to their
customers. A bank is generally understood as an institution which provides fundamental banking
services such as accepting deposits and providing loans. There are also nonbanking institutions that
provide certain banking services without meeting the legal definition of a bank. Banks are a subset of
the financial services industry. A banking system also referred as a system provided by the bank which
offers cash management services for customers, reporting the transactions of their accounts and
portfolios, through out the day. The banking system in India, should not only be hassle free but it
should be able to meet the new challenges posed by the technology and any other external and internal
factors. For the past three decades, India’s banking system has several outstanding achievements to its
credit. The Banks are the main participants of the financial system in India. The Banking sector offers
several facilities and opportunities to their customers. All the banks safeguards the money and valuables
and provide loans, credit, and payment services, such as checking accounts, money orders, and cashier’s
cheques. The banks also offer investment and insurance products. As a variety of models for cooperation
and integration among finance industries have emerged, some of the traditional distinctions between
banks, insurance companies, and securities firms have diminished. In spite of these changes, banks
continue to maintain and perform their primary role—accepting deposits and lending funds from these
deposits

Definition of bank.

The definition of a bank varies from country to country. See the relevant country pages under
for more information.

Under English common law, a banker is defined as a person who carries on the business of
banking, which is specified.

 conducting current accounts for his customers,

 paying cheques drawn on him/her and
 collecting cheques for his/her customers

In most common law jurisdictions there is a Bills of Exchange Act that codifies the law in
relation to negotiable instruments, including cheques, and this Act contains a statutory
definition of the term banker: banker includes a body of persons, whether incorporated or not,
who carry on the business of banking'. Although this definition seems circular, it is actually
functional, because it ensures that the legal basis for bank transactions such as cheques does
not depend on how the bank is structured or regulated.

The business of banking is in many English common law countries not defined by statute
but by common law, the definition above. In other English common law jurisdictions there are
statutory definitions of the business of banking or banking business. When looking at these
definitions it is important to keep in mind that they are defining the business of banking for the
purposes of the legislation, and not necessarily in general. In particular, most of the definitions
are from legislation that has the purpose of regulating and supervising banks rather than
regulating the actual business of banking. However, in many cases the statutory definition
closely mirrors the common law one. Examples of statutory definitions:

 "banking business" means the business of receiving money on current or deposit account,
paying and collecting cheques drawn by or paid in by customers, the making of advances
to customers, and includes such other business as the Authority may prescribe for the
purposes of this Act; (Banking Act (Singapore).
 "banking business" means the business of either or both of the following:
receiving from the general public money on current, deposit, savings or other similar account
repayable on demand or within less than [3 months] ... or with a period of call or notice of less
than that period;

1. Paying or collecting cheques drawn by or paid in by customers.

Since the advent of EFTPOS (Electronic Funds Transfer at Point Of Sale), direct credit, direct
debit and internet banking, the cheque has lost its primacy in most banking systems as a
payment instrument. This has led legal theorists to suggest that the cheque based definition
should be broadened to include financial institutions that conduct current accounts for
customers and enable customers to pay and be paid by third parties, even if they do not pay and
collect cheques

Risk

Risk is part of every human endeavor. From the moment we get up in the morning, drive or
take public transportation to get to school or to work until we get back into our beds (and
perhaps even afterwards), we are exposed to risks of different degrees. What makes the study
of risk fascinating is that while some of this risk bearing may not be completely voluntary, we
seek out some risks on our own (speeding on the highways or gambling, for instance) and enjoy
them. While some of these risks may seem trivial, others make a significant difference in the
way we live our lives. On a loftier note, it can be argued that every major advance in human
civilization, from the caveman’s invention of tools to gene therapy, has been made possible
because someone was willing to take a risk and challenge the status quo. In this chapter, we
begin our exploration of risk by noting its presence through history and then look at how best
to define what we mean by risk. We close the chapter by restating the main theme of this book,
which is that financial theorists and practitioners have chosen to take too narrow a view of risk,
in general, and risk management, in particular. By equating risk management with risk hedging,
they have underplayed the fact that the most successful firms in any industry get there not by
avoiding risk but by actively seeking it out and exploiting it to their own advantage. Given the
ubiquity of risk in almost every human activity, it is surprising how little consensus there is
about how to define risk. The early discussion centered on the distinction between risk that
could be quantified objectively and subjective risk. In 1921, Frank Knight summarized the
difference between risk and uncertainty thus Uncertainty must be taken in a sense radically
distinct from the familiar notion of Risk, from which it has never been properly separate The
essential fact is that "risk" means in some cases a quantity susceptible of measurement, while
at other times it is something distinctly not of this character; and there are far-reaching and
crucial differences in the bearings of the phenomena depending on which of the two is really
present and operating. It will appear that a measurable uncertainty, or "risk" proper, as we shall
use the term, is so far different from an un-measurable one that it is not in effect an uncertainty
at all." In short, Knight defined only quantifiable uncertainty to be risk and provided the
example of two individuals drawing from an urn of red and black balls; the first individual is
ignorant of the numbers of each color whereas the second individual is aware that there are
three red balls for each black ball. The second individual estimates (correctly) the probability
of drawing a red ball to be 75% but the first operates under the misperception.

Risk management is a series of steps whose objectives are to identify, address, and
eliminate software risk items before they become either threats to successful software operation
or a major source of expensive rework. (Boehm, 1989) The software industry is fraught with
failed and delayed projects, most of which far exceed their original budget. The Standish Group
reported that only 28 percent of software projects are completed on time and on budget. Over
23 percent of software projects are cancelled before they ever get completed, and 49 percent of
projects cost 145 percent of their original estimates. In hindsight, many of these companies
indicated that their problems could have been avoided or strongly reduced if there had been an
explicit early warning of the high-risk elements of the project. Many projects fail either because
simple problems were reported too late or because the wrong problem was addressed.
Problems happen. Teams can choose to be reactive or proactive about these problems. Reactive
teams fly into action to correct the problem rapidly in a crisis-driven, firefighting mode.
Without proper planning, problems often occur late in the schedule. At this point, resolving
any serious problems can require extensive modification, leading to big delays. Proactive teams
begin thinking about risks even before technical work is initiated. Their objective is to be able
to avoid risk whenever possible, to solve problems before they manifest themselves and to
respond to problems that do happen in a controlled and effective manner. This chapter is about
being proactive. Risk management is a series of steps whose objectives are to identify, address,
and eliminate software risk items before they become either threats to successful software
operation or a major source of expensive rework. (Boehm, 1989) The software industry is
fraught with failed and delayed projects, most of which far exceed their original budget. The
Standish Group reported that only 28 percent of software projects are completed on time and
on budget. Over 23 percent of software projects are cancelled before they ever get completed,
and 49 percent of projects cost 145 percent of their original estimates. (Standish, 1995) In
hindsight, many of these companies indicated that their problems could have been avoided or
strongly reduced if there had been an explicit early warning of the high-risk

Definition of risk

 A risk can be defined as an unplanned event with financial consequences resulting in

loss or reduced earnings (Vasavada, Kumar, Rao & Pai, 2005).
 An activity which may give profits or result in loss may be called a risky proposition
due to uncertainty or unpredictability of the activity of trade in future. In other words,
it can be defined as the uncertainty of the outcome. Risk refers to ‘a condition where
there is a possibility of undesirable occurrence of a particular result which is known or
best quantifiable and therefore insurable’ (Periasamy, 2008).
 Risk may mean that there is a possibility of loss or damage which, may or may not
happen. Risks may be defined as uncertainties resulting in adverse outcome, adverse in
relation to planned objective or expectations (Kumar, Chatterjee, Chandrasekhar &
Patwardhan 2005).
 In the simplest words, risk may be defined as possibility of loss. It may be financial loss
or loss to the reputation/ image (Sharma, 2003)
 Although the terms risk and uncertainty are often used synonymously, there is
difference between the two (Sharan, 2009).

Uncertainty is the case when the decision-maker knows all the possible outcomes of a particular
act, but does not have an idea of the probabilities of the outcomes. On the contrary, risk is
related to a situation in which the decision-maker knows the probabilities of the various
outcomes. In short, risk is a quantifiable uncertainty. elements of the project. Many projects
fail either because simple problems were reported too late or because the wrong problem was
addressed. Problems happen. Teams can choose to be reactive or proactive about these
problems. Reactive teams fly into action to correct the problem rapidly in a crisis-driven,
firefighting mode. Without proper planning, problems often occur late in the schedule. At this
point, resolving any serious problems can require extensive modification, leading to big delays.
Proactive teams begin thinking about risks even before technical work is initiated. Their
objective is to be able to avoid risk whenever possible, to solve problems before they manifest
themselves and to respond to problems that do happen in a controlled and effective manner.
Risk Management

The proactive management of risks throughout the software development lifecycle is important
for project success. In this chapter, we will explain the following: the risk management
practice, which involves risk identification, analysis, prioritization, planning, mitigation,
monitoring, and communication software development risks that seem to reoccur in
educational and industrial projects a risk-driven process for selecting a software development
model. Risk in itself is not bad; risk is essential to progress, and failure is often a key part of
learning. But we must learn to balance the possible negative consequences of risk against the
potential benefits of its associated opportunity. A risk is a potential future harm that may arise
from some present action . such as, a schedule slip or a cost overrun. The loss is often
considered in terms of direct financial loss, but also can be a loss in terms of credibility, future
business, and loss of property or life. This chapter is about doing proactive planning for your
software projects via risk management. Risk management is a series of steps whose objectives
are to identify, address, and eliminate software risk items before they become either threats to
successful software operation or a major source of expensive rework. The software industry is
fraught with failed and delayed projects, most of which far exceed their original budget. The
Standish Group reported that only 28 percent of software projects are completed on time and
on budget. Over 23 percent of software projects are cancelled before they ever get completed,
and 49 percent of projects cost 145 percent of their original estimates. In hindsight, many of
these companies indicated that their problems could have been avoided or strongly reduced if
there had been an explicit early warning of the high-risk elements of the project. Many projects
fail either because simple problems were reported too late or because the wrong problem was
addressed. Problems happen. Teams can choose to be reactive or proactive about these
problems. Reactive teams fly into action to correct the problem rapidly in a crisis-driven,
firefighting mode. Without proper planning, problems often occur late in the schedule. At this
point, resolving any serious problems can require extensive modification, leading to big delays.
Proactive teams begin thinking about risks even before technical work is initiated. Their
objective is to be able to avoid risk whenever possible, to solve problems before they manifest
themselves and to respond to problems that do happen in a controlled and effective manner.
This chapter is about being proactive.

The Risk Management Practice The risk management process can be broken down into
two interrelated phases, risk assessment and risk control, as outlined in Figure further broken
Risk assessment involves risk identification, risk analysis, and risk prioritization. Risk control
involves risk planning, risk mitigation, and risk monitoring. Each of these will be discussed in
this section. It is essential that risk management be done iteratively, throughout the project, as
a part of the team’s project management routine. Risk management is the identification,
assessment, and prioritization of risks followed by coordinated and economical application of
resources to minimize, monitor, and control the probability and/or impact of unfortunate
events or to maximize the realization of opportunities. Risk management’s objective is to
assure uncertainty does not deflect the endeavor from the business goals. Risks can come from
various sources including uncertainty in financial markets, threats from project failures (at any
phase in design, development, production, or sustainment life-cycles), legal liabilities, credit
risk, accidents, natural causes and disasters, deliberate attack from an adversary, or events of
uncertain or unpredictable root-cause. There are two types of events i.e. negative events can be
classified as risks while positive events are classified as opportunities.

Several risk management standards have been developed including the Project
Management Institute, the National Institute of Standards and Technology, actuarial societies,
and ISO standards. Methods, definitions and goals vary widely according to whether the risk
management method is in the context of project management, security, engineering, industrial
processes, financial portfolios, actuarial assessments, or public health and safety. Strategies to
manage threats (uncertainties with negative consequences) typically include avoiding the
threat, reducing the negative effect or probability of the threat, transferring all or part of the
threat to another party, and even retaining some or all of the potential or actual consequences
of a particular threat, and the opposites for opportunities (uncertain future states with
benefits).Certain aspects of many of the risk management standards have come under criticism
for having no measurable improvement on risk; whereas the confidence in estimates and
decisions seem to increase.

Management of interest rate risk

In a move towards effective management of interest rate risk in Indian banking, in addition to
the existing return on Interest Rate Sensitivity under Traditional Gap Analysis, a new return
is being introduced to monitor the interest rate risk using Duration Gap Analysis (DGA),
called Interest Rate Sensitivity under Duration Gap Analysis (IRSD). The DGA involves
bucketing of all Risk Sensitive Assets (RSA) and Risk Sensitive Liabilities (RSL) as per
residual maturity/re-pricing dates in various time bands and computing the Modified
Duration Gap (MDG). One of the important things to note is that the RSA and RSL include
the rate-sensitive off-balance sheet assets and liabilities as well. MDG can be used to evaluate
the impact on the Market Value of Equity (MVE) of the bank under different interest rate
scenarios. The past few years have seen banks’ foray into financing long-term assets, such as
home loans and infrastructure projects. Banks have been allowed to raise funds through long-
term bonds with a minimum maturity of five years to the extent of their exposure of residual
maturity of more than five years to the infrastructural sector. This article attempts to illustrate
the significance of interest rate risk management and approaches towards its management in
the Indian context.

Interest rate risk

Owing to the very nature of business, banks are required to accept the interest rate risk not by
chance but by choice. When a bank’s assets and liabilities do not reprice at the same time, the
result is a change in net interest income. 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.
IRR is the risk of a decline in earnings due to the movements of interest rates. It can also be
explained as risk arising from the mismatching of the maturity and the volume of banks’
assets and liabilities as part of their asset transformation function. The amount at risk is a
function of the magnitude and direction of interest rate changes and the size and maturity
structure of the mismatch position. If interest rates rise, the cost of funds increases more
rapidly than the yield on assets, thereby reducing net income. If the exposure is not managed
properly, it can erode both the profitability and shareholder value. Interest rate risk is the risk
where changes in market interest rates affect a bank’s financial position. Changes in interest
rates impact a bank’s earnings through changes in its Net Page 4 of 18 Interest Income (NII).
Changes in interest rates also impact a bank’s Market Value of Equity (MVE) or Net Worth
through changes in the economic value of its rate-sensitive assets, liabilities and off-balance
sheet positions.
 interest rate risk

repricing yield curve embeded

basis risk risk option risk
risk

Repricing Risk
Repricing Risk arises on account of mismatches in rates and can be measured by the measure
of risk in different time buckets. If interest rates change, the bank will have to reinvest the
cash flows from assets or refinance rolled-over liabilities at a different interest rate in the
future. If interest rates change, the market values of assets and liabilities also change. The
longer is duration, the larger is the change in value for a given change in interest rates. An
increase in rates, ceteris paribus, increases a bank’s interest income but also increases the
bank’s interest expense. Illustration presented here below explains the occurrence of repricing
risk due to change in interest rates.

Basis Risk

When the costs of liabilities and the yields of assets are linked to different benchmarks
resulting in a floating rate and there is no simultaneous matching movement in the benchmark
rates leads to basis risk. Interest rates on assets and liabilities do not change in the same
proportion. Interest rates movement is based on market perception of risk and also market
imperfections. Therefore, basis risk arises when interest rates of different assets and liabilities
change in different magnitudes. The `basis’ form of Interest Rate Risk (IRR) results from the
imperfect correlation between interest adjustments when linked to different index rates
despite having the same re-pricing characteristics. Basis risk arises when the benchmark rates
like base rate, bank rate, repo rates, and deposit rates are altered.
Yield Curve Risk

Risks caused due to the change in the yield curve from time to time depending on the
repricing and various other factors. Yield Curve is the relation between the interest rate (and
or cost of borrowing) and the time to maturity of the debt for a given borrower in a given
currency. The shape of the yield curve is influenced by supply and demand. The yield curve
may also be flat or hump-shaped, due to anticipated interest rates being steady or short-term
volatility outweighing long-term volatility. The risk of experiencing an adverse shift in
market interest rates associated with investing in a fixed income instrument.

Embedded option risk

Embedded option risk arises due to the risks arising out of prepayment of loans and bonds
(with put or call options) and / or premature withdrawal of deposits before their stated
maturity dates. Presented here below is the illustration of the embedded option risk