The Reserve Bank of India (RBI) working group on "market risk management (MRM) " has suggested that all commercial banks should put in place contingency funding plans, which quantify the likely impact of an event on their balance sheet and also evaluate their ability to withstand a prolonged adverse liquidity environment.
As part of the detailed guidance note on MRM, the working group said if the contingency funding plans (CFPs), which are liquidity stress tests, result in a funding gap within a three-month time frame, the asset liability committee (ALCO) must establish an action plan to address the situation.
MRM for a bank involves management of interest rate risk, foreign exchange risk, commodity price risk and equity price risk. Besides, it is equally concerned about the bank's ability to meet its obligations as and when they fall due.
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At a minimum, the CFPs under each scenario must consider the impact of accelerated runoff of large funds providers and they must take into account the impact of a progressive, tiered deterioration, as well as sudden, drastic events.
The note called upon all banks to establish specific policies, which should represent minimum requirements for them including approval levels and requirements for any exceptions, deviations or waivers, on MRM.
The policies should among others cover, the responsibilities of the risk management committee/ risk taking unit/ market risk manager; identify risks, limits and triggers. Further the risk reporting should enhance risk communication across different levels of the bank, from the trading desk to the CEO.
Successful implementation of any risk management process has to emanate from the top management and its strong commitment to integrate basic operations and strategic decision making with risk management.
Measuring and managing liquidity risk, which is the potential inability of banks to meet liabilities as they become due, are vital for effective operation of the banks.
"Experiences show that the assets commonly considered as liquid like the government securities, other money market instruments, etc, have limited liquidity as the market and players are unidirectional. Thus, analysis of liquidity involves tracking of cash flow mismatches," the Group said.
Banks should track the impact of pre-payments of loans, premature closure of deposits and exercise options built in certain instruments which offer put/call options after specified times. They should evolve a system for monitoring high value deposits (other than inter-bank deposits) say Rs 1 crore or more to track volatile liabilities.
The working group pointed out that management of the interest rate risk should be one of the critical components of MRM in banks as deregulation of the interest rates has exposed them to the adverse impacts of interest rate risk.
The RBI has advised all commercial banks to study the guidance note and forward their comments by April 15, 2002.