Presented by:

Viraf Badha 101

Saurabh Bahuwala 102
Subodh Bhave 103
Sonia Bose 105
Hashveen Chadha 106
Preeti Deshpande 107
Priya Deshpande 108
What's Risk ?
1995 – Barings
1996 – Sumitomo Bank
2005- Global Trust Bank
2006- Western Union Bank

Need for Basel

 Increase in volume of financial flow
 Wide spread banking net work
 Difference in supervisory control
 Quality of assets
 Spate of failure of banks
 Integration of market
BASEL :Basic Objective

Uniform regulation of banking sector across the

globe.
In nutshell it address both the liability & the
asset side of b/s
Basel ..brief history & work..
 1930: BIS (Bank International for International Settlements)
established.
 Focus on development of Breton wood system up to 1970.
 Up to 1980:focus on managing cross border capital flows
 Basel committee established in 1974
 Consists of 25 technical working groups
 No super national supervisory authority
 Specifies broad supervisory standards and guidelines.
 Recommendations towards common approaches & standards
 International standard
 1988 – Basel I
 1999- Basel II (Draft guidelines).
Basel I: objectives
 To ensure capital adequacy to meet financial crisis.
 to develop business volumes linked to capital.
 Parameters to measure and manage risk via Prudential accounting
norms.

Prudential Accounting Norms

 Capital adequacy
 Income recognition
 Asset classification
 Provision
Capital Adequacy
 TIER I CAPITAL: This one can absorb losses without a bank being
required to cease operation. This is Core Capital. Cushion for
unexpected losses.
 TIER II CAPITAL: This can absorb losses in the event of a winding up,
and also provides lesser degree of protection to depositors.
 Measured on Risk Weighted Assets (RWA)

Income Recognition
 Interest income not to be recognized until it is realized. Accrual
system to actual.
 One quarter default for recognizing income
 Either installment or interest or both
 Borrower wise and not Facility wise
 Out of order – applicable to cash /overdraft a/c
Asset classification
 Standard asset – servicing of int. & principal. Normal risk.
 Sub-Standard – NPA for a period up to 12 months. Asset
coverage / net worth of borrower not enough to cover the loan
 Doubtful asset –age of NPA is more than 12 months.
 Loss Assets – no chance of recovery but not written off.

Provisioning norms
 Loss Assts – 100% of out standing amount
 Doubtful Assets – 100% on unsecured portion & 20-50 %for
the secured portion.
 Substandard Asset -10% on the outstanding amount.
 Standard asset – 0.40%, 1% for personal loans, capital market
exposures, residential housing beyond Re 20 lakhs and
commercial real estate loans
Why BASEL II ?
 One size fit approach to be replaced by a menu of options for banks
to choose
 More risk sensitive to encompass all risks especially operational risk.
 To bridge the cap between Regulatory & Economic capital
 BASEL I did not address risk mitigation techniques such as collateral,
guarantees etc
 More emphasis on banks’ internal control and management
 More disclosure through market discipline

China Banking Regulatory Commission-

“To a large extent we are convinced that Basel II is
more about risk management than capital regulation,
particularly for the emerging markets”
Objectives of Basel II

 To encourage better and more systematic risk management

practices, especially in the area of credit risk and to provide
improved measure of capital adequacy.

 Introduction of Basel II has given incentives to many of the best

practices banks, to adopt better risk management techniques and
to evaluate their performance relative to market expectations and
relative to competitors.

 The new framework proposes a significant refinement of regulatory

and supervisory practice and encourages increased attention to
risk management practices.
New Basel Capital Accord

The
New Basel • Minimum capital
Capital Accord
requirements
Regulatory and Economic capital
Supervisory Review Process

• Supervisory review process

Minimum Capital

Market Discipline
Requirements

Transaction based to risk based

supervision

• Market discipline
Risk exposure, migration assets
from standard to NPA etc
PILLAR I: Explained

 Credit Risk:
 Standardized approach
 Internal Rating Based Approach (Foundation IRB/Advanced
IRB)

 Operation Risk:
 Basic Indicator Approach
 Standardized approach
 Advanced Measurement Approach

 Market Risk:
 VaR models for Trading Book (AFS + HFT) and EaR models
for Banking Book (HTM)
Pillar 1
Eligible capital Key Changes:
ON-BALANCE-SHEET CREDIT RISK • Wider spectrum of credit
+ risk weights.
= 8% • Greater recognition of
Off-balance-sheet credit risk
collaterals.
+ • More refined treatment
Market risk of
+ securitization.
OPERATIONAL RISK • Charge for Operational
Risk introduced

Economic Capital
Credit Risk

Credit Risk

Standardized Internal Rating Securitization

Approach Based approach Framework

Foundation IRB Advanced IRB

Collaterals
 The following collateral instruments are eligible for recognition in
comprehensive approach:
Cash, Gold, Securities issued by Central/ State Governments, IVPs,
KVPs, NSCs, LIC policies, Debt securities, equities etc.

 In case of NPAs, other collaterals viz., land and building, plant and
machinery will be recognized for assigning lesser risk weight of
100%, when provisions reach 15%, only where the bank is having
clear title and the valuation is not more than 3 years old and value
of machinery not higher than the depreciated value.
Risk weights on claims

Option 1 = Risk weights based on risk weight of the country

Option 2a = Risk weight based on assessment of individual bank
Option 2b = Risk weight based on assessment of individual
banks with claims of original maturity of less than 6 months.
Other Risk Weights
 Exposures to Central Govt.& Inv.in St.Govt 0%
 Exposures guaranteed by State Govt 20%
 Exposures on RBI/DICGC/CGTSI 0%
 Exposures on ECGC 50%
 Staff loans secured by superannuation benefits 20%
 Claims on Multilateral Development Banks 20%
 Claims on Banks (based on CRAR of Bank) 20%-625%
 Claims on Corporate based on ext.rating) 20%-150%
 Unrated claims in excess of Rs.10 cr 150%
 Claims on Commercial Real Estate 150%
 Consumer credit/personal loans/credit cards 125%
 Claims on restructured/rescheduled a/cs 125%*

*(till satisfactory performance of one year from the date when

the first payment of interest/installment falls due)
External Credit Assessments
 Disclose the names of the credit rating agencies that Banks use for
the risk weighting of their assets.
 The rating should be in force and confirmed from the monthly
bulletin of the concerned rating agency. The rating agency should
have reviewed the rating at least once during the previous 15
months.
 Credit assessment must be publicly available.
 Even though CC accounts are sanctioned for period one year or
less, these exposures should be reckoned as long term exposures
and accordingly long term ratings accorded by agencies will be
relevant.
 All loans above Rs 10cr will be rated by outside credit rating agencies
under standardized approach.

• Recognized agencies
• Credit Analysis and Research Ltd., (CRISIL)
• FITCH Ratings and
• ICRA Limited
• SMERA is not recognized
What is operational risk ?
“The risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and
systems or from external events”

Technology Regulatory Financial Social, Ethical and

Risk Compliance Risk Control Risk Environmental Risk

Product and Service Delivery Legal Risk People Risk

Sales Risk (Operations)
Risk
Standardized Approach &
Advanced Measurement Approach
 Standardized Approach:
 Bank’s activities would be divided into 8 business lines as under:
 Corporate finance, Trading, Retail banking, Commercial Banking,
Payment & settlement, Agency services, Asset Management and
Retail brokerage.
 Capital charge against each business to be provided on the basis of
annual average income for 3 years.
 Under each business line, capital charge is calculated by multiplying
the beta factor assigned to that business line. Gross income is
calculated for each business line and not for Bank as a whole.
 Advanced Measurement Approach:
 Regulatory capital will equal the risk capital measured by Bank’s
internal risk measurement.
 Measured by bank’s internal risk measurement system using
quantitative and qualitative approach.
Risk Based Supervision
 Present audit focuses on transaction testing – accuracy &
reliability of records, financial reports, adherence to legal &
regulatory requirements etc.

 RBS focuses on testing of risk in each transaction, evaluation of

effectiveness risk management & controls, periodicity of audit,
inherent risks in various activities of institution, prioritization of
audit areas, allocation of audit resources etc.

 In short, it is a migration form transaction to risk based audit.

 Ops risk – Bill passing activity
Sr. No. Key Risks Sources Controls Frequency- Key Risk Indicator
Severity

1 Bills passed Negligence Standard checklist of High –High Number of instances

without Accepting photocopies acceptable supporting of bills passed
adequate instead of originals Reject vouchers with without adequate
supporting Non-availability of a inadequate supporting supporting
valid supporting for
specific transaction
type
Exceptional payment
made pending receipt
of supporting

2 Advances not Advances accounted in Check for possible Low- Advances or debit
adjusted against different account advances before Medium balances outstanding
payment Advances not tracked payment for more than 3
separately and Periodic scrutiny of GL months
accounted as ‘on a/c’s, Advance Register,
account’ payment Ageing report

3 Applicable taxes Lack of awareness Up-to-date information Low-High Frequency of

not/ short about tax laws and on tax laws in reviewing and
deducted before rules consultation with tax updating tax masters
payment Incorrect/ delays in/ department
non-updation of tax Periodic review and Number of instances
deduction masters in updation of tax rates in of non/short tax
system tax master in system deducted
Examples – Unusual Events - Loss
types
Activity (Loss Event - Level 3)
Excess cash - Teller error
Delivery failure - vendor
Loss of receipt books by DRA
Cash shortage - Teller error
Debit card fraud - Misuse by outsider
Account used for fraudulent transactions
Connectivity failure
Fraudulent instrument presented in inward
clearing
Fraudulent instrument presented in payments
Vandalism by outsiders
DRA fraud - Cash embezzelement
KYC fraud by RL customer
Software error
Activity (Loss Event - Level 3)
Cheque deposit credited to wrong account
Customer fraud - Retail Asset (CV)
Delivery failure - LCC Operations
DRA fraud - Teeming and lading fraud
Inaction due to communication gaps between
Departments
KYC fraud by employee
Loss of branch assets
Non compliance of statutory provisions
Physical assault on bank staff
Salary paid in excess
Theft of instrument by staff
Account used for suspected fraudulent purpose
Bogus call received for cash extortion
Pillar II: Supervisory Review
 Banks should have Internal Capital Adequacy Process (ICAAP).

 Supervisor should verify maintenance of minimum capital

requirements by banks.

 Supervisor would take appropriate action if they are not satisfied with
the Bank’s minimum capital.

 ICAAP should faithfully capture the risks attached in the bank’s

portfolio.

 Supervisor may take early supervisory action by asking bank to

maintain additional capital.
Pillar III: Market Discipline
 To enable the market to understand the strengths and weaknesses
of the Bank.
 To encourage market discipline by developing a set of disclosure
requirements which allow market participants to assess key pieces
of information on capital, risk exposure, risk assessment process.
 Providing disclosures that are based on a common framework is an
effective means of informing the market about a bank’s exposure
to those risks and provides a comprehensive disclosure framework
that enhances comparability.

Disclosure Regime
 Board approved policy for disclosures.
 Financial position and performance.
 Risk management strategies and practices.
 Risk exposures.
 Accounting policies.
 Basic business, management and corporate governance information.
Benefits Of Disclosure Regime
 Incentive for improved risk analysis and pricing of risks.
 Better internal capital management
 Improvement in credit portfolio quality and better recognition of risk
mitigation.
 Control orientation to strategic advantage.
Current directives of RBI
 Draft guidelines - Feb 05.
 Revised draft guidelines - March 2006.
 Standardized approach – March 2009
 Parallel run

 RBI may enforce to have a uniform credit rating approach to

measure capital requirement since credit rating is a yard stick for
capital provisioning .
 Technological up gradation involves huge capital requirement but
return may not match. Smaller banks may suffer.
 Low penetration of credit rating and it has got to improve.
 Social obligation of public sector banks.
 Indian perspective
 FICCI’s 2005 survey (India)
 27% of banks expected their capital requirements to increase by 1-2% while
20% expected the increase to be larger than 3%
 IBA’s 2006 survey (India)
 A long term roadmap for Basel II implementation was missing in India, in
respect of operational risk. 65% banks had gone into implementation
without a preceding project planning exercise.
 40% of the banks considered cost of compliance to be a significant concern
in implementing Basel II
 KPMG India 2006 survey (27 public and private sector banks)
 Compliance with regulation was driving Basel II implementation in half the
banks surveyed.
 From a technology perspective some progress had been made in credit and
market risk management but not in Operation Risk.
 Only a few (16%) had commenced planning for the more advanced
approaches.
 A large number of Banks had not fully understood the complexities of
Operation Risk
Indian perspective

As of 2005
Implementation - issues
 Banks by manipulating credit risk measurement, may reduce CAR.
Non deliberate under estimation also may lead to lower CAR.
 Competition among banks for high quality loans/customers may
exert pressure on interest spread .
 Burden of approving internal risk models. It will lead to regulators
identifying themselves the banks they supervise. It will come difficult
not to bail out of a large problem since supervisors have validated
and approved of internal rating system of bank facing financial crisis.
 Non availability of data over longer time horizon to measure risk
based on historical data.
 Too much disclosure may cause information over load and may
create problem to the respective bank vis-à-vis competitors.
Challenges….
• Broad brush approach – irrespective of quality of counter
party or credit
• Encouraging regulatory arbitrage by cherry picking
• Lack of incentives for credit risk mitigation techniques
• Not covering Operational risk

 Capital Requirement
 Supervisory Framework
 Profitability
 Corporate Governance
 Risk Management Architecture Issues
 Rating requirement
 National Discretion
 Choice of Alternative Approaches
 Disclosure Regime
 Absence of Historical Database
 Disadvantage for
 Incentive to Remain Unrated
 Smaller Banks
 Discriminatory against
Developing Countries
 External and Internal
Auditors
The highest potential for increasing shareholder value is improving the
way allocate capital to businesses, (including) taking away capital from
businesses that are not achieving return expectations.

Michael E.O’Neill on SWM share holder wealth max., CFO, Bank of America