RISK MANAGEMENT

MODULE B A PRESENTATION BY K.ESWAR ASST GENERAL MANAGER CENTRAL BANK OF INDIA.

RISK MANAGEMENT
RISK IN BANKING BUSINESS ? WHAT IS RISK ? RISK , CAPITAL AND RETURN.

VALUATION OF SECURITIES.
VALUATION OF INVESTMENT PORTOLIO OF BANKS WILL BE CLASIFIED AS UNDER : HTM: VALUALTION METHOD: Investments classified under HTM category need not be marked to market and will be carried at acquisition cost unless it more than the face value. In such case the premium is amortized over a period of remaining maturity.
.

VALUATION OF SECURITIES
AFS : VALUATION METHOD : Individual scrip will be marked to market at the quarter end . The net depreciation under each classification should be recognized and fully provided for and any appreciation should be ignored. The book value of securities would not undergo any change after the revaluation. HTM. VALUATION METHOD : The individual scrips in the HTM category will be revalued at monthly interval and net appreciation or deprecation under each classification will be recognized in income account. The book value of the individual scrip will be changed with revaluation.

Liquidity Risk.
Q Funding risk is : A. Un anticipated withdrawal/non renewal of deposit. B. Unable to provide funds to Head office of Bank. C. Inadequate funds. Q. The liquidity risk arising out of non receipt of expected in flow of funds due to accounts turning as NPA is known as a. Time Risk. b. Call Risk. c. Operational Risk. d. Funding risk. Q. The liquidity risk arising out of crystallization of liabilities and conversion of non fund based limits to fund based limits is known as : a. Call risk. b. Time risk. c. Operational risk. d. Market risk.

Interest Rate Risk. Gap or Mismatch risk. Yield curve risk. Basis Risk. Embedded option risk.

Market Risk
Forex Risk. Equity price risk. Interest rate risk. Mark to Market. CREDIT RISK: Counter Party risk. OPERATION RISK.

MANAGEMENT OF RISK
RISK IDENTIFICATION.: RISK MEASURMENT. Sensitivity, Volatility, Var. RISK PRICING. RISK MONITORING. RISK MITIGATION.

 Risk Regulations in Banking Industry.

What is the Basel Committee? Established at the end of 1974 by Central Bank Governors of G10 to address cross-border banking issues
Reports to G10 Governors/Heads of Supervision Members are senior bank supervisors from G10, Luxembourg and Spain Work undertaken through several working groups

Outreach to other countries Committee started as a closed shop

Over time, has developed close ties with non-members Committee tries to address issues relevant for all jurisdictions worldwide Core Principles Liaison Group (16 non-Committee jurisdictionsincluding Indiaplus IMF, World Bank) Working Group on Capital

Regional groups
International Conference of Banking Supervisors (ICBS) Participation in work of the Secretariat

Training, speeches, consultation

11

The three Cs

Concordat (and subsequent papers dealing with cross-border

supervision)

Core Principles for Effective Banking Supervision

Capital Adequacy Framework

Many other topics: risk management, corporate governance, accounting, money laundering, etc, on the Committees website (www.bis.org/bcbs)

From Basel I to Basel II 1988 Capital Accord established minimum capital requirements for banks
Minimum ratio:

Capital 8% Risk weighted assets

In 1998, Committee started revising the 1988 Accord: More risk sensitive

More consistent with current best practice in banks risk management

Numerator (definition of capital) remains unchanged

What are the basic aims of Basel II?

To deliver a prudent amount of capital in relation to risk To provide the right incentives for sound risk management To maintain a reasonable level playing field Basel II is not intended to be neutral between different banks/different exposures

Three pillars of the Basel II framework

Minimum Capital Requirements

Credit risk
Operational risk Market risk

Supervisory Review Process

Banks own capital strategy
Supervisors review

Market Discipline
Enhanced disclosure

BANKS TYPICALLY FACE THREE KINDS OF RISK

Type of Risk Example

Market

Credit

Risk of loss due to unexpected re-pricing of assets owned by the bank, caused by either Exchange rate fluctuation Interest rate fluctuations Market price of investment fluctuations OUR FOCUS TODAY Risk of loss due to unexpected borrower default Risk of loss due to a sudden reduction in operational margins, caused by either internal or external factors

Daily price change (%)

Stocks

Unexpected price volatility

Time Default rate (%)

Loans with credit rating 3

Unexpected default Avg. default

Time Monthly change of revenue to cost (%)

Business unit A

Unexpected low cost utilization

Time

Operational

The three pillars

All three pillars together are intended to achieve a level of capital commensurate with a banks overall risk profile

Pillar I Credit Risk

Pillar 1 Credit Risk stipulates three levels of increasing sophistication. The more sophisticated approaches allow a bank to use its internal models to calculate its regulatory capital. Banks who move up the ladder are rewarded by a reduced capital charge
Advanced Internal Ratings Based Approach Foundation Internal Ratings Based Approach
Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes

Standardized Approach

Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.

Risk weights are based on assessment by external credit assessment institutions

Reduce Capital requirements

Advantages of capital
Provides safety and soundness Depositor protection Limits leveraging Cushion against unexpected losses Brings in discipline in risk taking

The Current Capital Accord Focused on credit risk but formula based Partially amended in 1996 to include market risk Operational risk not addressed Simple in its application Produced an easily comparable and verifiable measure of banks soundness

Need for a new frame-work

Financial innovation and growing complexity of transactions Categorized banks assets into one of only four categories each representing a risk class Made no allowance for the effect portfolio diversification Requirement of more flexible approaches as opposed to one size fits all Approach Requirement of Risk sensitivity as opposed to a broadbrush Approach Operational Risk not covered

Basle Accord I & II Differences

Talks of Credit Risk only Capital Charge for Credit Risk Does not mention separate Capital charge for Market and Operational Risk No mention about market Discipline No effort to quantify Market and Operational Risk

Talks of Credit, Market and Operational Risks Capital Charge dependant on Risk rating of assets Capital Charge to include risks arising out of Credit, Market and Operational risks. Not a broad brush approach Quantitative approach for calculation of Market and Operational risks as for Credit Risk.

Pillar I Minimum Capital Requirements

The new Accord maintains the current definition of total capital and the minimum 8% requirement*

Total capital = Banks capital ratio Credit risk + Market risk + Operational risk (minimum 9%)
Total Capital
Total capital = Tier 1 + Tier 2 Tier 1: Shareholders equity + disclosed reserves Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions) The risk of loss arising from default by a creditor or counterparty The risk of losses in trading positions when prices move adversely The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

Credit Risk Market Risk

Operational Risk

* The revisions affect the denominator of the capital ratio - with more sophisticated measures for credit risk, and introducing an explicit capital charge for operational risk

Framework

Internal Ratings Based Approach

Exposures in five categories because of different risk characteristics
Sovereigns Banks Corporates Retail NPA

Internal Ratings Based Approach

Internal ratings based (IRB) approach Foundation Advanced Goal: Should contain incentives for migration from standardized to IRB approach

IRB approach
Risk components PD, LGD, EAD,

Differentiation between IRB Advanced & Foundation

Advanced approaches
Requires supervisors approval Increased emphasis on banks internal assessments Banks to meet certain standards Capital Management Policy Committee Process to review the quality of risk management & control systems Appropriateness of the capital level and composition to the nature and scale of banks activities

General Market charge

Captures risk of loss arising from general changes in market interest rates / other market variables Two Approaches Standardized Duration approach. Internal risk management models

RBI adopted Standardized approach

Market Risk Internal Models

BIS requirement: 1. VaR to be calculated daily 2. Confidence level of 99% 3. Holding period 10 days 4. Historical data for at least one year to be taken and updated at least once in a quarter

Operational Risk
Explicit charge on capital Basic Indicator approach 15% of gross income Gross income = net interest income plus net non interest income

GROSS INCOME
GROSS INCOME = NET PFORIT+ PROVISIONS+OPERATING EXPENSES-PROFIT ON SALE OF INVSTEMENT-INCOME FROM INSURANCE-EXTRA ORDINARY ITEM OF INCOME+ LOSS ON SALE OF INVESTMENT

Operational Risk
Standardised Approach- Capital charge is calculated as a simple summation of capital charges across 8 business lines
Business lines % of gross income

Corporate finance
Trading & sales Retail Banking Commercial Banking Payment & Settlement Agency Services Asset Management Retail Brokerage

18
18 12 15 18 15 12 12

Pillar II- Supervisory Review

Principles:
Banks should have (a) process for assessing their Capital adequacy in relation to their Risk Profile and a strategy for maintaining their capital levels (b) Supervisors should review these and take action if they are not satisfied

Pillar II
Principles:
(c) Supervisors should expect banks to operate above the minimum CAR and should have the ability to require banks to hold capital in excess of the minimum

(d) Supervisors should intervene at an early stage to prevent capital from falling below required level and initiate rapid remedial action

Pillar II
Risk Based Supervision
Business risk and control risk

Prompt Corrective Action

CRAR Net NPAs ROA
Structured and discretionary actions

Pillar III
Sets out disclosure requirements and recommendations (core and supplementary)
Required disclosures on capital, risk exposures, risk assessment (credit risk, market risk, Operational risk etc) and hence the capital adequacy.

Allows market participants to assess key information about a banks risk profile and level of capitalisation

MARKET DISCIPLINE
a. Third Pillar to supplement first two pillars namely minimum capital requirement and supervisory review. b. The aim of this pillar is o encourage market discipline by developing a set of disclosure requirements which allows market participants to assess :

Scope of application
Capital Risk Exposures Risk assessment processes Ultimately Capital Adequacy

c. Such disclosures with common framework provides enhanced comparability. d. Achieving Appropriate Disclosure Market Discipline contributes to safe and sound banking. Non-disclosure attracts penalty including a financial penalty. No direct penalty of additional capital for nondisclosure but indirectly by way of lower risk weight under pillar-1 provided certain disclosures are made etc.

e. Interaction with accounting disclosures :

Disclosure framework not to conflict with requirements under accounting standards. All banks should provide Pillar-III disclosures both qualitative and quantitative as on March end each year along with annual financial statements.
Banks with capital funds of more than Rs.500 crores and their significant subsidiaries must disclosure on quarterly basis. - Tier 1 Capital - Total Capital

f. Scope and frequency of disclosures

- Total required capital

- Total Capital adequacy ratios

g. Validation : No need of audit of disclosures as they are either consistent with audited financial statements or gone through internal assessment/control procedures and systems.

h. Materially
Information is regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decision. - RBI will prescribe certain materiality threshold for certain limited disclosures to provide greater comparability among banks.

i.

Proprietory and Confidential Information Proprietory Information On products or Systems Confidential Information On customers RBI has prescribed in the form of various tables (1-11), a system of disclosures striking a balance between the need for meaningful disclosures and protection of proprietory and confidential information.

j.

General Disclosure Principle Each bank to have formal disclosure policy approved by Board. Approach for disclosures Internal control over disclosure process Process to assess appropriateness of its disclosures including validation and frequency Parent bank need not make disclosures of individual banks/entities except disclosure of Tier-I and total capital of each subsidiary bank. All Units to make Pillar-III disclosures.

k. Scope of application

Scope and frequency of disclosures

Annual disclosures qualitative & quantitative Interim disclosures for banks with capital > 100 crore
Quantitative aspects in websites

Quarterly disclosures for banks with capital > 500 crore

Tier I capital, Total capital, CRAR and Total required capital (including subsidiaries)

Banks to have formal disclosure policy

New Capital instruments

Innovative Perpetual Debt Instruments eligible for inclusion as Tier 1 capital Debt capital instruments eligible for inclusion as Upper Tier 2 capital Perpetual non-cumulative Preference shares eligible for inclusion as Tier 1 capital Redeemable cumulative Preference eligible for inclusion as Tier 2 capital shares

Innovative Perpetual Debt Instruments for inclusion as Tier 1 capital

Amount to be raised may be decided by the Board of Directors of banks Limited to 15 per cent of total Tier 1 capital Excess of the above limits shall be eligible for inclusion under Tier 2

Interest at a fixed rate or at a floating rate referenced to a market determined rupee interest benchmark rate
Step-up option after 10 years - not more than 100 bps.

Superior to the claims of investors in equity shares and Subordinated to the claims of all other creditors

One year transition matrix

Initial Rating

A++

A+

B+

C+

Default

A++ A+

90.81 0.70

8.33 90.65

0.68 7.79

0.18 0.64

0 0.06

0 0.14

0 0.02

0 0

A
B+ B C+
C

0.09
0.02 0.03 0 0

2.27
0.33 0.14 0.01 0

91.05
5.95 0.67 0.24 0.22

5.52
86.93 7.73 0.43 1.30

0.74
5.30 80.53 6.48 2.38

0.26
1.17 8.84 83.46 11.24

0.01
0.12 1.00 4.07 64.86

0.06
0.18 1.06 5.20 19.79

Thank You!