FIN 6002 – Session 16 - 17

Pradeepta Sethi
TAPMI
 Market risk
¢ Risk of losses in on-balance
sheet and off-balance sheet
B positions arising from
A movements in market prices.

S Pillar I: Minimum
capital requirements ¢ The market risk positions
E subject to capital charge
requirement are:
L
Market Risk ¢ The risks pertaining to interest
rate related instruments and
I equities in the trading book;
I and

¢ Foreign exchange risk

(including open position in
precious metals) throughout the
banking and trading books.
 ¢ Trading book items -

1. Securities included under the

Held for Trading (HFT)
category
B
A 2. Securities included under the
S Pillar I: Minimum Available for Sale (AFS)
capital requirements category
E
L 3. Open gold position limits
Market Risk
4. Open foreign exchange
I position limits
I
5. Trading positions in
derivatives, and

6. Derivatives entered for hedging

trading book exposures.
 ¢ Minimum capital requirement is
expressed in terms of two
B separately calculated charges -
A
Pillar I: Minimum ¢ Specific risk - designed to
S protect against an adverse
capital requirements
E movement in the price of an
individual security owing to
L Market Risk -
factors related to the individual
Measurement issuer.
I
¢ General market risk - are
I designed to capture the risk of
loss arising from changes in
market interest rates.
 ¢ Two broad methodologies for
computation of capital charge
B for market risks - Standardized
Approach and Internal models
A Approach (IMA)
S Pillar I: Minimum
capital requirements There are two principal methods
E ¢
of measuring market risk - a
L Market Risk - maturity method and a duration
Computation method
I ¢ As duration method is a more
I accurate method of measuring
interest rate risk, banks adopt
standardized duration method to
arrive at the capital charge.
 ¢ The specific risk charges for various
kinds of exposures are mentioned
below and the capital charge is
prescribed in the RBI circular for
these exposures. Example of the
B capital charge on one item is on the
next slide.
A
Pillar I: Minimum
S S. No. Nature of debt securities / Issuer
capital requirements
E a Central, State and Foreign Central
L Market Risk – Governments’ bonds:
(i) Held in HFT category
Standardized approach
ii) Held in AFS category
I b Bank’s bonds:
(i) Held in HFT category
I ii) Held in AFS category
c Corporate Bonds and securitized
debt:
(i) Held in HFT category
ii) Held in AFS category
Source: Prudential Guidelines on Capital Charge for Market Risks, RBI
Table 1: Duration Method – Time Bands and Assumed changes in Yield

Source: Prudential Guidelines on Capital Charge for Market Risks, RBI

 Equity Positions
¢ Capital charge for banks’ capital
market investments (sum of all long
and short equity positions – short
equity position is, however, not
B
allowed for banks in India), for
A specific risk will be 11.25% or
Pillar I: Minimum higher (equivalent to risk weight of
S 125% or higher).
capital requirements
E ¢ The general market risk charge will
L Market Risk- be 9% on the gross equity
Standardized approach positions.
Foreign Exchange Positions
I
¢ Foreign exchange net open
I positions and gold net open
positions are at present risk-
weighted at 100%. Thus, capital
charge for market risks in foreign
exchange and gold open position is
9%.
Source: Prudential Guidelines on Capital Adequacy and Market Discipline, RBI
 HFT
AFS

General
Specific risk
market risk

Capital charge
Duration
provided by
method
RBI
 Equity

General
Specific risk
market risk

Capital charge Capital charge

@11.25% @9%
 Fx & Gold

General
market risk

Capital
charge @9%
 Internal model approach (IMA)
¢ Advanced approach - risk capital is using
value-at-risk (VaR).

¢ The VaR is a number indicating the

B maximum amount of loss, with certain
specified confidence level - a financial
A position may incur due to some risk
events/factors, say, market swings
S Pillar I: Minimum (market risk) during a given future time
E capital requirements horizon (holding period).

L Market Risk - IMA ¢ Higher the value of VaR, higher the level
of market risk, thereby; larger the level of
minimum required capital for market risk.
I ¢ VaR-based models could be used to
calculate measures of both general
I market risk and specific risk.

¢ Banks quantify market risk through its own

VaR model and minimum required capital
for the quantified risk would be determined
by a rule prescribed by RBI.
 ¢ Calculating the eligible capital
for market risk, it will be
necessary first to calculate the
banks’ minimum capital
B
requirement for credit and
A operational risk
S Pillar I: Minimum
¢ Afterwards its market risk
E capital requirements
requirement to establish how
L Market Risk
much Tier 1 and Tier 2 capital is
available to support market risk.

I ¢ Eligible capital will be the sum of

I the whole of banks’ Tier 1
capital plus all of Tier 2 capital
provided Tier 2 capital does not
exceed 100% of the Tier 1
capital.
Source: Prudential Guidelines on Capital Charge for Market Risks, RBI
 Basel II

¢ Banks are required to maintain a minimum CRAR of 9 per cent on an

ongoing basis, Tier I CRAR of at least 6 per cent.

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Pillar I: Minimum
capital requirements
 ¢ Pillar II focuses on the aspect of
B
regulator-bank interaction.
A
S ¢ It empowers regulators in
matters of supervision and
E Pillar II: Supervisory
dissolution of banks.
review
L
¢ Recommend the supervisors to
evaluate the banks’ capital level
I in tune with their risk profile and
I ensure regulatory intervention in
case of need.
 ¢ Principle 1: Banks should have a
process [The Internal Capital
Adequacy Assessment Process
(ICAAP)] for assessing their overall
capital adequacy in relation to their risk
profile and a strategy for maintaining
B their capital levels.
A ¢ Principle 2: Supervisors should review
S and evaluate banks’ ICAAP, as well as
their ability to monitor and ensure their
E Pillar II: Supervisory compliance with the regulatory capital
review ratios.
L
¢ Principle 3: Supervisors should expect
banks to operate above the minimum
regulatory capital ratios and should have
I the ability to require banks to hold
I capital in excess of the minimum.

¢ Principle 4: Supervisors should seek to

intervene at an early stage to prevent
capital from falling below the minimum
levels required to support the risk
characteristics of a particular bank.
 ¢ Pillar III aims to induce discipline
within the banking sector of a
B
country.
A
¢ Disclosures of the bank’s capital
S and risk profiles which were
E Pillar III: Market shared solely with regulators till
Discipline this point should be made
L public.
¢ The premise was that
I information to shareholders
I could be widely disseminated to
ensure prudence in the risk
levels of banks.
 Pillar I: Minimum
Capital Requirement
B • Credit Risk • Framework for Banks
A • Standardized Approach
• Foundation Internal
S Ratings Based Approach
E • Advanced Internal
Ratings based approach • Supervisory
L • Operational Risk
• Basic Indicator Approach
• Standardized Approach
I • Advance Measurement
Approach
I • Market Risk
• Standardized Approach
• Internal Models
Approach
Pillar II: Supervisory Pillar III: Market
Review Process Discipline
•Disclosure
(ICAAP) requirements for banks
• Capital Allocation • Transparency for
• Risk Management market participants
regarding bank’s risk
position
Framework
• Enhanced
• Evaluation of Internal
comparability among
systems of Banks banks
• Assessment of Risk
Profile
• Review of Compliance
with regulations
• Supervisory measures
 Limitations of Basel II

¢ Basel II proved to be pro-cyclical - When the economy is booming and

asset prices are rising, loans seem less risky so banks are allowed to
maintain less capital at exactly the moment when they should be showing
restraint.

¢ Absence of any explicit regulation governing leverage.

¢ Focused more on individual financial institutions and ignored the systemic

risk arising from the interconnectedness across institutions and markets.

¢ Directing banks to monitoring their holdings based on a rating agency’s

assessment may cause banks to unknowingly increase their risk profile if
agencies base their analysis on mistaken assumptions and
methodologies.