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MODULE B A PRESENTATION BY K.ESWAR ASST GENERAL MANAGER CENTRAL BANK OF INDIA.
• 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.
c. Market risk. • • • • • • • • • • • • • • • • • Q Funding risk is : A. . b. b. The liquidity risk arising out of crystallization of liabilities and conversion of non fund based limits to fund based limits is known as : a.Liquidity Risk. Time Risk. The liquidity risk arising out of non receipt of expected in flow of funds due to accounts turning as NPA is known as a. d. Unable to provide funds to Head office of Bank. d. Operational Risk. Call risk. c. Operational risk. Q. Un anticipated withdrawal/non renewal of deposit. Funding risk. Time risk. B. C. Call Risk. Q. Inadequate funds.
. Yield curve risk. Basis Risk. Gap or Mismatch risk.• • • • • Interest Rate Risk. Embedded option risk.
OPERATION RISK. • Equity price risk. CREDIT RISK: Counter Party risk. • Mark to Market.Market Risk • Forex Risk. • Interest rate risk. .
: RISK MEASURMENT. RISK MONITORING. Var. RISK MITIGATION.MANAGEMENT OF RISK • • • • • RISK IDENTIFICATION. Volatility. RISK PRICING. Sensitivity. .
.• Risk Regulations in Banking Industry.
Luxembourg and Spain Work undertaken through several working groups .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.
has developed close ties with non-members Committee tries to address issues relevant for all jurisdictions worldwide Core Principles Liaison Group (16 non-Committee jurisdictions—including India—plus IMF. speeches. World Bank) Working Group on Capital Regional groups International Conference of Banking Supervisors (ICBS) Participation in work of the Secretariat Training. consultation 11 .Outreach to other countries Committee started as a ―closed shop‖ Over time.
money laundering.bis. etc. on the Committee’s website (www. accounting.The three C’s 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.org/bcbs) .
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 .From Basel I to Basel II 1988 Capital Accord established minimum capital requirements for banks Minimum ratio: Capital 8% Risk weighted assets In 1998.
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 – Bank’s own capital strategy – Supervisor’s review Market Discipline – Enhanced disclosure .
default Time Monthly change of revenue to cost (%) “Business unit A” Unexpected low cost utilization Time Operational .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.
The three pillars All three pillars together are intended to achieve a level of capital commensurate with a bank’s overall risk profile .
Risk weights are based on assessment by external credit assessment institutions Reduce Capital requirements . Other risk components are standardized. 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.Pillar I – Credit Risk Pillar 1 – Credit Risk stipulates three levels of increasing sophistication.
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 bank’s soundness .
Need for a new frame-work • Financial innovation and growing complexity of transactions • Categorized bank’s 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 .
Market and Operational risks. . Market and Operational Risks Capital Charge dependant on Risk rating of assets Capital Charge to include risks arising out of Credit. Not a broad brush approach Quantitative approach for calculation of Market and Operational risks as for Credit Risk.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.
g.Pillar I – Minimum Capital Requirements The new Accord maintains the current definition of total capital and the minimum 8% requirement* Total capital = Bank’s 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. 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.with more sophisticated measures for credit risk. and introducing an explicit capital charge for operational risk . undisclosed reserves. people and systems or from external events Credit Risk Market Risk Operational Risk * The revisions affect the denominator of the capital ratio .
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 –. .
• Differentiation between IRB – Advanced & Foundation . LGD.IRB approach • Risk components – PD. EAD.
Advanced approaches • • • • • Requires supervisor’s 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 bank’s 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 .
Holding period 10 days 4.Market Risk – Internal Models BIS requirement: 1. Confidence level of 99% 3. Historical data for at least one year to be taken and updated at least once in a quarter . VaR to be calculated daily 2.
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 .
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 .Operational Risk Standardised Approach.
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 .
• Allows market participants to assess key information about a bank’s risk profile and level of capitalisation . risk assessment (credit risk. risk exposures. market risk. Operational risk etc) and hence the capital adequacy.Pillar III • Sets out disclosure requirements and recommendations (core and supplementary) • Required disclosures on capital.
Third Pillar to supplement first two pillars namely minimum capital requirement and supervisory review. b.MARKET DISCIPLINE a. 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 .
d.c. 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. Non-disclosure attracts penalty including a financial penalty. Such disclosures with common framework provides enhanced comparability. . Achieving Appropriate Disclosure • • • Market Discipline contributes to safe and sound banking.
Scope and frequency of disclosures • • . All banks should provide Pillar-III disclosures both qualitative and quantitative as on March end each year along with annual financial statements. .Total required capital .500 crores and their significant subsidiaries must disclosure on quarterly basis.e.Total Capital f. Interaction with accounting disclosures : • Disclosure framework not to conflict with requirements under accounting standards.Tier – 1 Capital .Total Capital adequacy ratios . Banks with capital funds of more than Rs.
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.RBI will prescribe certain materiality threshold for certain limited disclosures to provide greater comparability among banks. .g. 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. h. .
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.
General Disclosure Principle • • • • Each bank to have formal disclosure policy approved by Board. k. All Units to make Pillar-III disclosures. Scope of application • • . 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.j.
Total capital. CRAR and Total required capital (including subsidiaries) • Banks to have formal disclosure policy .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.
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 .
Superior to the claims of investors in equity shares and Subordinated to the claims of all other creditors .not more than 100 bps.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 .
30 0.33 90.73 0.09 0.43 1.65 0.22 5.18 1.01 0.30 80.67 0.06 0 0.One year transition matrix Initial Rating A++ A+ A B+ B C+ C Default A++ A+ 90.95 0.20 19.12 1.84 83.24 0.07 64.81 0.17 8.86 0.06 0.03 0 0 2.06 5.05 5.27 0.00 4.18 0.02 0.48 2.24 0.93 7.33 0.46 11.53 6.79 .38 0.52 86.02 0 0 A B+ B C+ C 0.26 1.79 0.64 0 0.14 0.14 0 0.68 7.74 5.70 8.01 0 91.
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