Risk Management and Basel norms

Adopting the Basel Committee on Banking supervision

(BCBS) framework on capital adequacy

Bank for International Settlements (BIS), Est. in 1930 in

Basel
BIS fosters international monetary and financial co-
operation
Serves as a bank for central banks

Provided prudential guidelines on capital adequacy and

market discipline
Capital Adequacy Standards
Bank Capital Adequacy refers to the amount of equity
capital and other securities a bank holds as reserves
against risky assets to reduce the probability of a bank
failure.
Basel accord is agreed in 1988 at Basel at the instance of
G 10 nations.
The BIS ( Bank for International Settlements ) established a
frame work for measuring bank capital adequacy for
banks.
It was enforced by G10 countries in 1992
Capital Adequacy Standards
The accord divides bank capital into two categories:
Tier 1 core capital – shareholder equity and retained
earnings
Tier 2 supplemental capital – Additional external and
internal sources available to the bank – undisclosed
reserves, revaluation reserves, hybrid debt capital
instruments, subordinated debts ( limited to 100% of Tier 1
capital )
Risk- weighted assets are weighted at 0%,20%,50% and
100%
Total CRAR = Eligible total capital funds /credit risk
RWA +Market risk RWA +Operational risk RWA
Capital Adequacy Standards
The Basel accord called for a minimum bank capital
adequacy ratio of 8% of risk – weighted assets for banks
that engage in cross –border transactions

Balance sheet assets, non-funded items and off- balance

exposures are assigned prescribed risk weights

A 1996 amendment to the accord requires commercial

banks to set aside additional capital it cover the market
risks also.

Basel 1 focussed on credit risk and market risk

Basel 2, published in 2004, replaced Basel 1
Capital Adequacy Standards
Economic capital
• Amount of capital considered necessary by banks to
absorb potential losses associated with banking risks
• Accounting capital represents book values
• Economic capital is a forward looking measure of capital
adequate to cover banking risks
• The capital estimated to cover the probabilistic
assessment of potential future losses
Capital Adequacy Standards
Basel 2 prescribed rigorous risk and capital management
requirements

Minimum CRAR (capital to risk weighted assets ratio)

9%

Capital to be provided for credit risk, interest risk,

(market risk) and operational risk

It consists of 3 mutually reinforcing pillars

- Minimum capital requirement
- Supervisory review of capital adequacy
- Market discipline
Capital Adequacy Standards
Under pillar 1, three options for computing capital
requirements for credit risk

1. Standardised approach

2. Foundation Internal Rating based approach

3. Advanced Internal based approach

Capital Adequacy Standards
Options for computing capital requirements for
Operational risk
1. Basic Indicator Approach (BIA)

2. Standard Approach

3. Advanced Measurement Approach

Banks in India will follow Standardised approach and Basic

Indicator Approach, for credit risk and operational risk ,
respectively
Capital Adequacy Standards
Under standardised approach, the rating to be done by
eligible external credit rating agencies

Corporate have to be rated by CARE, CRISIL, FITCH,

ICRA - risk weights 20%, 30%, 50%, 100%, 150%

Housing loans to Individuals

Up to Rs 30 lakhs .. 50% ( risk weight )
Rs 30 lakhs & above .. 75% ( risk weight )
Capital Adequacy Standards
Venture capital funds & commercial real estate – 150%

Claims on foreign sovereigns – Risk Weights

S&P/FITCH..AAA to AA..A.. BBB..BB to B..Below B..Unrated

Moody’s .. Aaa to Aa.. A .. Baa.. Ba to B..Below B..Unrated

Risk weights .. 0% .. 20% ..50% .. 100% .. 150%.. 100%

Basel III
• G 20 leaders officially endorse Basel III frame work

• Far reaching reform in global banking system

• Introduces capital buffers that can be drawn upon in bad

times

• The new standards will markedly reduce banks’ incentive

to excessive risks, lower the severity of future crises
Basel III
• The new frame work will be translated into national laws and will be
implemented starting on Jan1, 2013 and fully phased in by Jan1,2019

• Tier 1 capital requirement will increase from 4% to 7%

• Tier 2 capital ~~ 2%

• Minimum total capital ~ 9% (7+2)

• Total capital ~ 11.5% (9+2.5*)

• * Capital conservation buffer ~ 2.5%

Prudential Norms
Income recognition, asset classification and provisioning
Assets – Performing assets and non-performing assets
( NPA )
NPA is defined as a credit facility in respect of which the
interest and /or instalment of the principal has remained “past
due” for a specified period of time ( 90 days from 31 st march
2005)
Agricultural advances – short duration crops – overdue two
crop seasons
Long duration crops – overdue one crop season
There are three categories of NPA
Prudential Norms
Sub – standard Assets
NPA for less than or equal to 12 months
Doubtful Assets
Sub-standard category for a period of 12 months
Loss Assets
A loss asset is one where loss has been identified by the
bank or the internal or external auditors or RBI inspectors,
but amount has not been written off wholly.
Prudential Norms
As per global practice, income from NPA is not recognised on accrual
basis but is booked as income only when it is actually received

Provisioning Norms
Standard assets ~ 0. 40%
Direct Agriculture / SME~ 0.25%
Advance to other sectors – personal loans, home loan > Rs 20
lakhs, commercial real estate loans, capital market exposure ~
2%

Sub-standard assets ~ 15% on the outstanding balance

Unsecured exposures ~ 25% on the outstanding balance
Prudential Norms
Provisioning Norms
Doubtful debts
Unsecured portion of the advance ~ 100%
Secured portion of the advance
Up to 1 year (D1) ~ 25%
1 year to 3 years (D2) ~ 40%
> 3 years (D3) ~ 100%

Loss assets
100% of the outstanding balance

•Restructured accounts classified as standard advances ~ 2%

“The business of banking is the business of risk
management. Plain and simple, that is business of
banking.”
Walter Wriston, Ex-CEO
Citi Bank
Commercial Bank Risk
Risk is the uncertainty or probability that a negative event
occurs. In financial terms, a negative event is a loss
Banks suffered dramatic losses in the past decade
Credit exposures turned sour, interest rate positions, or
derivative exposures
Commercial Banks assumes various kinds of financial risks
Not undertaking risk is the most risky proposition for banks
Commercial Bank Risk
Three separable types of risk
Risks that can be eliminated or avoided by simple business
practices
Risks that can be transferred to other participants
Risks that must be managed at the Institution level

Banks accept only those risks that are uniquely a part of

the bank’s array of services
Banks do not absorb the risks that can be efficiently
transferred to other participants
Commercial Bank Risk
Major risk factors
Credit risk
Most obvious risk. In terms of potential losses, the
largest type of risk
Market risk
Large movements in equities, FX rates, commodity
prices, interest rates
Operational risk
Risk of direct or indirect loss resulting from inadequate
or failed internal processes, people and systems, or
external events. Also includes legal risks
Commercial Bank Risk
Liquidity risk
Bank will not be able to efficiently meet expected and
unexpected current and future cash flows and collateral
needs, without affecting daily operations
Banks borrow short and lend long
They create liabilities which promise to be liquid and hold
few liquid assets themselves
Banks are forced into liquidation of assets, when large no
of depositors want liquidity at the same time
Unwise loans threaten the solvency
Risk Management
Risk Identification
Risk Measurement
Risk Control
Risk Mitigation
Financial and non-financial risks

Credit
Interest rate
Exchange rate
Risk Management

commodities
Liquidity
Legal, regulatory and operational aspects
Competition/ Market risk
Technology risk
Financial risk
Economic / Political risk
Risk Management
Key functions of risk management

Risk analysis
Investment and pricing decisions
Risk quantification
Risk monitoring and reporting
Strategic advisor
Solvency – bank capital required to absorb an unexpected
loss
Risk Management
Key functions of risk management

Risk analysis
Investment and pricing decisions
Risk quantification
Risk monitoring and reporting
Strategic advisor
Solvency – bank capital required to absorb an unexpected
loss
Risk Management
Risk Treatment
Risk avoidance
Risk reduction or mitigation
Risk acceptance
Risk transfer
Operational risk management
It aims at reducing the number of events and limiting the
losses on big events. It consists of assessment and loss
management.
Risk Management and Credit Rating
As per Basel 2 , borrowers and facilities must have their ratings
refreshed at least on an annual basis

Scores are awarded to various attributes of the borrower,viz, financial,

managerial, industrial and operational parameters

It is tool for pricing also

Evaluation of the loan book quality

Credit administration of large value accounts

Risk Management and Credit Rating
Parameters Marks
Financial 45
Managerial 15
Industry 20
Operational 20
Rating grade Band
Prime 90% and above
AAA 85% to < 90%
AA 80% to < 85%
A 75% to < 80%
BBB 70% to < 75%
Risk Management and Credit Rating
Parameters Marks
Financial 45
Managerial 15
Industry 20
Operational 20
Rating grade Band
Prime 90% and above
AAA 85% to < 90%
AA 80% to < 85%
A 75% to < 80%
BBB 70% to < 75%
Asset Liability Management (ALM)
Liquidity risk
90% of Bank A’s liabilities mature within the next 12
months. Bank A has invested 80% of these funds in
securities maturing after 5 years.
Interest rate risk
80% of Bank C’s liabilities mature after 3 years and have
been borrowed at a fixed cost. Interest rates are on a
downward trend., and 80% of Bank C’s loan portfolio
consists of short-term loans to be fully repaid over the next
6 months.
Asset Liability Management (ALM)
Management of ALM, Risk management and Basel accord
introduced by BIS are critical for the survival of Banks
Liabilities include deposits, borrowings and capital
Assets represent loans of various types
Compatible ALM structure is necessary to maintain
liquidity, improve profitability and manage risk
Sophistication of banking products and volatile financial
markets
Asset Liability Management (ALM)
Bank >liquidity risk > borrow high cost funds >low net
interest income >risky advances

Rate sensitive gaps of ABC Bank Ltd ( Rs in Cr)

0 -6m 6m -1 yr > 1 yr Total
Assets 100 1000 5000 6100
Liabilities 2000 1000 2500 5500
Gap - 1900 0 2500 600
Asset Liability Management (ALM)
The currency, interest rate, maturity and sensitivity
characteristics of the bank’s assets and liabilities are within
prescribed risk parameters
ALM makes extensive use of derivative products like,
currency swaps, interest rate swaps and other interest rate
management products
ALM refers to the process of managing the net interest
margin (NIM) within a given level of risk
[ NIM = Net interest income/ Average earning assets
NII = Interest income – interest expenses ]
Asset Liability Management (ALM)

• Traditional GAP analysis – measuring interest rate risk

• Most basic interest rate measurement techniques
employed by banks
• These models focus on GAP as a static measure of risk
and NII as the target measure of bank performance
• The GAP is defined as the absolute difference between
Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) for each time bucket
• The objective is to measure expected NII and then
identify strategies to stabilise or improve it
Asset Liability Management (ALM)
• When GAP is positive, the bank has more RSAs than RSLs
across the time interval. The bank is termed ‘asset sensitive’.

• When the GAP is negative, the bank has more RSLs than RSAs
across time interval. Such a bank is termed ‘liability sensitive’.

• The sign of a bank’s GAP would indicate whether interest

income or interest expenses are likely to change more when
interest rates change

• A bank can have a ‘zero GAP’ when RSAs equal RSLs