Risk Management in Indian

Banks via Asset -Liability

Management and Basel III
accord
Dr. Deepak Tandon Sr. Professor IMI NEW DELHI
 RISK MANAGEMENT

• The Banks are Commercial Organisations. Their

Business can be on Profit Or loss .
• Risk is the probability of loss that may arise due
to uncertainties which lead to variations in net
cash flows (positive) and can be favourable or
unfavourable .
• LOWER VARIATIONS IN CASH FLOW LEADS TO
LOWER RISK & VICE VERSA
RISK MANAGEMENT
Risk Identification and Pricing

PRICING :
 • It has to be for Risk Control :

• -Appropriate Organisational
structure

Risk • -Adoption of a Comprehensive

Risk measurement approach
Monitoring • -Setting of a Comprehensie Risk

& Control rating system

• -Adoption of risk Management

policies , consistent with broader
business strategy
Types Of Risks
Reputational Risk eg YES Bank
 Credit Risk Management
• Probability of default /loss emanated from
credit extended as a result of nonfulfillment of
the contractual obligation arising out of
unwillingness or inability of the counterparty
or for any other reason {.(Single Borrower) Or
Portfolio Credit Risk}
 Credit Risk
Management
 Credit Rating {EIIF)
• Very Low Risk—1,2 >99-95 Low Risk ---3,4 >88-91
• Low Moderate 5,6 >80-84 Moderate –7,8 >74-77
• Satisfactory 9,10 > 65-70
• Acceptable 11,12 11-20:New Customers not considered
• Moderate-High Risk -----13
• Moderate High Risk (Poor Quality ) -14
• High Risk ---15 High Risk Speculative -16
• Very High Risk -17, 18 Default –19
• Loss -20
External risk Factors :25 Marks , Industry Risk Factors : 25 Marks
Internal Risk factors -25 Marks Financial risk Factor : 25 Marks
TOTAL : 100 Marks

Customer PQR from ABC Bank gets 20,21,23, 21 by EIFF Then Total : 85 Gets Rating : 5
 Asset – Liability Management
I. It is a continuous process of PLANNING, ORGANIZING &
CONTROLLING
o Asset Liquidity
o Volumes
o Maturity
o Interest Rates
o Yields
II. The objective of ALM is:
o Protect/Enhance
o NII
o NIM or spread
o MV of NW of bank. Economic Value of the firm
Increase solvency of Bank. Avoid adverse impact of interest
III. 3 types of Strategies:
o Spread Management – Max spread to
decrease exposure to cyclical rates & stabilize
earnings
o GAP Management – Repricing of Interest
Sensitive Assets & Interest Sensitive Liabilities
RSA-RSL RSA>RSL =+ve gap
o Interest Sensitivity Analysis – Spread &
Margin
• • Risk Management through ALM –
• o Interest Rate Risk –
•  Gap or Mismatch
•  Basis
•  Embedded Option
•  Yield Curve
•  Reinvestment
• o Liquidity Risk –
•  CEO
•  High Powered Committee ALCO
  1-14 days
 15-28 days
 29 days – 3 months
 3 – 6 months
 6 months – 1 year
 1 – 3 years
10  3 – 5 years

Buckets: 

5 – 7 years
7 – 10 years
 > 10 years

• NII = Interest Income received on Assets

– Interest Expenses paid on Deposits
• NIM=NII/(Bank Average Interest Earning
Assets*)
• A Bank has RSA of Rs 600 million and RSL is
Rs 400 Million in a time bucket . The interest
rate gap is Rs 200 million . If the Interest rate
increases by 1%, the NII will increase by :
(600-400) X 0.01=Rs 2 Million
 In a Bank RSA and RSL Position is given:3
Maturity months
MATURITY MONTH 1 2 3

RSA ( in Million ) 200 240 300

RSL (in Million ) 40 60 80

GAP 160 180 220

Cumulative Gap 160 340 560

If Interest Rate increases by 1 % , NII over 3 month period will increase by

Based on monthly gap

=(160X0.01X3/12) + (180X0.01X2/12) + (220X0.01X1/12)= 0.400+0.300+0.183

=0.883
Alternatively : On Cumulative gap : 0.01X1/12(160+340+560)=0.883
• A Bank has the Following data in Balance sheet As on Mar 31
1. Calculate RSA
2. Calculate RSL
3. Calculate GAP whether Positive or Negative
4. Calculate Tier 1 capital of the Bank
 • QUESTION : Following is the available data of Balance sheet of ABC
Bank
• ASSET/LIAB Rs Cr
Call Money 300 Cr
Cash Credit Loans 240 Cr
Cash in hand 200 Cr
Savings Bank 300 Cr
Fixed Deposits 300 Cr
Asset Current Deposits 250 Cr
• Calculate :
Liability • (i) What is the Adjusted Gap

Management • (ii) If the Interest rate falls by 2 % points across the board
for all assets and Liabilities . What is NII impact
•
• (iii) If Interest rate increase by 2% what is the impact on NII

• (iv) If the interest rate falls on Call money by 1% and on

each cash credit by 0.6%, Sa vings by 0.2%, FD by 1% ,what is the
change in NII

• (v) If the Interest rate increase on Call Money by 1%, on CC

by 0.6 %, SB by 0.2% and on FD by 1% , What is the change in NII
 INTRODUCTION
• Risk management in banking is theoretically defined as “the
logical development and execution of a plan to deal with
potential losses”.

• Two economic units - surplus unit and deficit unit prefer to use
financial institutions (intermediaries) to transfer the necessary
funds to each other which increases the importance of the
financial intermediaries in the economy, but also poses some risks
to these institutions.

• Due to the issues with asymmetric information, economic entities

typically prefer to use intermediaries. As a result, the money is
directed toward the best projects that boost the economy.
However, there are risks involved in the process of moving
money from one unit to another by natural means.
 TYPES OF RISK

01 Credit Risk: ●
●
A customer's inability or unwillingness to fulfil agreements.
Influenced by both internal and external variables.

● Insufficient liquid assets to compensate the cash needs.

02 Liquidity Risk: ● Borrow money at a higher expense to help them with their financial
demands.

03 Market Risk:
● There is a close relationship between the banking and financial
markets sectors.
 TYPES OF RISK

04 Operational Risk:
● It includes things like sending payments to the incorrect account or
putting in the wrong order when trading in the markets.

05 Interest rate Risk:

● Interest rates that banks use to conduct their business have an impact on
the banks' revenues and costs.

06 Reputational Risk:
● There is a risk of unfavourable public perception as a result of a large
fraud or scam and the bank's failure to control operational risk.

● Bank management has a sizable number of defaulted loans in their credit

07 Default Risk: account, or when the value of its portfolio investments declines
significantly, cause a significant capital loss.
 IMPLICATION OF RISK

Discordance
between Effect on
Negative Non- Long-term Profitability of Cyber Fraud Bankruptcy
Performance Performing Banks Bank’s
Assets and Regulatory
of Bank Loans Short-term Capital Ratio
Liabilities

01 02 03 04 05 06 07
 BASEL ACCORDS
❖ How did Basel Accords come into picture?

● Crisis at Herstatt Bank in Cologne Germany in 1974.

● Deutsche Marks (DEM), the German currency to Herstatt Bank in exchange of US Dollars.
● German regulators forced the liquidation of Herstatt Bank at 16:30 hours.
● New York time was 10:30 hours when the liquidation happened and that’s why US Dollars were not paid in exchange of the
DEM to the foreign banks.
 BASEL-I
❖ RTGS & CLS implementation
❖ Primary Focus Area of Basel I- CAR & RWA
All the banks with a global presence were supposed to
maintain an 8% of the RWA as Capital. Out of this, the
Tier-1 capital ratio should be at least 4.5% of the RWA.
The ratio is given as:
Tier 1 Capital Ratio = (Core Capital/ RWA) * 100%
(The Core Capital includes retained earnings, ordinary
shares, and stock surpluses)
On the basis of the risk carried by the bank assets, they were
classified under 5 categories based on risk weights-
i) 0% - cash, bullion, and treasuries
ii) 20% - mortgage backed securities with AAA rating
iii) 50% - residential mortgages
iv) 100% - corporate debt
v) Assets with No Rating
BASEL-II BASEL-I BASEL-II
Lesser focus on risk Increased focus on risk
Only credit risk is Includes wide range of risks
considered

Capital calculation Capital calculation more risk

less risk sensitive
Why Basel- II is not perfect?
High leverage and lack of buffer for
liquidity
sensitive
OBJECTIVE OF BASEL-II
Minimum Capital Requirements
Regulatory Supervision
Market Discipline

No restrictions on
withdrawals/payouts

More focus on micro factors

 BASEL-III Minimum Capital
Requirement
Basel III is a list of comprehensive reforms whose goal is to
strengthen the regulations, supervision and risk management of the
banking sector. Basel III framework is built upon Basel I and II PILLAR 1
framework.
Supervisory
Capital Buffers in Basel III Review Process

PILLAR 2
Market Discipline
Capital Conservation Countercyclical Capital & Disclosure
Buffer Buffer

PILLAR 3
 Principles of Basel III
Following are the 5 principles of Basel III:
1. Minimum Capital Requirements
2. Countercyclical Measures
3. Leverage Ratio
4. Liquidity Requirements
5. Potential Effects of Basel III
 Objective of the BCBS

• To enhance financial stability by improving the quality of banking

supervision worldwide.

• To strengthening the Banks capital

• improving the quality of capital

• Strengthening the banks' transparency

• Improving market discipline

• Improving banking sector’s ability to absorb shocks

 HISTORY OF BASEL COMMITTIEES

• Basel I: the Basel Capital Accord, introduced in 1988 and focuses on

– Capital adequacy of financial institutions.

• Basel II: the New Capital Framework, issued in 2004, focuses on following three main pillars

– Minimum capital Standard [Minimum CAR or CRAR]

– Supervisory review and [Review by central Bank RBI, on time to time]
– Market discipline, [Review by market, stake holders, customer, share holder, gvt etc]

• Basel III: Basel III released in December, 2010, (implementation till March 31, 2018)"Basel III" is a
comprehensive set of reform measures in,
– regulation,
– supervision &
– risk management of the banking sector.
 WHY BASEL-III ?

• Because of the global financial crisis which begin 2008 because of,
– too much leverage
– inadequate liquidity buffers (liquidity issues)
– Mispricing of credit and
– liquidity risk, and
– Excess credit growth.

• Failures of Basel II being

– Inability to strengthen financial stability
– Insufficient capital reserve
– Global financial crisis in spite of Basel I & Basel II
– Liquidity issues in banking system
– Inadequate comprehensive risk management approach

Responding to these risk factors, the Basel Committee did following major reforms in BASEL-III:

– Increase the quality and quantity capital

– Introduce Leverage ratio
– Improve liquidity rules
– Introduce Countercyclical Buffer
– Introduce Liquidity coverage Ratios
 OBJECTIVES OF BASEL-III

• To improve quality of capital

• To improve liquidity of assets

• To bring further transparency and market discipline under Pillar III.

• To improve the banking sector's ability to deal with financial and economic stress,

• To enhancing the quantum of common equity;

• To improve risk management

• To strengthen the banks' transparency

• To Improving banking sector’s ability to absorb shocks (by creating capital buffer)

• To optimizing the leverage through Leverage Ratio

• To reduce risk spillover to the real economy

 Three pillars of BASEL-II still standing in BASEL-III

• Pillar-1: Capital Requirement:

Minimum capital required based on Risk Weighted Assets (RWAs).

• Pillar-2: Supervisory Review:

Whether Bank is maintaining proper capital or not, that aspect will be reviewed
time to time by central bank (RBI) in India

• Pillar-3: Market Discipline:

Pillar 3 is designed to increase the transparency in banking system
 Pillar-1

Pillar-1: Capital Requirement

I. Capital adequacy

II. Risk Coverage

III. Leverage ratio

IV. Liquidity requirements

 Pillar-1 (cont)
I. Capital adequacy:
(The basic 8% minimum ratio of capital to RWA remain same under Basel III)

a. Quality and level of Capital:

o Tier1: Banks core capital = 6%

 paid up capital (common equity),
 Reserves
 Non-redeemable non-cumulative preferred stock

Common equity should be minimum 4.5% of RWAs

o Tier2:Supplementary capital =2%

 Undisclosed Reserves
 General Loss reserves
 hybrid debt capital

b. Capital Conservation Buffer: 2.5% of RWAs- (CET 1 capital)

c. Countercyclical buffer: 0-2.5% (depending on macroeconomic circumstances)- (CET 1 capital)

 REGULATORY CAPITAL IN INDIA

Overall capital as % to risk weighted assets:

 Pillar-1 (cont)

II. Risk Coverage:

• Higher capital requirements for trading and securitization activities.

• Capital requirements for certain counterparty credit risk exposures (arise from
derivatives, and financial securities)s

• Market risk: Banks have to maintain additional capital to face market risk.
Banks can use any of the following Model:

– Standardized Measurement Method (SMM) (central bank model)

– Internal Models Approach (IMA) (banks own model)
Example of RWA
RWA in Basel-II & Basel-III
 Pillar-1 (cont)
III. Leverage ratio: (capital to exposure)

• Leverage ratio should be more than 3%.

• Higher capital for systemic derivatives

• Higher capital for inter-financial exposures

• Capital surcharge for systemic banks (maintaining Buffer capital above 10.5% )
 Pillar-1 (cont)
IV. Liquidity requirements: BCBS introduce two standards for the
liquidity of bank assets.

• Short term-Liquidity Coverage Ratio (LCR):

– To ensure that banks have sufficient liquidity to deal with liquidity outflows during a 30-day period of
stress.
– Asset should be highly liquid

• Long term-Net Stable Funding Ratio (NSFR):

– To promote more medium and long-term funding activities of banking organizations.
– To promote more stable funding of the banks
– Stable funding in this context means capital, preferred stock and debt with maturities of more than
one year
 Pillar-2

Pillar-2: Supervisory Review

Whether Bank is maintaining proper capital or not, that aspect will be reviewed time to time by
central bank (RBI) in India

• Coverage in Pillar-2:

– Interest rate risk

– Liquidity risk
– Business risk
– Credit concentration risk
– Counterparty credit risk
 Pillar-3

Pillar-3: Market Discipline

• Pillar 3 is designed to increase the transparency in banking system

• Increased in minimum public disclosure of banks risk information

• Improve disclosure of capital structure

• Improve disclosure of risk measurement and management practices

• Improve disclosure of capital adequacy

 Major Changes Proposed in Basel III

• Capital adequacy: basic 8% including buffer 10.50%

• Capital Conservation Buffer:2.5% of RWAs

(CCB is designed to ensure that banks build up capital buffers during normal times which can be used to absorb losses during
periods of financial and economic stress)

• Countercyclical Buffer: The countercyclical buffer has been introduced with the objective to
increase capital requirements in good times and decrease the same in bad times”.

• Introduced Leverage Ratio: 3% leverage ratio will be tested till from Jan 2013- Jan 2017
before a mandatory leverage ratio is introduced under piller-1 in January 2018.

• Introduced Liquidity Ratios: Banks have to hold enough highly liquid assets to cover expected net
outflows during a 30-day stress period.

• Reduce the overreliance of institutions and investors on external credit ratings,

 The Impact of Basel III
Impact on economy:

• IIF study:
(IIF) calculated that the economies of G3 (US, Euro Area and Japan) would be 3% smaller after
implementation of Basel-III till 2015.

• Basel Committee study:

 0.2% Impact on GDP each year for 4 years

 Global banks could have a gap of liquid assets of € 1,730 billion in four years

 Global big banks could have a capital shortfall of € 577 billion to meet 7% common equity norm

 However, long term gains will be immense

 Impact of Basel-III on Indian banks:

• India may need at least $30 billion to $40 billion (i.e. around Rs 1.6 trillion) as capital over the next
six years to comply with the new norms.

• Capital for PSU Banks Would impose a huge financial burden on the government,

• RBI Deputy Governor, Mr. Anand Sinha viewed that the implementation of Basel III may have a
negative impact on India's growth story.

• Banks depending heavily on wholesale funds may be impacted due to the new liquidity standards
(75% RWA)
 CONCLUSION

• Imposing economic loss and emotional pain on hundreds of millions and billions of
people because of the crisis which arise due to improper regulation, deregulation,
and lake of supervision,

• It is worthwhile to give up a little economic growth in the average year in order

to avoid these major impacts,
 DOES INDIA NEEDS BASEL-IV?
We firmly believe that India needs Basel 4 regulations given the current situation because

New Technology in Banking

High Demand of Credit Doubtful BASEL III
System

The general public and retail
investors now demand more credit
in such circumstances. However,
Basel III's requirement to maintain
additional capital as a reserve means
that the banks may not have as
much cash on hand to lend.
The present NPA estimates
stand at more than 7 lakh
crores, which is a big hole in
the total financial structure,
and there are already a
sizable amount of stressed
assets.
To better serve a wider
spectrum of customers, a
considerable deep network
has already been built within
banks.
NIM : NET INTEREST MARGIN
CASA
THANK YOU