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Basel Capital Accord &Risk Management in Banks

Presentation at Dr.D.Y.Patil Institute ofManagement & Research

On 09.02.2011

Shri. V E Dalvi

General Manager

Bank of Maharashtra

Integrated Risk Management

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What is Bank Capital A bank balance sheet gives the financial

conditions of the bank.

It consists of Assets and Liabilities

Assets such as Loans which are income producingitems.

Liabilities such as deposits which are what it owesor sources of funds for Bank

Capital:-It is defined as assets minus liabilities

Bank Balance Sheet

Assets Liabilities & Capital

Loans 1000 Deposits 900

Capital 100

Total 1000 Total 1000

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Why Bank Need Capital Bank needs capital for protection in case of losses onloans or other assets

Suppose borrower defaults on loan of Rs 50, AfterLoan loss capital falls by amount of loss

The Bank still owes depositor Rs 900

If capital falls below zero Bank's assets are no longer enough to cover what it

owes depositors. It is insolvent and must ceaseoperations Its share holders lose every thing theyhave invested.

Balance Sheet of the bankAssets Liab & Capital

Loans 950 Deposits 900

Capital 50

Total 950 950

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More leverage Means More Risk

A Bank with less capital in

relation to its assets is said to

have higher leverage

High Leverage puts a bank atgreater risk of insolvency.

The low leverage bank could

survive up to Rs. 500 loan

Losses

The Higher Leverage bank

would become insolvent after

just Rs. 100 loan losses.

Balance Sheet of a

Bank

Assets Lia & Capital

Loans 1000 Deposit 500

Capital 500

Total 1000 1000

Loans 1000 Deposit 900

Capital 100

Total 1000 1000

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But More Leverage means Higher Returns

More leverage means higher risk, but alsohigher returns for shareholders if the bank

remains solvent

Assume interest received from Loans to be 10%

and interest paid on deposits to be 8%. In first case income will be Rs 100 and Cost of

Deposit will be Rs 40 so profit will be Rs 60. so

return on capital of Rs 500 is 12%

In second case income will be Rs 100 and Cost

of Deposit will be Rs 72 so profit will be Rs 28.

so return on capital of Rs 100 is 28%

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Who Regulates Bank Capital

Bank Regulators of individual countries (RBI) donot act alone in setting rules for bank capital.

They coordinate their capital regulation through

the Basel Committee on Banking Supervision

(BCBS)

The Committee meets at the Bank for

International Settlement (BIS), an international

organization, founded in 1930, that fostersmonetary and financial cooperation and acts as

a bank for central banks

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The Basel Accords

The Basel Committee periodically issues Accords thatset out international standards for bank capital as well asother bank regulations.

The first Basel Accord, now called Basel I were issued in1988.

RBI implemented in India w.e.f. 1992 with introduction ofIRAC norms and provisions for loan losses.

Basel I Accord replaced by a new set of standards ,Basel II , in 2004.

In India, it was implemented w.e.f31.03.2008 to Foreign

Banks having branches in India and Indian Banks havingInternational Presence and w.e.f31.03.2009 for all othercommercial Banks in India.

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Basel I vis--vis Basel II

Basel I Basel II

Focus on single risk

measure

More emphasis on banks own

internal risk management

methodologies, supervision

review and market discipline.

One size fits all &

Broad Brush

Approach

More risk sensitive approach,

Flexibility, capital incentives for

better risk management.Centered around

Credit Risk & Market

Risk

Operational Risk addressed

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CRAR

Capital to Risk weighted Asset Ratio

(CRAR)

CRAR = Capital (Tier I +Tier II)

Risk Weighted Assets CR, MR OR

Minimum As per Basel II 8% As per RBI 9% Why? (as cushion)

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Elements of Capital Tier I

Paid up equity, statutory reserves Capital reserves Innovative perpetual debt instruments (IPDI) (max 15% of Tier I) Other instruments notified by RBI

Tier II Revaluation reserves General provisions and loss reserves (max 1.25% of RWA)

Hybrid debt capital instruments (Upper Tier II) Subordinated debt (Lower Tier II) Surplus innovative perpetual debt Instruments

(IPDI) in excess of 15% taken in Tier I

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Basel II Pillars

Basel II framework rests on 3 mutually reinforcingpillars which are :

Pillar I -Sets out minimum capital requirements

Pillar II -Supervisory Review of Capital Adequacy Pillar III -Market Discipline

The II & III Pillars are complementary toPillar I

Regulatory Capital Charge for risk

Credit, Market & Operational Risks

Evolutionary in Risk Sensitivity to CapitalRegime

Transparency in Public Reporting

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Pillar 1- Methods for assessment of capitaladequacy

Credit Risk Market Risk Operational

Risk

Standardized

Approach

Standardized

Approach

Basic Indicator

Approach

Foundation IRB

Approach Internal Models

Approach

Standardized

Approach

Advanced IRBApproach

AdvancedMeasurement

Approach

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BaselBasel--II FrameworkII Framework

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RW for Domestic Sovereign - Central Govt. DICGC = 0%

State Govt. and ECGC cover = 20%

RW for Claims on Corporate /PSEs

RW for Regulatory Retail 75%

RW for Banks: Linked to CRAR if or

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What is Risk Management

Basic Elements of the Risk Management

Identifying the Risk

Quantifying/Measuring the Risk Controlling the Risk &

Managing the Risk.

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Types of Risk &

Risk profile of Bank/FIVarious Types Of

Risks

Credit Risk

Market Risk

Liquidity Risk

Operational Risk

Credit RiskMkt Risk

Liq RiskOp Risk

Ot er Risks

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Objectives of Risk

Management TO optimize the Risk Adjusted Returns

and not to minimize the absolute Risk.

Taking the Risk with prudential

safeguards and not to avoid or

eliminate the Risk.

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What is Credit Risk?

Credit risk is a risk resulting from uncertainty

in a counterpartys ability or willingness to

meet its contractual obligations.

Credit risk is the probability of lossesassociated with changes in the credit quality

of borrowers or counterparties.

These losses could arise due to outright

default by counterparties or due to

deterioration in credit quality even when

default has not taken place

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Why should Banks be concerned

with Credit Risk?Nature of Loan Returns

Borrower A has been sanctioned a term loan of Rs

10 crore, for 1 year at 10% rate of interest (annual)

If A does not default

Rs 11.00 lcrore at the end of 1 year

If A does default

Rs 0 under extreme circumstances

Rs 50 lac if we can recover 50%

of the principal

Upside gain

is limited

Downside loss

is large

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Why should Banks be concerned

with Credit Risk

Skewed nature of loan returns

Loan returns are highly asymmetric since there is

limited upside

If borrowers credit quality improves - no benefit tolending bank since the borrower can refinance his

loan at a lower rate

If borrowers credit quality declines - bank is not

compensated for taking the additional risk since loan

price is not revised

If borrower defaults - accrued interest is reversed

and any new payments are towards principal

If borrower becomes NPA - minimal recovery

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Risk Identification

Elements of Credit Risk

Concentration

Risk

Intrinsic

Risk

Portfolio Risk Individual Risk

Credit Risk

Downgrade

Risk

Default

Risk

Recovery

Risk

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Why Manage Credit Risk?

Market Realities structural increase in non performing assets

higher concentrations in loan portfolios

increasing competition leading to lower spreads

Volatility in values of Collateral

growth of off-balance sheet credit products (as aconsequence of enhancing non-interest income)

Changing Regulatory environment

Basel II implementation

Risk Vision

Capital is a scarce resource need for optimalutilization

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Credit Risk Management - Tools

Credit Approving Authority

Prudential Limits

Credit Risk RatingRisk Pricing

Controlling the risk through effective

Portfolio Management Loan ReviewMechanism and.

Estimation of Expected loan losses

Estimation of Unexpected loan losses

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Prudential limitsFor individuals Borrowers including NBFC-AFC:

Excl. Infrastructure

Finance

15 % of Total of Tier I and Tier II Capital as on

31.03.2007 (Rs. 449.74 crore).

Infrastructure

finance

20% of Total of Tier I and Tier II Capital as on

31.03.2007 (Rs. 599.65 crore).

For Group Borrowers including NBFC-AFC:Excl. Infrastructure

Finance


31.03.2007 (Rs. 1199.31 crore).

Infrastructure

finance


31.03.2007 (Rs. 1499.14 crore).

INDIVIDUAL NBFCExcl. Infrastructure 10% of Total Tier I and Tier II capital as on

31.03.2007 (Rs. 299.82 crore)

For Infrastructure 15% of Total Tier I and Tier II capital as on

31.03.2007 (Rs. 449.74 crore)

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Exposure Norms

Policy on Very Large Exposure:

Entry Level sub ceiling for

Individual/ Proprietary concerns - Rs. 5.00 crore

Partnership / Private / Public Ltd. Co. - 10% of Banks networth as of 31st March 2007. (This ceiling excludesPSUs, State Govt. owned companies, State Govt. Bodies)

Entry Level exposure beyond above ceiling will betreated as very large exposure. The very large exposureshall be taken only under Consortium/ Multiple BankingArrangements, where minimum credit risk rating shall beA.

Substantial Exposure Limit:

Threshold limit - 10% of the total capital funds as on31.03.2007 Substantial exposure limit- 7.5 times of theBanks capital funds as on 31.03.2007.

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Exposure ceilings - Sectors

No Particulars Exposure not to exceed

1. Real Estate Sector- 30% of Gross Creditof which

a) Housing Loans to Individuals 12.5% of Gross Credit

b) Comm. Real Estate 7.5% of Gross Credit

c) Indirect Real Estate 10% of Gross Credit2 Shares, Debentures and Bonds 10% of Net Worth

3 Advances to Stock brokers 10% of Net Worth

4 Advances to NBFCs /NBFIs 20% of Gross Credit

of whichHousing Finance Companies 10% of Gross Credit

NBFC ND - SI 2% of Gross Credit

All Other ( NBFC- D, AFC,

Factoring and other activities)

8% of Gross Credit

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Exposure ceilings - Sectors


5 Infrastructure 25% of Gross Credit

of which

a) Power Sector 10% of Gross Credit

b) Roads incl. Highways 5% of Gross Creditc) Telecommunication 3% of Gross Credit

d) Residual Infrastructure

Activities

7% of Gross Credit

6 Any other sector 10% of Gross Credit7 Non Fund Business 30% of Gross Credit

8 Unsecured Exposure

(excluding Food Credit and

Staff Schematic advances)

35% of Gross Credit

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Exposure ceilings - Industries


1 Sugar Industry 2% of the Gross Credit

2 Advances to Film Industry

(Cinema Theatre etc.)

1% of the Gross credit

3 Software/ IT Industry 5% of Gross Credit4 Auto and Auto Ancillary 10% of Gross Credit

5 Any other Industry 10% of Gross Credit

Exposure ceilings:Exposure ceilings:Indian Joint ventures/wholly owned subsidiaries abroad:Indian Joint ventures/wholly owned subsidiaries abroad:

Not to exceed 20% of unimpaired capital fundsNot to exceed 20% of unimpaired capital funds

(Tier I and Tier II capital).(Tier I and Tier II capital).

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What is Credit Risk Rating

Rating is an assessment/ evaluation of a person,

property, project against a specific yardstick /

benchmark.

Objective of Credit Rating

Assess a particular credit proposition (incl.

investment) on the basis of certain parameters

Outcome of rating - Degree of reliability & risk

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Credit Risk Rating

It helps in- Evaluation of borrower on the basis of certain

parameters (Outcome: Degree of reliability & risk)

Credit selection / rejection (Entry level rating Benchmark rating)

Activity-wise/ sector-wise portfolio study keeping inview the macro-level position.

Estimating concentration risk within a portfolio

Deciding concentration limit and exposure limit

Deciding exit point of syndicated loans

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Credit Risk Rating Models

The model should provides forassessment of risks under variouscomponents: such as

Financial Risk

Account Operating risk

Management Risk

Industrial RiskBusiness Risk &

Project Risk

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Credit Risk Rating Model

Within each risk component, risk parameters

and Risk factors have to be identified

Each risk factor should be assigned weight

according to its Importance

Scoring Norms should be developed for

assigning scores to each risk factor

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CRR Model - Risk parameters

Financial Risk

Assessment of Financial Statements

Past Financial Performance

Future risk

Cash Flow adequacy (Projected)

Account Operating Risk

Security Coverage Conduct of the account

Observance of financial discipline

Maturity risk

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Management Risk

Ownership Experience & Competence

Track record

Corporate Governance

Industry Risk

Industry Characteristics

Competitive forces within the industry

Industry financials

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Business Risk

Market Position

Operating Efficiency

Growth

Project Risk (For Project Loan only) Timeliness in completion of the project

Cost escalation of the project

Funding arrangement for cost escalation

Achievement of production target Deficiency in management of the project

Repayment period of loan (Excluding

Moratorium Period)

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a ng gra on

During the period of 12 months

Rating AAA AA A BBB BB B C Default Total

AAA 900 50 40 10 1000

AA 200 1500 200 50 50 2000

A 300 450 1800 300 50 50 50 3000

BBB 200 200 300 700 100 50 50 100 1700

BB 50 50 100 100 200 50 100 50 700

B 20 20 40 20 50 50 80 70 350

C -- -- 25 25 25 25 300 200 600

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Probability of rating Migration

During 12 months period

Rating AAA

%

AA

%

A

%

BBB

%

BB

%

B

%

C

%

Default

%

AAA 90% 5% 4% 1%

AA 10% 75% 10% 2.5% 2.5%

A 10% 15% 60% 10% 1.6% 1.6% 1.6%

BBB 12% 12% 17% 42% 6% 3% 3% 5%

BB 7% 7% 14% 14% 28% 7% 14% 9%

B 6% 6% 12% 6% 14% 14% 22% 20%

C 4.2% 4.2% 4.3% 4.3% 50% 33%

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Measuring credit RiskFormulation of Credit risk models

Probability of default(PD)

PD is the probability of a particular credit

facility defaulting within a given time horizon

(usually 12 months)

PD is the primary output of a credit risk model

Estimation of PD is based on rating migration

in 1 year time horizon over a period of time

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Measuring credit Risk

Formulation of Credit risk models

Loss Given Default (LGD)

LGD is the percentage of exposure lost

when default occurs (1- recovery rate).

It is related risk measure to PD.

LGD data sources are: banks own

historical data by risk segment, trade

association data, published regulatoryreports and rating agency reports.

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Estimation of Expected Loss (EL)

EL= PD x LGD x EAD

EL is average loss expectation will vary

from year to year EL shows the amount of credit loss a bank

would expect on its credit portfolio over

the chosen time horizon.

To begin with RBI introduced IRAC Norms(Standard, Sub Standard, Doubtful and Loss

Assets and Provision of 10%, 30 to 50% and

100%).

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Credit exposure (Rs. in crore)

Amount

of EAD

Initial

Rating

PD (%) LGD(%) Expected

Loss

1000 AAA 0 0.5 0

1000 AA 0 0.5 0

800 A 0.06 0.5 0.24

600 BBB 0.18 0.5 0.54

400 BB 1.06 0.5 2.12

500 B 5.20 0.5 13.00

200 C 19.79 0.5 19.79

4500 Total 35.69

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Estimation of Unexpected Loss (UL)

UL is the amount by which actual

losses exceed the expected loss.

UL is impacted by many things,

particularly volatility.

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What is Market Risk

Market Risk is the possibility of loss tothe bank caused by changes in market

variables such as Interest Rate, FEX

Rate, Equity Price and Commodity

price

Loss arises in two ways

Loss to the earnings and

Decline in the economic value of theassets.

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Market Risk Management

Market risk involves management of

risk in following areas as under

Liquidity Risk

Interest Rate Risk

Foreign Exchange Risk

Equity Price Risk &

Commodity Price Risk

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Liquidity Risk

Liquidity means

Ability of bank to honor the

commitments as and when it fallsdue.

Banks inability to honor the

commitments to meet the liquidity iscalled Liquidity Risk

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Types of Liquidity risks

Funding Risk

Need to replace net outflows due to

unanticipated withdrawal/non-renewal of

deposits

Time Risk

Need to compensate for non-receipt of expected

inflows of funds- NPAs Call Risk

Due to crystallisation of contingent liabilities &

needs of new business

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Liquidity Risk Management

Liquidity Risk is measured throughStructural Liquidity Statement and Short

Term Dynamic Statement.

Liquidity Risk is managed through AssetLiability Management.

ALCO is the Committee who monitored

and managed liquidity by deciding on therequirement of funds by changing interest

rates on assets and liabilities.

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Interest Rate Risk

Why there is Interest Rate Risk? On account of Banks core business being

financial intermediation and asset

transformation

Due to periodical renewal of assets andliabilities

Due to mismatches between

maturity/repricing dates as well as maturity

amounts between Assets and Liabilities

Since depositors and borrowers can pre-

close their accounts

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Interest Rate Risk

Rising interest rate scenario

Deposits rates are Fixed

Interest expenses will be same Loans Rates are Floating

Interest income will increase resulting

into increase in NII

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Interest Rate Risk

Falling Interest rate scenario

Deposits Rates are fixed

Interest expenses will be same

Loans Rates are Floating

Interest income will be less

NII will reduced.

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Types of Interest Rate Risk

Gap or Mismatch Risk

Basis Risk

Embedded Option Risk Price Risk

Reinvestment Risk

Revaluation Risk/Regulatory Risk

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Interest Rate Risk

Gap/Mismatch Risk

It arises on account of holding rate

sensitive assets and liabilities withdifferent principal amounts,

maturity/repricing rates

Even though maturity dates are same, if

there is a mismatch between amount ofassets and liabilities it causes interest rate

risk and affects NII

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Interest Rate Risk

Gap Report

1. RSA > RSL = POSITIVE GAP

2. RSL > RSA = NEGATIVE GAP

3. RSA = RSL = NEUTRAL GAP

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Interest Rate Risk

Basis Risk

Basis risk occurs when interest rates ofdifferent assets and liabilities move in

different magnitudes

there will be interest rate risk due to

movement of interest rates in differentmagnitudes for different types ofassets and liabilities

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Interest Rate Risk

Embedded Option Risk

Pre-payment of loans in case of falling

interest rates

Premature withdrawal of deposits in

case of rising interest rates

In both the cases banks actual NII is

less than the anticipated NII

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Interest Rate Risk

Price Risk

Bond prices and interest rates areinversely related

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Interest Rate Risk

Reinvestment Risk

It is difficult to correctly predict the

interest rates at which future cash

flows will be invested. This uncertainty

causes reinvestment risk

If interest rates declines, reinvestment

will be at lower rate

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Interest Rate Risk

Revaluation Risk/Regulatory Risk

Occurs when revaluation of assets are

to be done as per regulatory

prescriptions

When regulators change the norms the

assets may have to be re-valued as per

the changed norms and this mayreduce the value of total assets

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Interest Rate Risk

Measures of IRR

Maturity Gap Analysis to measure

interest rate sensitivity of earnings or

NII

Duration Gap Analysis to measure

interest rate sensitivity of equity

Simulation

Value at Risk

IRR Management - Falling

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IRR Management - Falling

Interest Rate Scenario

Increase maturities of investmentportfolio

Increase fixed rate loans

Increase short-term deposits /

borrowings (reduce maturity of

liabilities)

Increase floating rate deposits

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IRR Management - Rising

Interest Rate Scenario

Reduce investment portfolio maturities

Increase floating rate assets

Increase short-term assets Increase long-term

deposits/borrowings

Sell fixed rate assets

O ti l Ri k

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Operational Risk

WHAT if suddenly ATMs stopped vendingcrisp notes, bank branches closed for fewdays, the data centre of major banks shutdown, busy operations in dealing rooms ofmajor banks come to a halt and banking

personnel don't reach their offices.

This is not a doomsday scenario but whatactually happened during the Mumbai floods.Uncertainty has crept into our lives. In

technical parlance, we can call the riskinvolved in running daily operations"operational risk",

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What is Operational Risk?

Basel II has defined operational risk as

the risk of loss resulting from inadequate

or failed internal processes, people and

systems or from external events. Basel IIhas clarified that OR includes legal risk

but specifically excludes strategic and

reputational risks.

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Definition of Operational Risk

The risk of loss resulting from inadequate or failedor

external eventsinternal processes,

people & systems

Potential or

Forward looking

Inadequate collateralmanagement

Unenforceable documentation

People and systems in

the regulatory definition

are captured in internal

process

External Fraud,

Fire, Flood,

Legal action,

Tax,

Regulations,

Terrorism

Causal Categories:

Employee Behaviour

Corporate BehaviourInformation

Technology

External Environment

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Scope of Operational Risks

Op-risk is as old as banking itself.

Present in virtually all bank transactions

and activities

Clear appreciation and understanding bybanks of OR is crucial to effectivemanagement and control thereof

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Basel II definition-

Analysing specific risks: People Risk Employee fraud ( collusion, embezzlement, theft,

programming fraud)

Unauthorized activity ( insider trading, misuse of

privileged information, limit breach, incorrect models-intentional, aggressive selling tactics, ignoring/shortcircuiting procedures ( deliberate)

Employment practices and workplacesafety-(employee turnover, loss of key personnel,motivation, leave /absence from work, wrongful termination,discrimination/harassment, non-adherence to employmentlaws, workforce disruption, lack of suitable personnel)

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Basel II definition-

Analysing specific risks: Process Risk Transaction risk- Payment/settlement /delivery risk- failure of

/inadequate payment/settlement processes, losses throughreconciliation failure, delivery errors

Documentation risk- document not designed properly,

inadequate clauses/contract terms, inappropriate contractterms, failure of due diligence;

valuation/pricing ( model risk);

Internal/external reporting ( inadequate financial reporting,inadequate regulatory reporting, inadequate stock exchangereporting), compliance ( failure of internal/external complianceprocedures);

Selling risks ( product complexity, poor advice)

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Basel II definition-Analysing specific

risks: Systems Risk

Technology risk

# System failure

# Security breaches#Communications failure

# Backup & disaster recovery

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Basel II definition-Analysing specific risks:

Risk from External Events Legal liability- breach of law, misrepresentation,

etc.

Criminal activities- external frauds, robberies,money laundering, physical damage to property

caused by vandalism, arson Outsourcing risk- inadequate contract, delivery

failure( ontime, quality service), inadequate mgt ofservice providers, bankruptcy of supplier, misuse ofconfidential data, etc.

Disasters - earthquakes, floods, fire, transportfailure, energy failure, external telecommunicationfailure, etc.

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ORM framework under Basel II

All the three pillars of the New Capital Accord play an

important role in OR capital framework

3 methods of calculation of OR in a continuum of increasing

sophistication and risk sensitivity:

1) Basic Indicator Approach

2) Standardized Approach

3) Advanced Measurement Approach

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Basic Indicator Approach (the alpha)

Capital = E*gross income (E =15%)

Standardised Approach (the betas)

Capital = F*gross income, by business lines(F 12%, 15% or18% depending on business line)

Advanced Measurement Approach (AMA)

Capital = firm specific calculation

Basel II - 3 methodologies for estimation of

Minimum Capital Requirement

From 31.03. 2009 BIA has been adopted by all banks in India

C t ti f C it l Ch f

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Computation of Capital Charge for

OP Risk as per BIA

Capital Charge = 15% of Avg Gross Income forLast 3 years.

Gross Income = Net Profit

+ Provisions & Contingencies+ Operating Expenses

- Profit on sale of HTM Investment

-One time Income (Insurance Income)

-Profit on sale of Immovable/Movable

assets.

If there is Loss in any year, it should be excluded.

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Operational Risk capital:

Standardised ApproachBusiness Lines Beta Factors

1.Corporate finance 18%

2.Trading and sales 18%

3.Retail banking 12%

4.Commercial banking 15%

5.Payment and settlement 18%6.Agency services 15%

7.Asset management 12%

8. Retail brokerage 12%

basel & rm gm 09[1].02

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