Risk Management ::( Very important content read everyone)
The growing sophistication in banking operations, online electronic banking,
improvements in information technology etc, have led to increased diversity and
complexity of risks being encountered by banks. These risks can be broadly grouped
into Credit Risk, Market Risk and Operational Risk. These risks are
interdependent and events that affect one area of risk can have ramifications for a
range of other risk categories.
Basel-I Accord: It was introduced in the year 2002-03, which covered capital
requirements for Credit Risk. The Accord prescribed CRAR of 8%, however, RBI
stipulated 9% CRAR. Subsequently, Banks were advised to maintain capital charge
for Market Risk also.
Basel-II New Capital Accord: Under this, banks have to maintain capital for Credit
Risk, Market Risk and Operational Risk w.e.f 31.03.2007. The New Capital Accord
rests on three pillars viz., Minimum Capital Requirements, Supervisory Review
Process & Market Discipline. The implementation of the capital charge for various risk
categories are Credit Risk, Market Risk and Operational Risk. Analysis of the bank’s
CRAR under should be reported to the Board at quarterly intervals.
Internal Ratings Based (IRB) Approach: Under this approach, banks must
categorise the exposures into broad classes of assets as Corporate, Sovereign, Bank,
Retail and Equity. The risk components include the measures of the Probability of
Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective
Maturity (M). There are two variants i.e Foundation IRB (FIRB) and Advanced IRB.
Under FIRB, banks have to provide their own estimates of PD and to rely on
supervisory estimates for other risk components (like LGD, EAD) while under
Advanced IRB; banks have to provide their own estimates of all the risk components.
It is based on the measures of Expected Losses (EL) and Unexpected Losses (UL).
Expected Losses are to be taken care of by way of pricing and provisioning while the
risk weight function produces the capital requirements for Unexpected Losses.
Market Risk: It is a risk pertaining to the interest rate related instruments and
equities in the Trading Book i.e AFS (Available For Sale) and HFT (Held for Trading)
positions and Foreign Exchange Risk throughout the bank (both banking & trading
books). There are two approaches for measuring market risk viz., Standardized
Duration Approach & Internal Models Approach.
Operational Risk: Banks have to maintain capital charge for operational risk under
the new framework and the approaches suggested for calculation of the same are –
Basic Indicator Approach and The Standardized Approach. Under the first approach,
banks must hold capital equal to 15% of the previous three years average positive
gross annual income as a point of entry for capital calculation. The second approach
suggests dividing the bank’s business into eight lines and separate weights are
assigned to each segment. The total capital charge is calculated as the three year
average of the simple summation of the regulatory capital charges across each of the
business lines in each year.
Advanced Measurement Approach (AMA): Under this, the regulatory capital
requirement will equal the risk measure generated by the bank’s internal operational
risk measurement system using certain quantitative and qualitative criteria. Tracking
of internal loss event data is essential for adopting this approach. When a bank first
moves to AMA, a three-year historical loss data window is acceptable.
Pillar 2 – Internal Capital Adequacy Assessment Process (ICAAP): Under this,
the regulator is cast with the responsibility of ensuring that banks maintain sufficient
capital to meet all the risks and operate above the minimum regulatory capital
ratios. RBI also has to ensure that the banks maintain adequate capital to withstandthe risks such as Interest Rate Risk in Banking Book, Business Cycles Risk, and
Credit Concentration Risk etc. For Interest Rate Risk in Banking Book, the regulator
may ensure that the banks are holding sufficient capital to withstand a standardized
Interest Rate shock of 2%. Banks whose capital funds would decline by 20% when
the shock is applied are treated as ‘Outlier Banks’. The assessment is reviewed at
quarterly intervals.
Pillar 3 – Disclosure Requirements: It is aimed to encourage market discipline by
developing a set of disclosure requirements which will allow market participants to
assess the key pieces of information on the capital, risk exposures, risk assessment
processes and hence the capital adequacy of the institution. Banks may make their
annual disclosures both in their Annual Reports as well as their respective websites.
Banks with capital funds of `500 crore or more, and their significant bank
subsidiaries, must disclose their Tier-I Capital, Total Capital, total required capital
and Tier-I ratio and total capital adequacy ratio, on a quarterly basis on their
respective websites. The disclosures are broadly classified into Quantitative and
Qualitative disclosures and classified into the following areas:
Area Coverage
Capital Capital structure & Capital adequacy
Risk Exposures &
Assessments
Qualitative disclosures for Credit, Market, Operational,
Banking Book interest rate risk, equity risk etc.
Credit Risk General disclosures for all banks.
Disclosures for Standardised & IRB approaches.
Credit Risk Mitigation Disclosures for Standardised and IRB approaches.
Securitisation Disclosures for Standardised and IRB approaches.
Market Risk Disclosures for the Standardised & Internal Models
Approaches.
Operational Risk The approach followed for capital assessment.
Equities Disclosures for banking book positions
Interest Rate Risk in
the Banking Book
(IRRBB)
Nature of IRRBB with key assumptions. The increase /
decrease in earnings / economic value for upward /
downward rate shocks.
The Basel-II norms are much better than Basel-I since it covers operational risk.
However, risks such as Reputation Risk, Systemic Risk and Strategic Risk (the risk of
losses or reduced earnings due to failures in implementing strategy) are not covered
and exposing the banks to financial shocks. As per Basel all corporate loans attracts
8 percent capital allocation where as it is in the range of 1 to 30 percent in case of
individuals depending on the estimated risk. Further, group loans attract very low
internal capital charge and the bank has a strong incentive to undertake regulatory
capital arbitrage to structure the risk position to lower regulatory risk category.
Regulatory capital arbitrage acts as a safety valve for attenuating the adverse effects
of those regulatory capital requirements that activity’s underlying economic risk.
Absence of such arbitrage, a regulatory capital requirement that is inappropriately
high for the economic risk of a particular activity could cause a bank to exit that
relatively low-risk business by preventing the bank from earning an acceptable rate
of return on its capital.
Nominally high regulatory capital ratios can be used to mask the true level of
insolvency probability. For example – Bank maintains 12% capital as per the norms
risk analysis calls for 15% capital. In a regulatory sense the bank is well capitalized
but it is to be treated as undercapitalized from risk perspective.
Basel-III is a comprehensive set of reform measures developed to strengthen the
regulation, supervision and risk management of the banking sector. The new
standards will considerably strengthen the reserve requirements, both by increasing
the reserve ratios and by tightening the definition of what constitutes capital. The
new norms will be made effective in a phased manner from 1st July 2013 and
implemented fully by 31st March 2019 and banks should maintain minimum 5.5% in
common equity (as against 3.6% now) by 31st March 2015 and create a Capital
Conservation Buffer (CCB) of 2.5% by 31st March 2019. Further, banks should
maintain a minimum overall capital adequacy of 11.5% by 31st March 2019 and
supplement risk based capital ratios by maintaining a leverage ratio of 4.5%. These
measures will ensure well capitalization of banks to manage all kinds of risks besides
to bring in more clarity by clearly defining different kinds of capital.
Counter Cyclical Capital Buffer (CCCB): The objective of CCCB is twofold viz., it
requires banks to build up a buffer of capital in good times which may be used to
maintain flow of credit to the real sector in difficult times and also to achieve the
broader macro-prudential goal of restricting the banking sector from indiscriminate
lending in the periods of excess credit growth that have often been associated with
the building up of system-wide risk. It may be maintained in the form of Common
Equity Tier-1 capital or other fully loss absorbing capital only and the amount of the
CCCB may vary from 0 to 2.5% of total risk weighted assets of the banks. RBI
intends banks to have a sustainable funding structure. This would reduce the
possibility of banks’ liquidity position eroding due to disruptions in their regular
sources of funding thus increasing the risk of failure leading to broader systemic
stress. The Basel committee on banking supervision framed two ratios viz., Liquidity
Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) as part of global
regulatory standards on liquidity to be implemented from 1st January 2018.
i) Liquidity Coverage Ratio (LCR): In order to promote short-term resilience of
the liquidity risk profile of banks, RBI has introduced LCR in a phased manner,
starting with a minimum requirement of 60% from 1st January 2015, and reaching a
maximum of 100% by 1st January 2019. The LCR will ensure that banks have an
adequate stock of unencumbered high-quality liquid assets that can be converted
easily and immediately in private markets into cash to meet their liquidity needs for
a 30-calendar day liquidity stress scenario.
ii) Net Stable Funding Ratio (NSFR): The ratio seeks to ensure that banks
maintain stable source of funding with respect to the profile of their assets (loans
and investments) and off-balance sheet activities such as extending asset
management and brokerage services to the clients. The NSFR should be 100% on an
ongoing basis. It limits over reliance on short-term wholesale funding, encourages
better assessment of funding risks across all assets and off-balance sheet items and
promotes funding stability.
Tier – I capital consists of Paid up Equity Capital + Free Reserves + Balance in
Share Premium Account + Capital Reserves (surplus) arising out of sale proceeds of
assets but not created by revaluation of assets MINUS Accumulated loss + Book
value of Intangible Assets + Equity Investment in Subsidiaries+ Innovative Perpetual
Debt instruments.
Tier – II consists of Cumulative perpetual preferential shares & other Hybrid debt
capital instruments + Revaluation reserves + General Provisions + Loss Reserves
(up to maximum 1.25% of weighted risk assets) + Undisclosed Reserves +
Subordinated Debt + Upper Tier-II instruments. Subordinated Debts are unsecured
and subordinated to the claims of all the creditors. To be eligible for Tier-II capital
the instruments should be fully paid, free from restrictive clauses and should not be
redeemable at the instance of holder or without the consent of the Bank supervisory
authorities. Subordinated debt usually carries a fixed maturity and they will have to
be limited to 50% of Tier-I capital.
However, due to the stress on account of rollover of demonetization and GST, the
implementation of Basel-III norms may slightly be delayed and the regulator likely to
inform the timeframe shortly.
Economic Capital (EC) is a measure of risk expressed in terms of capital. A bank
may, for instance, wonder what level of capital is needed in order to remain solvent
at a certain level of confidence and time horizon. In other words, EC may be
considered as the amount of risk capital from the banks’ perspective; therefore,
it differs from Regulatory Capital (RC) requirement measures. It primarily aims to
support business decisions, while RC aims to set minimum capital requirements
against all risks in a bank under a range of regulatory rules and guidance. So far, EC
is rather a bank-specific or internal measure of available capital and there is no
common domestic or global definition of EC. The estimates of EC can be covered by
elements of Tier-1, 2 & 3, or definitions used by rating agencies and/or other types
of capital, such as planned earning, unrealized profit or implicit government
guarantee. EC is highly relevant because it can provide key answers to specific
business decisions or for evaluating the different business units of a bank.
Dynamic Provisioning: At present, banks generally make two types of provisions
viz., general provisions on standard assets and specific provisions on non-performing
assets (NPAs). The present provisioning framework does not have countercyclical or
cycle smoothening elements. Though the RBI has been following a policy of
countercyclical variation of standard asset provisioning rates, the methodology has
been largely based on current available data and judgment, rather than on an
analysis of credit cycles and loss history. Since the level of NPAs varies through the
economic cycle, the resultant level of specific provisions also behaves cyclically.
Consequently, lower provisioning during upturns, and higher provisioning during
downturns have pro-cyclical effect on the real economy. However, few banks have
started making floating provisions without any predetermined rules; many banks are
away from the concept which has become difficult for inter-bank comparison. In the
above backdrop, RBI introduced dynamic provisioning framework for Indian banks to
address pro-cyclicality of capital and provisioning to meet the international
standards. Recently, RBI has allowed banks to recognize some of their assets like
real estate, foreign currency and deferred tax, reducing the extra capital needs of
state-owned banks by 15 per cent. The move is aimed to align the regulatory capital
of banks with the Basel-III standards.
Leverage Ratio: It is the tier-1 capital divided by the sum of on-balance sheet
exposures, derivative exposures, securities financing transaction exposures and off-
balance sheet items. This ratio is calibrated to act as a credible supplementary
measure to the risk based capital requirements with the objective to constrain the
build-up of leverage in the banking sector to avert destabilizing deleveraging
processes for the sound financial economy and to reinforce the risk based
requirements with a simple, non-risk based “backstop” measure. The desirable
exposure should be within 25 times of tier-1 capital.
Banks in India need substantial capital funds in the ensuing years mainly to fund the
credit growth which is likely to grow at around 15% to 20% p.a. and banks are
required to set aside a portion of capital for the said purpose. Banks also need
additional capital to write off bad loans as well as to meet the operational risks on
account of weaker implementation of systems and procedures. More importantly, the
implementation of Basel-III norms warrants pumping of substantial capital funds.
Raising these funds, though, will require several steps, apart from legislative
changes as Public Sector Banks can not dilute its equity below 51%. Attracting
private capital warrants minimum governance and structural reforms. It is also
proposed to create an independent Bank Holding Company to invite private capital
without diluting the equity to address the issue.
