Risk management important article

 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.