Risk management very Important Terms
Capital Funds
Equity contribution of owners. The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business. Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II.
Tier I Capital
A term used to refer to one of the components of regulatory capital. It consists mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I items are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital.
Tier II Capital
Refers to one of the components of regulatory capital. Also known as supplementary capital, it consists of certain reserves and certain types of subordinated debt. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank's activities. Tier II's capital loss absorption capacity is lower than that of Tier I capital.
Revaluation reserves
Revaluation reserves are a part of Tier-II capital. These reserves arise from revaluation of assets that are undervalued on the bank's books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale.
Leverage
Ratio of assets to capital.
Capital reserves
That portion of a company's profits not paid out as dividends to shareholders. They are also known as undistributable reserves and are ploughed back into the business.
Deferred Tax Assets
Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets. The deferred Tax Assets are accounted as per the Accounting Standard 22.
Deferred Tax Liabilities
Deferred tax liabilities have an effect of increasing future year's income tax payments, which indicates that they are accrued income taxes and meet definition of liabilities.
Subordinated debt
Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid.
Hybrid debt capital instruments
In this category, fall a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.
BASEL Committee on Banking Supervision
The BASEL Committee is a committee of bank supervisors consisting of members from each of the G10 countries. The Committee is a forum for discussion on the handling of specific supervisory problems. It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks' activities worldwide.
BASEL Capital accord
The BASEL Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardised risk-based capital requirements for banks across countries. The Accord was replaced with a new capital adequacy framework (BASEL II), published in June 2004. BASEL II is based on three mutually reinforcing pillars hat allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are:
Minimum capital requirements, which seek to refine the present measurement framework
supervisory review of an institution's capital adequacy and internal assessment process;
market discipline through effective disclosure to encourage safe and sound banking practices
Risk Weighted Asset
The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number. Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank etc.
CRAR(Capital to Risk Weighted Assets Ratio)
Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is.
Credit Risk
The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments. Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk
1.standardised approach (SA) - Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.
2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types:
a) Foundation IRB (FIRB):The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure At Default (EAD).
b) Advanced IRB (AIRB):In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the outset and on an ongoing basis such as those relating to the design of the rating system, operations, controls, corporate governance, and estimation and validation of credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the minimum, PD data for five years and LGD and EAD data for seven years. In India, banks have been advised to compute capital requirements for credit risk adopting the SA.
Market risk
Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement. The capital charge for market risk was introduced by the BASEL Committee on Banking Supervision through the Market Risk Amendment of January 1996 to the capital accord of 1988 (BASEL I Framework). There are two methodologies available to estimate the capital requirement to cover market risks:
1) The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a 'building block' approach for interest-rate related and equity instruments which differentiate capital requirements for 'specific risk' from those of 'general market risk'. The 'specific risk charge' is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The 'general market risk charge' is designed to protect against the interest rate risk in the portfolio.
2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority.
Operational Risk
The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:
1) The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed percentage ("alpha factor") of a single indicator, which serves as a proxy for the bank's risk exposure.
2) The Standardised Approach (SA): This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.
3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks' internal operational risk measurement system. In India, the banks have been advised to adopt the BIA to estimate the capital charge for operational risk and 15% of average gross income of last three years is taken for calculating capital charge for operational risk.
Internal Capital Adequacy Assessment Process (ICAAP)
In terms of the guidelines on BASEL II, the banks are required to have a board-approved policy on internal capital adequacy assessment process (ICAAP) to assess the capital requirement as per ICAAP at the solo as well as consolidated level. The ICAAP is required to form an integral part of the management and decision-making culture of a bank. ICAAP document is required to clearly demarcate the quantifiable and qualitatively assessed risks. The ICAAP is also required to include stress tests and scenario analyses, to be conducted periodically, particularly in respect of the bank's material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank's capital.
Supervisory Review Process (SRP)
Supervisory review process envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. The objective of the SRP is to ensure that the banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks.
Market Discipline
Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks.
Credit risk mitigation
Techniques used to mitigate the credit risks through exposure being collateralised in whole or in part with cash or securities or guaranteed by a third party.
Mortgage Back Security
A bond-type security in which the collateral is provided by a pool of mortgages. Income from the underlying mortgages is used to meet interest and principal repayments.
Derivative
A derivative instrument derives its value from an underlying product. There are basically three derivatives
a) Forward Contract- A forward contract is an agreement between two parties to buy or sell an agreed amount of a commodity or financial instrument at an agreed price, for delivery on an agreed future date. Future Contract- Is a standardized exchange tradable forward contract executed at an exchange. In contrast to a futures contract, a forward contract is not transferable or exchange tradable, its terms are not standardized and no margin is exchanged. The buyer of the forward contract is said to be long on the contract and the seller is said to be short on the contract.
b) Options- An option is a contract which grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset, commodity, currency or financial instrument at an agreed rate (exercise price) on or before an agreed date (expiry or settlement date). The buyer pays the seller an amount called the premium in exchange for this right. This premium is the price of the option.
c) Swaps- Is an agreement to exchange future cash flow at pre-specified Intervals. Typically one cash flow is based on a variable price and other on affixed one.
Duration
Duration (Macaulay duration) measures the price volatility of fixed income securities. It is often used in the comparison of interest rate risk between securities with different coupons and different maturities. It is defined as the weighted average time to cash flows of a bond where the weights are nothing but the present value of the cash flows themselves. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same.
Modified Duration
Modified Duration = Macaulay Duration/ (1+y/m), where 'y' is the yield (%), 'm' is the number of times compounding occurs in a year. For example if interest is paid twice a year m=2. Modified Duration is a measure of the percentage change in price of a bond for a 1% change in yield.
Non Performing Assets (NPA)
An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank.
Net NPA
Gross NPA - (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part payment received and kept in suspense account + Total provisions held).
Coverage Ratio
Equity minus net NPA divided by total assets minus intangible assets.
Slippage Ratio
(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the year)*100
Restructuring
A restructured account is one where the bank, grants to the borrower concessions that the bank would not otherwise consider. Restructuring would normally involve modification of terms of the advances/securities, which would generally include, among others, alteration of repayment period/ repayable amount/ the amount of installments and rate of interest. It is a mechanism to nurture an otherwise viable unit, which has been adversely impacted, back to health.
Substandard Assets
A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. Such an asset will have well defined credit weaknesses that jeopardize the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.
Doubtful Asset
An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, - on the basis of currently known facts, conditions and values - highly questionable and improbable.
Loss Asset
A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.
Off Balance Sheet Exposure
Off-Balance Sheet exposures refer to the business activities of a bank that generally do not involve booking assets (loans) and taking deposits. Off-balance sheet activities normally generate fees, but produce liabilities or assets that are deferred or contingent and thus, do not appear on the institution's balance sheet until and unless they become actual assets or liabilities.
Current Exposure Method
The credit equivalent amount of a market related off-balance sheet transaction is calculated using the current exposure method by adding the current credit exposure to the potential future credit exposure of these contracts. Current credit exposure is defined as the sum of the positive mark to market value of a contract. The Current Exposure Method requires periodical calculation of the current credit exposure by marking the contracts to market, thus capturing the current credit exposure. Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor prescribed by RBI, according to the nature and residual maturity of the instrument.
Capital Funds
Equity contribution of owners. The basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business. Capital is divided into different tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II.
Tier I Capital
A term used to refer to one of the components of regulatory capital. It consists mainly of share capital and disclosed reserves (minus goodwill, if any). Tier I items are deemed to be of the highest quality because they are fully available to cover losses Hence it is also termed as core capital.
Tier II Capital
Refers to one of the components of regulatory capital. Also known as supplementary capital, it consists of certain reserves and certain types of subordinated debt. Tier II items qualify as regulatory capital to the extent that they can be used to absorb losses arising from a bank's activities. Tier II's capital loss absorption capacity is lower than that of Tier I capital.
Revaluation reserves
Revaluation reserves are a part of Tier-II capital. These reserves arise from revaluation of assets that are undervalued on the bank's books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale.
Leverage
Ratio of assets to capital.
Capital reserves
That portion of a company's profits not paid out as dividends to shareholders. They are also known as undistributable reserves and are ploughed back into the business.
Deferred Tax Assets
Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets. The deferred Tax Assets are accounted as per the Accounting Standard 22.
Deferred Tax Liabilities
Deferred tax liabilities have an effect of increasing future year's income tax payments, which indicates that they are accrued income taxes and meet definition of liabilities.
Subordinated debt
Refers to the status of the debt. In the event of the bankruptcy or liquidation of the debtor, subordinated debt only has a secondary claim on repayments, after other debt has been repaid.
Hybrid debt capital instruments
In this category, fall a number of capital instruments, which combine certain characteristics of equity and certain characteristics of debt. Each has a particular feature, which can be considered to affect its quality as capital. Where these instruments have close similarities to equity, in particular when they are able to support losses on an ongoing basis without triggering liquidation, they may be included in Tier II capital.
BASEL Committee on Banking Supervision
The BASEL Committee is a committee of bank supervisors consisting of members from each of the G10 countries. The Committee is a forum for discussion on the handling of specific supervisory problems. It coordinates the sharing of supervisory responsibilities among national authorities in respect of banks' foreign establishments with the aim of ensuring effective supervision of banks' activities worldwide.
BASEL Capital accord
The BASEL Capital Accord is an Agreement concluded among country representatives in 1988 to develop standardised risk-based capital requirements for banks across countries. The Accord was replaced with a new capital adequacy framework (BASEL II), published in June 2004. BASEL II is based on three mutually reinforcing pillars hat allow banks and supervisors to evaluate properly the various risks that banks face. These three pillars are:
Minimum capital requirements, which seek to refine the present measurement framework
supervisory review of an institution's capital adequacy and internal assessment process;
market discipline through effective disclosure to encourage safe and sound banking practices
Risk Weighted Asset
The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number. Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank etc.
CRAR(Capital to Risk Weighted Assets Ratio)
Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is.
Credit Risk
The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments. Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk
1.standardised approach (SA) - Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.
2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types:
a) Foundation IRB (FIRB):The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure At Default (EAD).
b) Advanced IRB (AIRB):In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the outset and on an ongoing basis such as those relating to the design of the rating system, operations, controls, corporate governance, and estimation and validation of credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the minimum, PD data for five years and LGD and EAD data for seven years. In India, banks have been advised to compute capital requirements for credit risk adopting the SA.
Market risk
Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement. The capital charge for market risk was introduced by the BASEL Committee on Banking Supervision through the Market Risk Amendment of January 1996 to the capital accord of 1988 (BASEL I Framework). There are two methodologies available to estimate the capital requirement to cover market risks:
1) The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a 'building block' approach for interest-rate related and equity instruments which differentiate capital requirements for 'specific risk' from those of 'general market risk'. The 'specific risk charge' is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The 'general market risk charge' is designed to protect against the interest rate risk in the portfolio.
2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority.
Operational Risk
The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:
1) The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed percentage ("alpha factor") of a single indicator, which serves as a proxy for the bank's risk exposure.
2) The Standardised Approach (SA): This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.
3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks' internal operational risk measurement system. In India, the banks have been advised to adopt the BIA to estimate the capital charge for operational risk and 15% of average gross income of last three years is taken for calculating capital charge for operational risk.
Internal Capital Adequacy Assessment Process (ICAAP)
In terms of the guidelines on BASEL II, the banks are required to have a board-approved policy on internal capital adequacy assessment process (ICAAP) to assess the capital requirement as per ICAAP at the solo as well as consolidated level. The ICAAP is required to form an integral part of the management and decision-making culture of a bank. ICAAP document is required to clearly demarcate the quantifiable and qualitatively assessed risks. The ICAAP is also required to include stress tests and scenario analyses, to be conducted periodically, particularly in respect of the bank's material risk exposures, in order to evaluate the potential vulnerability of the bank to some unlikely but plausible events or movements in the market conditions that could have an adverse impact on the bank's capital.
Supervisory Review Process (SRP)
Supervisory review process envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. The objective of the SRP is to ensure that the banks have adequate capital to support all the risks in their business as also to encourage them to develop and use better risk management techniques for monitoring and managing their risks.
Market Discipline
Market Discipline seeks to achieve increased transparency through expanded disclosure requirements for banks.
Credit risk mitigation
Techniques used to mitigate the credit risks through exposure being collateralised in whole or in part with cash or securities or guaranteed by a third party.
Mortgage Back Security
A bond-type security in which the collateral is provided by a pool of mortgages. Income from the underlying mortgages is used to meet interest and principal repayments.
Derivative
A derivative instrument derives its value from an underlying product. There are basically three derivatives
a) Forward Contract- A forward contract is an agreement between two parties to buy or sell an agreed amount of a commodity or financial instrument at an agreed price, for delivery on an agreed future date. Future Contract- Is a standardized exchange tradable forward contract executed at an exchange. In contrast to a futures contract, a forward contract is not transferable or exchange tradable, its terms are not standardized and no margin is exchanged. The buyer of the forward contract is said to be long on the contract and the seller is said to be short on the contract.
b) Options- An option is a contract which grants the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset, commodity, currency or financial instrument at an agreed rate (exercise price) on or before an agreed date (expiry or settlement date). The buyer pays the seller an amount called the premium in exchange for this right. This premium is the price of the option.
c) Swaps- Is an agreement to exchange future cash flow at pre-specified Intervals. Typically one cash flow is based on a variable price and other on affixed one.
Duration
Duration (Macaulay duration) measures the price volatility of fixed income securities. It is often used in the comparison of interest rate risk between securities with different coupons and different maturities. It is defined as the weighted average time to cash flows of a bond where the weights are nothing but the present value of the cash flows themselves. It is expressed in years. The duration of a fixed income security is always shorter than its term to maturity, except in the case of zero coupon securities where they are the same.
Modified Duration
Modified Duration = Macaulay Duration/ (1+y/m), where 'y' is the yield (%), 'm' is the number of times compounding occurs in a year. For example if interest is paid twice a year m=2. Modified Duration is a measure of the percentage change in price of a bond for a 1% change in yield.
Non Performing Assets (NPA)
An asset, including a leased asset, becomes non performing when it ceases to generate income for the bank.
Net NPA
Gross NPA - (Balance in Interest Suspense account + DICGC/ECGC claims received and held pending adjustment + Part payment received and kept in suspense account + Total provisions held).
Coverage Ratio
Equity minus net NPA divided by total assets minus intangible assets.
Slippage Ratio
(Fresh accretion of NPAs during the year/Total standard assets at the beginning of the year)*100
Restructuring
A restructured account is one where the bank, grants to the borrower concessions that the bank would not otherwise consider. Restructuring would normally involve modification of terms of the advances/securities, which would generally include, among others, alteration of repayment period/ repayable amount/ the amount of installments and rate of interest. It is a mechanism to nurture an otherwise viable unit, which has been adversely impacted, back to health.
Substandard Assets
A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months. Such an asset will have well defined credit weaknesses that jeopardize the liquidation of the debt and are characterised by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.
Doubtful Asset
An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that were classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, - on the basis of currently known facts, conditions and values - highly questionable and improbable.
Loss Asset
A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. In other words, such an asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted although there may be some salvage or recovery value.
Off Balance Sheet Exposure
Off-Balance Sheet exposures refer to the business activities of a bank that generally do not involve booking assets (loans) and taking deposits. Off-balance sheet activities normally generate fees, but produce liabilities or assets that are deferred or contingent and thus, do not appear on the institution's balance sheet until and unless they become actual assets or liabilities.
Current Exposure Method
The credit equivalent amount of a market related off-balance sheet transaction is calculated using the current exposure method by adding the current credit exposure to the potential future credit exposure of these contracts. Current credit exposure is defined as the sum of the positive mark to market value of a contract. The Current Exposure Method requires periodical calculation of the current credit exposure by marking the contracts to market, thus capturing the current credit exposure. Potential future credit exposure is determined by multiplying the notional principal amount of each of these contracts irrespective of whether the contract has a zero, positive or negative mark-to-market value by the relevant add-on factor prescribed by RBI, according to the nature and residual maturity of the instrument.
