Risk In Financial Institute Banks

Published Date: 02 Nov 2017

A Capstone Project Report submitted in partial fulfilment of the requirements for the award of

Post Graduate Diploma in Management

Submitted by:

Nirantara Poddar (KHR2011PGDM21F194)

Under the Guidance of

Faculty Guide

Dr. Neena Nanda

ITM Business School, Kharghar

ITM Business School, Navi Mumbai

Plot 25/26, Institutional Area, Sector -4 Kharghar East,

Navi Mumbai - 410 210

Risk in Financial Institute: Banks – An Overview

Taking risk is an integral part of the banking business. Continuing increases in the scale and complexity of financial institutions and in the pace of their financial transactions demand that they employ sophisticated risk management techniques and monitor rapidly changing risk exposures. At the same time, advances in information technology have lowered the cost of acquiring, managing and analysing data, and have enabled considerable and on-going advances in risk management at leading institutions worldwide.

Banks in many emerging market countries are also increasing their focus on risk management in an effort to build more robust and sound financial systems, to remedy weaknesses that were exposed by recent regional problems, and to position themselves to participate more fully in the global economy.

Although avoiding failure is a principal reason for managing risk, global financial institutions also have the broader objective of maximizing their risk-adjusted rate of return on capital, or RAROC. This means not just avoiding excessive risk exposures, but measuring and managing risks relative to returns and to capital. By focusing on risk-adjusted returns on capital, global institutions avoid putting too much emphasis on activities and investments that have high expected returns but equally high or higher risk. This has led to better management decisions and more efficient allocation of capital and other resources.

To ensure accuracy of risk management accounting systems need to be supplemented by auditing systems and backed up by enforceable legal penalties for providing fraudulent or misleading information to government agencies and outsiders. Banks also need reliable information on the credit history of potential borrowers and on macroeconomic and financial variables that can affect credit and other risks.

Institutions may have different risk management systems depending on their sizes and complexity. Risk Management entails four key processes

Risk Identification

Risk Measurement

Risk Control

Risk Monitoring

The key elements that need to be dealt with to manage risk in a financial institution are:

(a) Interest-Rate Risk (b)Credit Risk (c) Liquidity Risk (d)Market Risk (e)Operational Risk (f)Strategic Risk (g) Compliance Risk

To avert these shortfalls the steps that are usually taken up by the financial institutions are:

Financial Products and How They are used for Hedging

Bank Regulation and Basel III

The VaR Measure

Credit Derivatives

However several more methods are emerging to reason and solve risk management in banks.

Need for risk Management

Globalization has resulted in pressure on margins. The lower the margin, the greater is the need for risk management. As a result, risk management has become a key area of focus. Additionally, due to the failure of many banks/ financial institutions in recent past, it has attracted the attention of regulators also.

The challenges of the modern corporation is to ensure wealth maximization for their shareholders, i.e., consistent with the risk preference. On the other hand risk has to be managed effectively and on the other hand, adequate returns have to be ensured. The role played by banks and financial institutions is to take a critical view of risk. An impact on one institution can have fallout for other institutions in the market. Hence, risk needs to be understood and dealt with carefully

Institutions structured as limited liability corporations involve the separation of ownership and management. The management consists of Executive Directors and other functional managers who work on behalf of the stakeholders. In a financial institute, core business and risk need to be integrated.

Why risk matters

Because taking risk is an integral part of the banking business, it is not surprising that banks have been practicing risk management ever since there have been banks - the industry could not have survived without it. The only real change is the degree of sophistication now required to reflect the more complex and fast-paced environment.

The Asian financial crisis of 1997 illustrates that ignoring basic risk management can also contribute to economy-wide difficulties. The long period of remarkable economic growth and prosperity in Asia masked weaknesses in risk management at many financial institutions. Many Asian banks did not assess risk or conduct a cash flow analysis before extending a loan, but rather lent on the basis of their relationship with the borrower and the availability of collateral - despite the fact that collateral was often hard to seize in the event of default. The result was that loans - including loans by foreign banks - expanded faster than the ability of the borrowers to repay. Additionally, because many banks did not have or did not abide by limits on concentrations of lending to individual firms or business sectors, loans to overextended borrowers were often large relative to bank capital, so that when economic conditions worsened, these banks were weakened the most.

The Asian crisis also illustrates the potential benefit of more sophisticated risk management practices. Many Asian banks did not adequately assess their exposures to exchange rate risk. Although some banks matched their foreign currency liabilities with foreign currency assets, doing so merely transformed exchange rate risk into credit risk, because their foreign currency borrowers did not have assured sources of foreign currency revenues. Similarly, foreign banks underestimated country risk in Asia. In both cases, institutions seemed to have assumed that stability would continue in the region and failed to consider what might happen if that were not the case. A greater willingness and ability of banks to subject their exposures to stress testing could have highlighted the risks and emphasized the importance of key assumptions. Had they conducted stress tests, some lenders might have seen how exposed they were to changes in exchange rates or to an interruption of steady economic growth. Although avoiding failure is a principal reason for managing risk, global financial institutions also have the broader objective of maximizing their risk-adjusted rate of return on capital, or RAROC. This means not just avoiding excessive risk exposures, but measuring and managing risks relative to returns and to capital. By focusing on risk-adjusted returns on capital, global institutions avoid putting too much emphasis on activities and investments that have high expected returns but equally high or higher risk. This has led to better management decisions and more efficient allocation of capital and other resources. Indeed, bank shareholders and creditors expect to receive an appropriate risk-adjusted rate of return, with the result that banks that do not focus on risk-adjusted returns will not be rewarded by the market.

Risk management is clearly not free. In fact, as I will discuss, it’s expensive in both resources and in institutional disruption. But the cost of delaying or avoiding proper risk management can be extreme: failure of a bank and possibly failure of a banking system. A point too often overlooked, however, is that, by focusing on risk-adjusted returns, risk management also contributes to the strength and efficiency of the economy. It does so by providing a mechanism that is designed to allocate resources - initially financial resources but ultimately real resources – to their most efficient use. Projects with the highest risk-adjusted expected profitability are the most likely to be financed and to succeed. The result is more rapid economic growth. The ultimate gain from risk management is higher economic growth. Without sound risk management, no economy can grow to its potential.

Stability and greater economic growth, in turn, lead to greater private saving, greater retention of that saving, greater capital imports and more real investment. Without it, not only is there loss of these gains, but also incurrence of the considerable costs of bank disruptions and failures that follow from unexpected, undesired and unmanaged risk-taking.

Identification of Risks

Credit risk Management

Credit risk

Credit Risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances

A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan

A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company

A business or consumer does not pay a trade invoice when due

A business does not pay an employee's earned wages when due

A business or government bond issuer does not make a payment on a coupon or principal payment when due

An insolvent insurance company does not pay a policy obligation

An insolvent bank won't return funds to a depositor

A government grants bankruptcy protection to an insolvent consumer or business

Risk Identification: Types of Credit Risk

Downgrade Risk (Migration Risk):

If a borrower does not default, there is still risk due to worsening in credit quality. This results in the possible widening of the credit spread. This is credit spread risk. Usually this is reflected through rating downgrade. It is normally firm specific.

Default Risk

Default risk is driven by the potential failure of borrower to make promised payment, either partly or wholly. In the event of default, fraction of the obligation will normally be paid.

Systematic Risk

Portfolio risk is reduced due to diversification. If a portfolio is fully diversified, i.e., diversified across geography, industries, borrowers, market, etc. equitably then the portfolio risk is reduced to minimum level. This minimum level corresponds to risk in the economy in which it is operating.

Concentration Risk

If the portfolio is not diversified, i.e., to say that it has higher weight in respect of a borrower or geography or an industry etc., the portfolio gets concentration risk.

To reduce the lender's credit risk, the lender may perform a credit check on the prospective borrower, may require the borrower to take out appropriate insurance, such as mortgage insurance or seek security or guarantees of third parties, besides other possible strategies. In general, the higher the risk, the higher will be the interest rate that the debtor will be asked to pay on the debt.

Methods of measuring Credit Risk

Standardized

Foundation IRB

Advanced IRB

Standardized

The term standardized approach (or standardized approach) refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation. The Basel Accord proposes to permit banks a choice between two broad methodologies for calculating their capital requirements for credit risk. The other alternative is based on internal ratings.

• Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings)

• Least sophisticated capital calculations; least differentiation in required capital between safer and riskier credits

• Generally highest capital burdens

Credit Risk measurement according to Standardized Approach

Risk weight assigned to exposures based on Basel II norms:

Risk Weights for Calculation of CRAR I. Domestic Operations

Sr

I

1.

2.

II

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

III

1.

2.

3.

4.

5.

6.

7.

Item of asset or liability Risk

Balances

Cash, balances with RBI

i. Balances in current account with other banks

ii. Claims on Bank

Investments (Applicable to securities held in HTM)

Investments in Government Securities.

Investments in other approved securities guaranteed by Central/State Government.

Investments in other securities where payment of interest and repayment of principal are guaranteed by Central Govt.

Investments in other approved securities where payment of interest and repayment of principal are not guaranteed by Central/State Govt.

Claims on commercial banks

Investments in bonds issued by other banks

Investments in subordinated debt instruments and bonds issued by other banks or Public Financial Institutions for their Tier II capital.

Deposits placed with SIDBI/NABARD in lieu of shortfall in lending to priority sector.

Investments in debentures/ bonds/ security receipts/ Pass Through Certificates issued by Securitisation Company / SPVs/ Reconstruction Company and held by banks as investment

Direct investment in equity shares, convertible bonds, debentures and units of equity oriented mutual funds

Investments in Venture Capital Funds

Loans & Advances including bills purchased and discounted and other credit facilities

Loans guaranteed by Govt. of India

Loans granted to public sector undertakings of Govt. of India

For the purpose of credit exposure, bills purchased/discounted negotiated under LC

Leased assets

Advances covered by DICGC/ECGC

Loans and Advances granted to staff of banks which are fully covered by superannuation benefits and mortgage of flat/house.

Housing loans above Rs. 30 lakh sanctioned to individuals against the mortgage of residential housing properties having LTV ratio equal to or less than 75%

Weight %

0

20

20

0

0

0

20

20

20

100

100

100

125

150

0

100

100

100

50

20

75

Claims on sovereigns

Credit Assessment

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

unrated

Risk Weight

0%

20%

50%

100%

150%

100%

Claims on the BIS, the IMF, the ECB, the EC and the MDBs

Risk Weight: 0%

Claims on banks and securities companies

Related to assessment of sovereign as banks and securities companies are regulated.

Credit Assessment

AAA to AA-

A+ to A-

BBB+ to BBB-

BB+ to B-

Below B-

unrated

Risk Weight

20%

50%

100%

100%

150%

100%

Claims on corporates

Credit Assessment

AAA to AA-

A+ to A-

BBB+ to BB-

Below BB-

unrated

Risk Weight

20%

50%

100%

150%

100%

Claims on retail products

This includes credit card, overdraft, auto loans, personal finance and small business.

Risk weight: 75%

Claims secured by residential property

Risk weight: 35%

Claims secured by commercial real estate

Risk weight: 100%

Overdue loans

more than 90 days other than residential mortgage loans.

Risk weight:

150% for provisions that are less than 20% of the outstanding amount

100% for provisions that are between 20% - 49% of the outstanding amount

100% for provisions that are no less than 50% of the outstanding amount, but with supervisory discretion are reduced to 50% of the outstanding amount

Other assets

Risk weight: 100%

Cash

Risk weight: 0%

Capital Requirement under Standardized Approach:

Capital Requirement = Risk Weighted Asset X 9%

Where, 9% is the prevailing CAR

Total Risk Weighted Asset includes Fund Based as well as Non-Fund Based Exposure

IRB Approach

Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the Internal Ratings-Based (IRB) Approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.

There are 3 parameters for the measurement of a single credit facility

Probability of default (PD)

Exposure at default (EAD)

Loss given default (LGD)

Probability of default (PD)

It is the likelihood of the counter-party to default on its obligation either over the life of the obligation or over some specified time horizon.

Exposure at default (EAD)

EAD for loan commitment measures the amount of the facility that is likely to be drawn in the event of the default.

Loss given default (LGD)

LGD measures the proportion of the exposure that will be lost if default occurs.

Expected loss is covered through the pricing of the banks products and services. Unexpected loss is the variability about this mean loss, which should be covered through adequate capital allocation or provisioning.

Expected loss = PD X EAD X LGD

Foundation IRB

• Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M)

• More risk sensitive capital requirements; more differentiation in required capital between safer and riskier credits

Advanced IRB

• Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD and M

• Most risk-sensitive (although not always lowest) capital requirements; most differentiation in required capital between safer and riskier credits

• Transition to Advanced IRB status only with robust internal risk management systems and data.

Market risk

Market risk is the risk of losses in positions arising from movements in market prices. . It is the risk that the value of on-/off-balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices. Market risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities, of those prices.

Some market risks include:

Equity risk the risk that stock or stock indexes prices and/or their implied volatility will change.

Interest rate risk, the risk that interest rates and/or their implied volatility will change.

Currency risk, the risk that foreign exchange rates and/or their implied volatility will change.

Commodity risk, the risk that commodity prices and/or their implied volatility will change.

Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Market Risk Management provides a comprehensive and dynamic frame work for measuring, monitoring and managing liquidity, interest rate, foreign exchange and equity as well as commodity price risk of a bank that needs to be closely integrated with the bank’s business strategy.

Liquidity Risk:

Bank Deposits generally have a much shorter contractual maturity than loans and liquidity management needs to provide a cushion to cover anticipated deposit withdrawals. Liquidity is the ability to efficiently accommodate deposit as also reduction in liabilities and to fund the loan growth and possible funding of the off-balance sheet claims. The cash flows are placed in different time buckets based on future likely behaviour of assets, liabilities and off-balance sheet items. Liquidity risk consists of Funding Risk, Time Risk & Call Risk.

Funding Risk: It is the need to replace net out flows due to unanticipated withdrawal/nonrenewal of deposit

Time risk: It is the need to compensate for no receipt, of expected inflows of funds, i.e. performing assets turning into nonperforming assets.

Call risk: It happens on account of crystallisation of contingent liabilities and inability to undertake profitable business opportunities when desired.

The Asset Liability Management (ALM) is a part of the overall risk management system in the banks. It implies examination of all the assets and liabilities simultaneously on a continuous basis with a view to ensuring a proper balance between funds mobilization and their deployment with respect to their a) maturity profiles, b) cost, c) yield, d) risk exposure, etc. It includes product pricing for deposits as well as advances, and the desired maturity profile of assets and liabilities.

Interest Rate Risk

Interest Rate Risk is the potential negative impact on the Net Interest Income and it refers to the vulnerability of an institution’s financial condition to the movement in interest rates. Changes in interest rate affect earnings, value of assets, liability off-balance sheet items and cash flow. Hence, the objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and affect risk return trade-off.

The objective of interest rate risk management is to maintain earnings, improve the capability, ability to absorb potential loss and to ensure the adequacy of the compensation received for the risk taken and effect risk return trade-off. Management of interest rate risk aims at capturing the risks arising from the maturity and re-pricing mismatches and is measured both from the earnings and economic value perspective.

Earnings perspective involves analysing the impact of changes in interest rates on accrual or reported earnings in the near term. This is measured by measuring the changes in the Net Interest Income (NII) equivalent to the difference between total interest income and total interest expense.

Types of Interest Rate Risk

Embedded option Risk: Option of pre-payment of loan and Fore- closure of deposits before their stated maturities constitute embedded option risk

Yield curve risk: Movement in yield curve and the impact of that on portfolio values and income.

Re-price risk: When assets are sold before maturities.

Reinvestment risk: Uncertainty with regard to interest rate at which the future cash flows could be reinvested.

Net interest position risk: When banks have more earning assets than paying liabilities, net interest position risk arises

There are different techniques such as a) the traditional Maturity Gap Analysis to measure the interest rate sensitivity, b) Duration Gap Analysis to measure interest rate sensitivity of capital, c) simulation and d) Value at Risk for measurement of interest rate risk. The approach towards measurement and hedging interest rate risk varies with segmentation of bank’s balance sheet. Banks broadly bifurcate the asset into

Trading Book: Trading book comprises of assets held primarily for generating profits on short term differences in prices/yields

Banking Book: Banking book consists of assets and liabilities contracted basically on account of relationship or for steady income and statutory obligations and are generally held till maturity/payment by counter party

Value at Risk (VaR) is a method of assessing the market risk using standard statistical techniques. It is a statistical measure of risk exposure and measures the worst expected loss over a given time interval under normal market conditions at a given confidence level of say 95% or 99%. Thus VaR is simply a distribution of probable outcome of future losses that may occur on a portfolio. The actual result will not be known until the event takes place. Till then it is a random variable whose outcome has been estimated.

To calculate the interest rate risk, Duration Gap model is used. In this method, the assets and liabilities are segregated according to the maturity. The duration of assets and liabilities is calculated, which in used to calculate the duration gap, which in turn is used to find the probable impact of interest rate change on the assets of the banks. The table below shows the various maturity buckets under which the assets and liabilities are classified. The Duration gap is calculated as –

DUR gap = DUR a – (L*DUR l)/ A

DUR a = average duration of assets

DUR l = average duration of liabilities

L = market value of liabilities

A = market value of assets

Forex Risk

Foreign exchange risk is the risk that a bank may suffer loss as a result of adverse exchange rate movement during a period in which it has an open position, either spot or forward or both in same foreign currency. Even in case where spot or forward positions in individual currencies are balanced the maturity pattern of forward transactions may produce mismatches.

There is also a settlement risk arising out of default of the counter party and out of time lag in settlement of one currency in one centre and the settlement of another currency in another time zone. Banks are also exposed to interest rate risk, which arises from the maturity mismatch of foreign currency position.

Currency Risk is the possibility that exchange rate changes will alter the expected amount of principal and return of the lending or investment. At times, banks may try to cope with this specific risk on the lending side by shifting the risk associated with exchange rate fluctuations to the borrowers. However the risk does not get extinguished, but only gets converted in to credit risk.

Country Risk

This is the risk that arises due to cross border transactions that are growing dramatically in the recent years owing to economic liberalization and globalization. It is the possibility that a country will be unable to service or repay debts to foreign lenders in time.

It comprises of Transfer Risk arising on account of possibility of losses due to restrictions on external remittances; Sovereign Risk associated with lending to government of a sovereign nation or taking government guarantees; Political Risk when political environment or legislative process of country leads to government taking over the assets of the financial entity (like nationalization, etc.) and preventing discharge of liabilities in a manner that had been agreed to earlier; Cross border risk arising on account of the borrower being a resident of a country other than the country where the cross border asset is booked; Currency Risk, a possibility that exchange rate change, will alter the expected amount of principal and return on the lending or investment.

VaR Analysis for Market Risk

Managing risk is an essential activity for all banks, whether the financial institution focuses on commercial or investment banking. In order to manage risk, financial institutions must first measure their exposure to risk. Value at risk is a probabilistic method of measuring the potential loss in portfolio value over a given time period and for a given distribution of historical returns. V

Percent Var can be calculated as :

Var (X%) = zX% σ

Where:

Var (X%) = the X% probability value at risk

zX% = the critical z-value based on the normal distribution and the selected X% probability

σ = the standardized deviation of daily returns on a percentage basis.

To calculate VaR on a dollar basis, the per-cent Var is multiplied by the asset value as follows:

Var (X%)dollar basis = Var (X%)decimal basis X asset value

= zX% σ X asset value

If an expected return (R) other than zero is given, VaR becomes the expected return minus the quantity of the level of significance multiplied by the standard deviation

VaR = [E(R) – zσ]

Time Conversion for VaR

In case VaR is to be calculated for a week, month, quarter or year, the daily VaR is to be multiplied by the square root of the number of day (J)

Var(X%)J-days = VaR(X%)1-day √J

Regression Analysis for Market Risk

Using regression analysis on the historical data of stocks of selected banks, the change or effect on the stocks due to change in interest rate by 100 bps, 200 bps and 300 bps is estimated.

For measuring the sensitivity of an individual stock to fluctuations in the market index, the ―market model‖ is used. It consists of the time-series regression:

(rj − rf ) = a + b(rM − rf ) + e

Where,

rj is the return on a stock,

rf is the returns on a short-dated government bond, and

rM is the return on the equity market index.

The reason of using zero-investment portfolios or (rM − rf) as an explanatory variable on the augmented market model, instead of directly using interest rates is that the null hypothesis H0 : a= 0 is a useful specification test

Operational Risk

Operational Risk

Operational risk presents the risk of losses from failed systems, process, people and from events beyond the control of organization. Some firms define operational risk as ‘all risk that is not a credit risk or a market risk’. Operational risk is not clearly defined as every industry has its own particular view of operational risk based on experience and context of that industry. Operational can be defined in the following:

Financial risk that is not caused by market risk or a credit risk ( i.e., increased financing cost associated with the firm’s inability to transact quickly to cover a foreign currency exposure).

Any risk developing from breakdown an d normal operation (ex: system failure or processing mistake).

Any risk from internal source (ex: internal fraud), excluding the impact of regulatory action or a natural disaster.

Direct or indirect losses that result from ineffective or insufficient system, personnel or an external event (ex: natural disaster or political events), excluding business risk.

Types of Operational Risk:

Process risk

People risk

Technological/ system risk

Legal risk

Event Based Classification of Operations

Internal fraud

External fraud

Client

Employee

Damage of assets

System risk

Execution or delivery

Process of Operational Risk Management:

Risk identification

Risk measurement

Risk assessment

Risk mitigation

Risk Mitigation:

Basic indicator approach

The standardised risk

Advanced measurement approach (AMA)

BASEL II VS BASEL III Approach in risk management

Evolution of reform

Basel I

•In effect since 1988

• Very simple in application

• Easy to achieve significant capital

reduction with little or no risk transfer

Overly simple rules were subject to

"regulatory arbitrage" and poor risk

management

Basel II

• In effect since 2004

• More risk sensitive

• Treats both exposures and banks very

unequally

Profoundly altered bank behaviour

but contained "gaps" that banks

exploited

Basel III

• Fully implemented only in 2023

• Addresses perceived shortcomings of

Basel II

• Greatest impact on trading book, bank

liquidity and bank leverage

Will increase capital charges

materially and make certain banking

activities much more capital

intensive

Emerging trends in Risk Management: Basel III

The paradigm shift from Basel I to Basel II was that while Basel I had a ‘one-size-fits-all’ approach, Basel II introduced risk sensitive capital regulation. The main charge against Basel II is that it is this risk sensitivity that made it blatantly pro-cyclical. In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose significant additional capital requirement on banks. On the other hand, in stressed times, when banks require additional capital and market are wary of supplying that capital, Basel II requires banks to bring in more of it. It was the failure to bring in capital when under pressure that forced major banks into a vicious cycle of deleveraging, thereby hurting global financial markets into seizure and economies around the world into recession.

BASEL II meet capital regulation more risk sensitive, but it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics. The market risk models failed, in particular, to factor in the risk from complex derivative products that were coming on to the market in a big way. These models demanded less capital against trading book exposures on the premise that trading book exposure readily sold and positions rapidly unwound. These gave a perverse incentive for banks to park banking book exposures in trading book to optimise capital. Much of the toxic acids & their securitised derivatives which were the epicentre of the crisis were parked in the trading book. Hence, though BASEL II was supposedly risk sensitive it fails to promote modelling frameworks for accurate measurement of risk and to demand sufficient loss absorbing capital to mitigate that risk.

Also, BASEL II did not have any explicit regulation governing leverage. It assumed that its risk based capital requirement would automatically mitigate the risk of excessive leverage. This assumption, as it turned out, was flawed as excessive leverage of banks was one of the prime causes of the crisis. Similarly, BASEL II did not explicitly cover liquidity risk. Since liquidity risk, if left unaddressed, could cascade in to a solvency risk, this prove to be undoing of virtually every bank that came under stress in the depth of the crisis

Finally, BASEL II focused exclusively on individual financial institutions, ignoring systemic risk arising from interconnectedness across institution which finally resulted in to the ferocious spreading of the crisis across financial markets.

BASEL III represents and efforts to fix the gaps and lacunae in BASEL II that came to light during the crisis as also to reflect other lessons of the crisis. BASEL III is not a negation but and enhancement of BASEL II. The enhancements of BASEL III over BASEL II come primarily in four areas:

Augmentation in the level and quality of capital

Introduction of liquidity standards

Modification in Provisioning norms

Better and more comprehensive disclosures

Higher Capital Requirement

Basel III requires higher and better quality capital. The minimum total capital remains unchanged at 8% of risk weighted assets (RWA). However, Basel III introduces a capital conservative buffer of 2.5% of RWA over and above the minimum capital requirement, raising the total capital requirement to 10.5 % against 8% under Basel II. This buffer is intended to adsorb losses without breaching the minimum capital requirements, and is able to carry on business even in downturn without deleveraging. This buffer is not part of the regulatory minimum but determines the dividend distributed to shareholders and bonus paid to staff.

There are also other prescriptions regarding the quality of capital within the minimum total so that capital is able to absorb losses. Basel III also introduces the countercyclical capital buffer in the range of 0-2.5 % of RWA which could be imposed on banks during periods of excess credit growth. Also, there is a provision for higher capital surcharge on systematically important banks.

To mitigate the risk of banks building up excess leverage as happened under Basel II, Basel III institutes a leverage ratio as a backdrop to the risk based capital requirement. The Basel Committee is contemplating a minimum Tier 1 leverage ratio of 3 % which will eventually become pillar 1 requirement as on January, 2018.

Basel II failed to demand adequate loss absorbing capital to cover market risk, hence Basel III strengthens the counterparty credit risk framework in market risk instruments. This includes the use of stressed input parameters to determine the capital requirement for counterparty credit default risk. Also, there is a new capital requirement known as CVA ( credit valuation adjustment) risk capital charge for OTC derivatives to protect banks against the risk of decline in the credit quality of the counterparty.

Table: Capital Requirements under Basel II and Basel III

As percentage of risk weighted assets

Basel II

Basel III (as on January 1, 2019)

A=(B+D)

Minimum Total Capital

8.0

8.0

B

Minimum Tier 1 capital

4.0

6.0

C

Of which:

Minimum Common Equity Tier 1 Capital

2.0*

4.5

D

Maximum Tier 2 Capital (within Total capital)

4.0

2.0

E

Capital Conservation Buffer (CCB)

-

2.5

F= C+E

Minimum Common Equity Tier 1 Capital +CCB

2.0

7.0

G= A+E

Minimum Total capital + CCB

8.0

10.5

Liquidity Standards

To mitigate liquidity risk, Basel III addresses both potential short term liquidity stress and longer term structural liquidity mismatches in in banks’ balance sheets. To cover short term liquidity stress, banks will be required to maintain sufficient high-quality unencumbered liquid assets to withstand any stressed funding scenario over a 30-day horizon as measured by the liquidity coverage ratio (LCR). To mitigate liquidity mismatches in the longer term, banks will be mandated to maintain a net stable funding ratio (NSFR). The NSFR mandates a minimum amount of stable funding sources of funding relative to the liquidity profile of the asset, as well as the potential for contingent liquidity needs arising from off-balance sheet commitments over a one year horizon.

Table: Liquidity Standards

Ratio

Basel II

Basel III

Liquidity Coverage Ratio (LCR)

(to be introduced as on

January 1, 2015)

?

Stock of high-quality liquid assets ≥ 100%

Total net cash outflows over next 30 calendar days

Net Stable Funding Ratio (NSFR)

(to be introduced as on

January 1, 2018)

?

Available amount of stable funding > 100%

Required amount of Stable funding

Provisioning Norms

The Basel Committee is supporting the proposal for adoption of an ‘expected loss’ based measure of provisioning which captures actual losses more transparently and is also less procyclical than the current ‘incurred loss’ approach. The expected loss approach for provisioning will make financial reporting more useful for all stakeholders, including regulators and supervisors.

Table : Additional (On top of internal accruals) Common Equity Requirements of Indian Banks Under Basel III (INR billion)

Public Sector Banks

Private Sector Banks

Total

A

Additional Equity Capital requirements under Basel III

1400-1500

200-250

1600-1750

B

Additional Equity Capital Requirements under Basel II

650-700

20-25

70-725

C

Net Equity Capital Requirements under Basel III (A-B)

750-800

180-225

930-1025

D

Of additional Equity Capital Requirements under Basel III for Public Sector Banks (A)

Government Share

(if present shareholding pattern is maintained)

880-910

Government Share

(if shareholding pattern brought down to 51%)

660-690

Market Share

(if the Govt. shareholding pattern is maintained at present level)

520-590

Risk Management Scenario in the Future

Risk management activities will be more pronounced in future banking because of liberalization, deregulation and global integration of financial markets. This would be adding depth and dimension to the banking risks. As the risks are correlated, exposure to one risk may lead to another risk, therefore management of risks in a proactive, efficient & integrated manner will be the strength of the successful banks. The standardized approach would be implemented by 31st March 2007, and the forward-looking banks would be in the process of placing their MIS for the collection of data required for the calculation of Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The banks are expected to have at a minimum PD data for five years and LGD and EAD data for seven years.

Presently most Indian banks do not possess the data required for the calculation of their LGDs. Also the personnel skills, the IT infrastructure and MIS at the banks need to be upgraded substantially if the banks want to migrate to the IRB Approach.

http://www.coolavenues.com/sites/default/files/aashika_1.jpg

Fig: Strategic Continuum of risk Scoring Models

SBI

BOB

PNB

2011

2012

2011

2012

2011

2012

tier 1 capital

8509000

10772100

2140476

2671248

2094692

2697494

tier 2 capital

4330200

4,354,500

950415

933137

967226

929458

total capital

12839200

15126600

3090891

3604385

3061918

3626952

tier 1 capital ratio

7.67

8.93

8.82

9.57

8.37

8.72

tier 2 capital ratio

3.9

3.61

3.91

3.34

3.86

3.01

total capital ratio

11.57

12.54

12.73

12.91

12.23

11.73

Risk Weighted Asset

110969749.4

120626794.3

24280369

27919326

25036124

30920307

Total Capital Required

9987277.442

10856411.48

2185233

2512739

2253251

2782828

Capital Requirement for Credit Risk

Portfolio Subject to Standardised Approach in respect of Credit Risk

97194566.67

104731211.1

20440247

24235307

21662633

26704267

Securitization exposure (RWA)

0

0

0

652

0

0

Total RWAs in Credit Risk

97194566.67

104731211.1

20440247

24235959

21662633

26704267

Minimum Capital Requirement for Credit Risk @9% of RWA

8747511

9425809

1839622

2181236

1949637

2403384

Capital Requirement for Market Risk

Interest Rate

3311633.333

3704177.778

701902

763324

718022.2

1095289

Forex

118455.5556

108655.5556

22500

22500

20000

20000

Equity

1927622.222

1918144.444

1677122

1070626

531966.7

603088.9

Total RWA in respe ct of Market Risk

5357711.111

5730977.778

2401524

1856450

1269989

1718378

Minimum Capital Requirement for Market Risk @9% of the RWAs

482194

515788

216137.2

167080.5

114299

154654

Capital Requirement for Operational Risk

Basic Indicator Approach

8671355.556

10490966.67

1439644

1820300

2097111

2504489

Minimum Capital Requirement for Operational Risk @9% of the RWAs

780422

944187

129568

163827

188740

225404

Total RWA, Capital & CRAR

Total RWA in respect of Credit, Market & Operational Risk

111223633.3

120953155.6

24281415

27912709

25029733

30927133

Minimum Capital Requirement for Credit, Market & Operational Risk @ 9% of RWAs

10010127

10885784

2185327

2512144

2252676

2783442

ICICI

AXIS

HDFC

2011

2012

2011

2012

2011

2012

tier 1 capital

4643500

5263900

1848680

2190664

2625261

3112205

tier 2 capital

2157400

2375200

626675

975572

1167094

1553627

total capital

6800900

7639100

2475355

3166236

3792355

4665832

tier 1 capital ratio

13.36

12.78

8.48

8.99

11.44

11.37

tier 2 capital ratio

6.21

5.76

2.87

4.00

5.09

5.67

total capital ratio

19.57

18.54

11.35

12.99

16.53

17.04

Risk Weighted Asset

34751660.7

41203344

21809295

24374411

22255604

28226449

Total Capital Required

3127649.46

3708301

1962837

2193697

2003004

2540380

Capital Requirement for Credit Risk

Portfolio Subject to Standardised Approach in respect of Credit Risk

31506666.7

37041111

18582522

20446133

19208056

23183544

Securitization exposure (RWA)

90000

48888.89

0

0

998188.9

1115733

Total RWAs in Credit Risk

31596666.7

37090000

18582522

20446133

20206244

24299278

Minimum Capital Requirement for Credit Risk @9% of RWA

2843700

3338100

1672427

1840152

1818562

2186935

Capital Requirement for Market Risk

Interest Rate

2197777.78

2118889

1625778

1968144

587644.4

492888.9

Forex

60000

60000

30066.67

30066.67

30000

30000

Equity

356666.667

520000

146633.3

128577.8

44133.33

88844.44

Total RWA in respe ct of Market Risk

2614444.44

2698889

1802478

2126789

661777.8

611733.3

Minimum Capital Requirement for Market Risk @9% of the RWAs

235300

242900

162223

191411

59560

55056

Capital Requirement for Operational Risk

Basic Indicator Approach

2484444.44

2698889

1432533

1805811

2075133

2465189

Minimum Capital Requirement for Operational Risk @9% of the RWAs

223600

242900

128928

162523

186762

221867

Total RWA, Capital & CRAR

Total RWA in respect of Credit, Market & Operational Risk

36695555.6

42487778

21817533

24378733

22943156

27376200

Minimum Capital Requirement for Credit, Market & Operational Risk @ 9% of RWAs

3302600

3823900

1963578

2194086

2064884

2463858