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Basel II
International Convergence of Capital
internationally active and competitive unless they comply with these standards Is complex and will take time to achieve Yes, the OECD countries will be initial beneficiaries
risk
Capital is needed to deal with losses
when revenue from asset shrinks capital
Risk
Transaction Risk Exchange Risk Economic Risk Political Risk Strategic Risk Reputational Risk These are subsidiary risks that impact/ are subset of primary risk groups Mentioned above
Types of Loss
Expected Loss Unexpected Loss
acceptable manner, subject to regulatory review, EL should receive same consideration as UL.
include loan capital: capital issues the terms of issue of which are such that it behaves exactly like equity, giving preference to depositor money: subordinated debt
so, lower is the profitability The lower it is, the higher is profitability but higher is the risk This adds to the drive toward non-capital consuming (fee) income opportunities
Return on Capital
Shareholders seek return on capital Enhancing return requires greater interest
income: which itself requires greater capital You need to find sources which consume less capital Or reduce the capital you need for your current activities
RISK MANAGEMENT
RISK TYPES
RISK EVENT WITHIN THE TYPE
EXPECTED LOSSES
NOT FACTORED
UNEXPECTED LOSS
Total of risk weighted assets (as against total assets of Rs. 300)
quality of a borrower So capital weight for a good borrower is same as for a bad borrower Which implies unexpected losses would be the same Does not take into account other events that cause loss: market risk, operations risk
A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:
Operational Operational Risk Risk The operational risk element of the denominator is the operational risk requirement which can be calculated using either the Basic Indicator, the Standardised of Advanced Measurement Approaches
Risk Sensitivity
Started with regulators Regulations have deeper economic and
fundamental reasons Awareness amongst banks that profits must be regarded in a risk reward context
Risk Management
Identify analyse and manage risks Eliminate risks you do not like Identify risks you are going to take Determine components of risk Monitor the risk you are taking-thru compo Ensure you earn in proportion to the risk
you run
RBIs stipulations
Judicious mix of both sides Provides adequate wider framework Does not use the BCBS framework out of
context, in fact sets the tone on a wider context Is getting banks to move on both sides Moving on both sides of the piece is essential for truly meeting international standards Quality of regulatory environment is recognised under Basel II as one of the
Establishes minimum
Capital
The new capital accord will place greater reliance on internal modeling, used by all world class banks to calculate economic capital.
Methodologies
Standard Approach If a bank was to do nothing but start on Basel II Cannot meet statistically demanding reqmts Foundation / Basic Approach
Some of the issues can be addressed
Advanced approach Internal processes are refined / defined Data availability BCBS criteria are fully met
Business Structure
RBI Stipulations
Basic method But in preparation is asking banks to
address all business issues that will enable the banks to go for advanced approach That is indeed the role of the regulator
Credit Risk
There is adequate experience in India,
perhaps more than most countries The emphasis is on reorganising the business Putting a structure to credit processes Adopt rating methodologies Work out capital allocation based on rating: external or internal
Internal Internal Ratings Ratings Based Based Approach Approach Advanced Advanced PD, LGD, EAD and Maturity (M)are measured internally. This varies slightly between categories of exposures.
Internal Internal Ratings Ratings Based Based Approach Approach Foundation Foundation Depending on the exposure category, PD is measured internally LGD and EAD are provided by the banking regulator
Considerations
Risk Weight Credit Risk Mitigants
Collateral taken reduces the exposure What is acceptable collateral
Exposure Adjustments
Drawn, undrawn Committed, uncommitted
Risk Weights for Corporate, sovereign, bank and Retail exposures under revised Standardized Approach
Risk weightings by credit assessment Risk weightings by credit assessment Claims on Sovereign Banks Corporates Retail Residential mortgage Commercial mortgage Past due loans with specific provisions: Less than 20% More than 20% More than 50% 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2 150% 100% 100%/50%2
1
Credit assessment AAA to AA0% 20% 20% N.A. N.A. N.A. A+ to A20% 50% 50% N.A. N.A. N.A. BBB+ to BBB50% 50% 100% N.A. N.A. N.A. BB+ to B100% 100% 100% N.A. N.A. N.A. Below B150% 150% 150% N.A. N.A. N.A. Unrated 100% 50% 100% 75% 35% 100%
90 days or more past due (applies only to unsecured exposure net of provisions) Can be reduced to 50% at national discretion
Basel IIs revised risk weightings under the standardized approach demonstrate a greater degree of risk sensitivity than Basel I
Note: For additional details please refer to Part . or page of the consultative document The New Basel Capital Accord
categories
Corporate Sovereign Bank Retail Equity
Exposures
Disclosure Requirements
Retail exposures
For Retail exposures, there is only one type of IRB
segments or pools and the risk components are then determined for each pool rather than for each exposure.
Retail exposures
Exposure
Borrower Characteristic
Facility Characteristic
Rating
PD
LGD
Internally measured The bank must estimate an LGD for each internal risk segment For retail products with uncertain future exposures, e.g. credit cards, the history and or expectation of additional drawings prior to default must be taken into consideration when calibrating loss estimates
EAD
Internally measured The bank must estimate EAD for each transaction For on balance sheet items, EAD must be estimated at no less than the current drawn amount
Non-retail exposures
For non-retail exposures there are two
borrower grade A grade is defined as an assessment of borrower risk on the basis of a specified and distinct set of rating criteria There must be at least six different grades for good loans and at least one grade for defaulted loans Exposures are then assigned to a borrower grade There must be a meaningful distribution across the borrower grades
Definition
The possibility of loss to a bank caused
Trading category Securities included under the Available for Sale category Open gold position limits Open foreign exchange position limits Trading positions in derivatives, and Derivatives entered into for hedging trading book exposures.
Market Risk
Put briefly
Just as you need to set aside capital for loss
due to NPAs You are asked to set aside capital for losses due to change in value of your investment book
How determine probability of loss in
investment book?
what period will I be able to reprice my balance sheet to meet todays cost structure All deposits must expire, renew at new rates All advances must expire, renew, new rates When will this happen? Over a prd of time The average of that period of time= duration
Investment Risk/VAR
Value of the investment portfolio that is
exposed due to possible changes in mkt rate Probability that mkt rates will change Impact of that on the portfolio value=VAR Over what time period What percent confidence interval
Modified duration is used to arrive at the price sensitivity of an interest rate related instrument. For all the securities listed below, date of reporting is taken as 31/3/2003. (Rs. in crore) Party Maturity dt Govt. 01/03/2004 Govt. 01/05/2003 Govt. 31/05/2003 Govt. 01/03/2015 Govt. 01/03/2010 Govt. 01/03/2009 Govt. 01/03/2005 Banks 01/03/2004 Banks 01/05/2003 Banks 31/05/2003 Banks 01/03/2006 Banks 01/03/2007 Others 01/03/2004 Others 01/05/2003 Others 31/05/2003 Total Val 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 1500 Coup Charge 12.50 0.84 12.00 0.08 12.00 0.16 12.50 3.63 11.50 2.79 11.00 2.75 10.50 1.35 12.50 0.84 12.00 0.08 12.00 0.16 12.50 1.77 11.50 2.29 12.50 0.84 12.00 0.08 12.00 0.16 Rs 17.82 equals Rs 198 crores in val
A bank will determine the proportion of its capital that it must keep in reserve based on this calculation:
Operational Operational Risk Risk The operational risk element of the denominator is the operational risk requirement which can be calculated using either the Basic Indicator, the Standardised of Advanced Measurement Approaches
Operational Risk
Defined
the risk of loss
resulting from inadequate or failed Internal processes, people systems or Resulting from external events.
Broad categories
Internal fraud. For example, intentional
misreporting of positions, employee theft, and insider trading on an employees own account. External fraud. For example, robbery, forgery, cheque kiting, and damage from computer hacking. Employment practices and workplace safety. For example, workers compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims, and general liability. Clients, products and business practices . For example, fiduciary breaches, misuse of confidential customer information, improper trading activities on the banks account, money laundering, and sale of unauthorised products.
Damage to physical assets. For example, terrorism, vandalism, earthquakes, fires and floods. Business disruption and system
failures.
management.
management failures, incomplete legal documentation, and unauthorized access given to client accounts, non-client counterparty misperformance, and vendor disputes.
Risk enhancers
Highly Automated Technology - transforms risks from
manual processing errors to system failure risks Emergence of E- Commerce internal and external fraud and system securities issues) Emergence of banks as large volume service providers creates the need for continual maintenance of highgrade internal controls and back-up systems. Outsourcing Large-scale acquisitions, mergers, de-mergers and consolidations test the viability of new or newly integrated systems. Banks may engage in risk mitigation techniques (e.g. collateral, derivates, netting arrangements and asset securitisations) to optimise their exposure to market risk and credit risk, but which in turn may produce other forms of risk (eg. legal risk). Fee products are typically transaction / ops risk intensive
responsibilities for Operational Risk Policy requirements and strategic approach Identification and Assessment of Operational Risk Monitoring of Operational Risk Controls / Mitigation of Operational Risk Independent evaluation of Operational Risk Management
Business Structure
Organisation reqmts
Board of Directors Risk Management Committee of the Board ORM Committee ORM Department Operational Risk Managers Support Group for operational risk
management
Business Structure
Capital requirements
measurement issue
Basic approach Standardised Advanced
Basel requirements
RBIs document essentially follows Basels
recommendations for following the Advanced approach But on the capital side, follows the Basic approach
Clear signal of intent of the regulator to