Banking

and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Value at Risk (VAR)

Value at Risk is a statistical method to quantify the level of financial risk (i.e., the maximum potential
loss) associated with any financial asset over a specified time frame. It is built around the
fundamental concepts in statistics of normal distribution and standard deviation.
There are three methods to compute Value at Risk.
1. The Monte Carlo simulations (Based on hypothetical historic data)
2. The parametric model (which does not require data)
3. Historical Simulation (also refers to as non-parametrical model which is based entirely on
historic data)
The most commonly used VaR model is Historic Simulation.
Based on historic data and the day-to-day variation in that data, say for the last one year, the
average price (mean ) as well as the standard deviation () for the same one year period are
computed.

The daily volatility would be based on standard error as

Where n is the number of days/weeks/fortnight considered for the computation

At 95% confidence level:
The maximum value would be = + 2
The minimum value would be = 2
At 99% confidence level:
The maximum value would be = + 3
The minimum value would be = 3
This method is extensively used by financial institution to value their portfolio of loans and
investment, to determine the maximum likely loss in the event prices, interest rates and exchange
rates vary by 3 (+ or -) for each asset.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Shortcomings of VaR:
1. The assumption of normality in the movements of prices, interest rate and exchange rate in
the market.
2. During times of extreme volatility, the Value at Risk model could fall terribly short when
estimating potential losses, because of the normality assumption.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

BASEL II Guidelines for Capital Adequacy

Under Basel I guidelines, Capital Adequacy Ratio was defined as:

Capital
Adequacy Ra8o
(CAR)

Banks Capital
Risk Weighted Assets

The numerator term in the above equation Capital is classified as:

Tier I Capital

Tier II Capital

Equity Capital
Other Forms of
Perpetual Capital

Long Term Debt

Specic Categories of
Reserves
Provisions for Loan Losses

The denominator term Risk Weighted Assets involves assigning risk weights to the various
categories of assets on a scale of 0 to 100%:

G-Sec / T-Bonds

Risk
Weight
0%

Unsecured Loans

Risk
Weight

100%

Mortgage Loans

Risk
Weight

50%

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Basel II came into being almost ten years after Basel I guidelines were implemented with a view to
enhance the flexibility and accuracy of computing Capital Adequacy

Basel-II rests on three pillars:

BASEL II

NEW BASEL CAPITAL ACCORD

PILLAR I

PILLAR II

PILLAR III

Minimum
Capital
Requirements

Supervisory
Review
Process

Market
Discipline and
Disclosure

Strengthening and Safeguarding Financial System

1. Pillar 1: Minimum Capital Requirements
a. When computing capital adequacy, Basel II aligns the minimum capital requirements
more closely to the banks actual underlying risks.
b. Capital charge for operational risk has also been mandated under Pillar-1
2. Pillar 2: Supervisory Review Process
a. Pillar -2 mandates that the Board of Directors and the management team of every bank
will have primary responsibility to ensure that the bank has adequate capital
commensurate with its risk profile.
b. It capture risks such as liquidity risk, reputation risk, etc.
c. It covers the Business cycle effects, which represent factors external to the bank
3. Pillar 3: Market Discipline
a. It supplements regulation in as much as monitoring of the banks and financial
institutions is not merely carried out by the regulators, but equally by the financial
markets and stakeholders in the bank.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Basel II guidelines are admittedly more sophisticated than Basel-I guidelines, because the one-sizefits-all idea that prevailed in Basel-I has been abandoned. Pillar-1 (Minimum capital requirements)
under Basel-II addresses this by providing three distinct approaches for credit and operational risk,
thereby offering a high degree of flexibility, at the same time, maintaining standardization.

Approaches to Credit Risk:

1. Standardized Approach: Capital allocation to be governed by risk weights based on the nature of
the risk and external credit assessments by accredited credit rating agencies
2. Internal Ratings Based (IRB) Approach: Capital adequacy computation is based on estimating:
a. Probability of default (PD)
b. Loss given default (LGD)
c. Exposure at default (EAD)
d. Maturity (M)
3. In Foundation Internal Ratings Based (FIRB) Approach, Bank provides only the PD, and the
Banking Regulator in the country provides the rest.

4. In Advanced Internal Ratings Based (AIRB) Approach, the bank is required to provide all the
above parameters, to be approved by the Banking Regulator prior to implementation.

Approaches to Operational Risk:

1. Basic Indicator Approach (BIA): A single indicator, say percentage of gross profit, to be used as
the basis for allocating operational risk capital, as specified by the Banking Regulator.
2. Standard Approach (SA): This approach uses a combination of indicators for each line of
business as the basis for allocating operational risk capital, as specified by the Banking Regulator.
3. Advanced Measurement Approach: This approach is based on clearly defining the lines of
business and defining the potential loss events in each line of business. For every such
combination based on internal data, determine:
a. Exposure indicator (EI)
b. Probability of that loss event (PE)
c. Likely loss given that event (LGE)
Expected loss will be computed as EI*PE*LGE and capital allocation for operational risk will
be made accordingly.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

BASEL III Guidelines for Capital Adequacy

The global financial crisis of 2008 unearthed several facets that could not be safeguarded under the
Basel II guidelines. These include the following:
1. Credit intermediation outside the traditional banking system (shadow banking channels)
2. Shadow banking channels, however, depend on the traditional (regulated) banking channels to
fulfill their payment and settlement obligations
3. The systemic risk further compounded by the exponential growth in structured financial
instruments such as collateralized debt obligations and credit default swap in the years
immediately preceding the 2008 crisis.
4. Massive mark-to-market losses in the financial markets and consequent settlement defaults
and a liquidity crisis that eventually devolved on the traditional banking system.
Therefore, Basel III was conceived as an attempt to cope better with such unforeseen eventualities.

Highlights of Basel III guidelines
The Basel Committee on Banking Supervision announced the following changes under Basel III
guidelines in 2009, with implementation commencing from 2013:

Component

BASEL II

BASEL III

Tier I Capital Ra5o

4%

6%

Core Tier I Capital (Equity Stock)

2%

4.5%

Tier II Capital

4%

2%

Capital Conserva5on Buer (CoB)

NA

2.5%

Counter Cyclical Buer (CyB)

NA

0% - 2.5%

Remains 0% un5l 2016

go up to 0.625% (by Jan 2016)

1.25% (by Jan 2017)
1.875% (by Jan 2018)
2.5% (by Jan 2019)

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Perceived downside of Basel III

1. Maintaining higher capital as required under Basel III is the responsibility of only the
regulated banks in that country.

2. Entities in the shadow banking system such as hedge funds and CDOs are not governed by
the Basel III guidelines or by any other norms of capital adequacy.

3. In view of the above, moral hazard in the form of regulatory arbitrage by the shadow
banking system is bound to aggravate

4. Regulated banks are likely to find their cost of capital going up significantly under Basel III. As
a result, lending rates by Banks are also likely to go up.

5. The Too-Big-To-Fail Syndrome would aggravate and Governments will be called upon to
bail out such banks.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Regulatory Framework for Banks

World over the banking industry is highly regulated, for a variety of reasons as shown below:
Bank

Banking Industry is Highly Regulated Because

Hold a
major
por:on of
public
savings

Intermediate
funds
between
savers and
borrowers

Hold a large
part of the
money supply
channel for
implemen.ng
monetary policy
in the country

The biggest
par:cipants in
the payment &
se4lement
system (both
domes:c &
interna:onal
transac:ons)

Problems in the
banking sector in
any country
could rapidly
impact the en:re
nancial system
and have a
contagion eect

Specific laws enacted by the parliamentary or equivalent system in every country govern the
regulatory framework in that country.

Specific roles of a Central Bank in any country include:

Central
Bank

Specic Roles of a Central Bank

q
q
q
q

Serve as Bankers to the Government

Currency Issuing Func>on
'Lender of Last Resort'
Develop the Overall Financial System of
the Country
Helping to Set Up Ins>tu>ons and
Fund Specic Sectors of the Economy:
Agriculture, Rural Development,
Exports & Imports, Housing, etc.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Central Banks are also responsible for creating a stable and consistent monetary policy environment
as shown in the diagram below:
Bank

Stable and Consistent Monetary Policy Environment:

Control the price levels

in the economy by
carefully monitoring
and targe3ng expected
ina3on in the country

Help maintain the value

of the domes4c currency
vis--vis other foreign
currencies ensure
exchange rate stability

Ensure a sound and

healthy banking system
through liquidity and
capital adequacy
measures

Central Banks in all countries also have a supervisory role that involves:

Financial supervision of the banks in their jurisdiction including onsite verification

(inspection) and offsite surveillance

Monitoring the banks under their charge, based on reports submitted by the banks in
pre-specified formats at pre-specified periodicity.

The supervisory framework pursued in most countries is the CARMELS framework:

Supervisory Framework:
Capital Adequacy
C
Asset Quality
A
Risk Management
R
M Quality Of Management Personnel
Earnings Quality
E
L
Liquidity Management

Systems & Processes

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Monetary Policy
In all well run economies, Monetary Policy is vested with the Monetary Authority (usually the
Central Bank) in the country and comprises effective management of the following:
1. Price Stability (i.e. effective control on expected inflation)
2. Interest Rate Stability
3. Currency Stability (i.e. stability in foreign exchange rates)
4. Overall Stability of the financial markets
5. Economic Growth
6. Employment

Monetary policy formulation most often involves managing the conflicts among these goals.

Tools to administer
Monetary Policy includes:
Change in the Reserve
Requirements
Open Market
Opera:ons
Aiming at Targets
rather than Goals

Such as Cash Reserve and in some countries the

Statutory Liquidity Reserve
Transac:ons specically undertaken by the Central Bank
to either reduce or expand money supply in the economy
Almost precise, :mely, exible and can be reversed or
changed easily
Opera:ng targets
Intermediate targets

Most Central Banks use inflation as the target for monetary policy and effectively use other
resources at their command such as money supply, cash reserves, interest rates etc. to achieve the
monetary policy goals.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

10

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

Degree of Independence of Central Banks

Independence of Central Bank is fundamental to a well-functioning economy. An independent
Central Bank, i.e. one that is insulated from political pressures, is more likely to work on long term
objectives like price stability, stable exchange rates, etc.
An independent Central Bank can better resist the excessive borrowings by the government and
consequently hold the real interest rates in check.
An independent Central bank can caution the government on inflationary pressures arising from
mismatches in the demand and supply of goods and services in the country as well as control money
supply to contain inflation.
The case against an independent Central Bank also revolves around some equally forceful
arguments:

Too much independence and the resulting (possible) lack of accountability could make the
Central Bank extraordinarily powerful in any economy.

It is imperative that the Central Banks and the federal government of the country work in a
synchronized manner because if the two sides are not in agreement, the countrys economy
would inevitably falter!

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

11

Banking and Financial Markets: A Risk Management Perspective

Prof. PC Narayan
Summary for Week Six

STRESS TEST
Stress tests focus on the impact of credit risk, liquidity risk, market risk, etc. in adverse situations,
both at the bank level and at the systemic level.
Stress test is designed to assess:
(a) The impact of adverse Marco-economic as well as institution specific scenarios on the capital
adequacy and solvency of the institution and/or the financial system as a whole and
(b) The extent of capital cushion available to withstand such an adverse impact.
Stress tests involves laying down a set of adverse scenarios against which the banks and/or the
financial systems resilience is measured.
Stress tests acquired enormous significance subsequent to the 2008 financial crisis resulting in new
Laws that required Banks to mandatorily undertake stress test periodically and report the results of
such stress tests. In the context of the United States, these include:
o

The Dodd-Frank Act (2010)

Standardized documentation such as the Comprehensive Capital Analysis and Review

(CCAR)

The Supervisory Capital Assessment Program (SCAP)

Specific Stress Tests that are undertaken by the Banking Regulator to determine the ability of any
countrys financial system to withstand macro-economic shocks is referred to as Macro-prudential
Analysis.
Stress Test is as much as Art and it is a Science because such tests are entirely dependent on the
scenario envisaged for the Stress Test.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the course
FC201.2x titled Banking and Financial Markets: A Risk Management Perspective delivered in the online course format by IIM Bangalore. All rights
reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the Indian Institute of Management Bangalore (fc201.support@iimb.ernet.in)

12