Basel Capital Accord

& Risk Management

- A perspective

B. Banerji
DGM,BTC,
RBI, Mumbai
Capital Regulation
Role of capital
 Cost of capital and ROE
 Depositor confidence
 Expected and unexpected loss
 Regulatory, accounting and economic
capital
Banking and infinite leverage
Controversy about focus of regulation

8-Apr-19 2
Capital Regulation – Basel Accord
Basle Committee on Capital:
 “The purpose of bank supervision is to
ensure that banks operate in a safe and
sound manner and that they hold capital
and reserves sufficient to support the risks
that arise in business.”
Enlargement of focus from depositor
protection to financial stability
How meaningful are capital standards? Loan
Loss Provisioning and other issues.

8-Apr-19 3
What Are Core Principles:1
Set of 25 Principles
Set of supervisory principles/guidelines aimed
at providing a general framework for EBS.
Provides a Benchmark against which the
Effectiveness of Banking Supervisory
Regimes can be Assessed
Objective-Strengthening Supervisory
Standards in emerging and developed
Countries

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Seven Major Categories
1. Objectives, autonomy, powers, and
resources (CP 1)
2. Licensing and structure (CPs 2-5)
3. Prudential regulations and requirements
(CPs 6-15)
4. Methods of ongoing supervision (CPs 16-
20)
5. Information requirements (CP 21)
6. Formal powers of supervisors (CP 22)
7. Cross-border banking (CPs 23-25)
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Scope of Application
Internationally Active Banks, Significant
Banks
Full consolidation, sub-consolidation
All financial activities to be consolidated
except Insurance
Why Insurance is different from banking
and securities.

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 The New Basel Capital Accord
– 16 January 2001

Structure of the accord-

First Pillar - Minimum Capital

Requirements

Second Pillar- Supervisory Review Process

Third Pillar - Market Discipline

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The New Basel Capital Accord
– 16 January 2001

Computation of Capital requirements

Total Capital (unchanged) = Minimum 8%

Credit Risk + Market Risk + Operational Risk

India - 9%.

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An illustration

Assume that RWA= 2000

Market Risk Capital Charge= 30
Operational Risk Capital charge= 50
Total Capital = 240
Capital adequacy Ratio =
240 / 2000 + (30 +50) x 12.5
= 240/ 3000
= 8%
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Capital for credit, market and operational
risk- Different approaches
Credit Risk Market Risk Operational Risk
Standardised Standardised Basic Indicator
Approach Approach Approach
Foundation Internal Standardised
IRB Approach Models Approach
Approach
Advanced - Advanced
IRB Approach Measurement
Approach

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Evolutionary Approach to Capital for Credit Risk

Credit Risk
Modelling
– Owner/
IRB Vendor
Advanced Models
Approach

Standardized
Approach (Correlation
Foundation
Effects)
Approach

NOT Accepted
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Currently
The First Pillar
Approaches to measurement of credit risk
 Standardized approach

 Goal: aggregate regulatory capital inclusive of

operational risk to remain unchanged
 Internal ratings based (IRB) approach

 Foundation
 Advanced
 Goal: Should contain incentives for migration from
standardized to IRB approach

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Pillar I - Credit Risk
Issues
 Dependence on rating agencies: low
penetration, poor track record, lagging
indicators, unsolicited ratings and rating
blackmail, rating horizon, issuer versus
issues assessment
 Methodology issues, transparency,
mapping of rating by supervisors -
supervision and validation

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Pillar I - Credit Risk
IRB ( Internal Ratings Based) Systems
(Process)
 Categorise all risk exposures into 1 of 6
categories viz. Corporate, retail, bank,
sovereign, project finance and equity
 Derive risk weight for each category from a
specific, continuous function depending on
Probability of Default and Loss Given
Default and adjusted for maturity,
granularity and CRMT.
 Incentives in IRB

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Pillar II
Capital is not a substitute for Risk
Management Systems or Internal
Control. Supervisory review covers
these processes.
Principles:
 (I) Banks should have (a) process for
assessing Capital with respect to Risk
Profile and (ii) strategy for maintaining
capital level.
 (II) Supervisors should review these and
take action if they are not satisfied
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Pillar II
Principles:
 (III) Supervisors should (a) expect banks to
operate above the minimum CAR and (b)
have the ability to require banks to hold
capital in excess of the minimum
 (IV) Supervisors should (a) intervene at an
early stage to prevent capital from falling
below required level and (b) require rapid
remedial action

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Pillar II
Issues:
 Need for guidance
 Legal ability
 Risk profiling
 Push towards Risk Based Supervision
 Interest rate risk in banking book
 Macroeconomic factors

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Pillar III
Sets out disclosure requirements and
recommendations (core and
supplementary)
Required disclosures on scope of
application, capital, risk exposures, risk
assessment (credit risk, CRM
techniques, market risk, Operational
risk etc) and hence the capital
adequacy.

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Pillar III
Basis for recommended disclosure
should be materiality
Frequency of disclosure
 Semi-annually, (but on broader issues like
risk management it could be annual and
quarterly in cases of information subject to
rapid change.)
Volume of disclosure: based on
comments, likely to be significant
reduction

8-Apr-19 20
The story of Risk
The revolutionary idea that defines the
boundary between modern times and
the past is the mastery of risk: the
notion that the future is more than a
whim of the gods and that men and
women are not passive before nature.

Peter Bernstein

8-Apr-19 21
The story of risk
If everything is a matter of luck, risk
management is a meaningless exercise. Invoking
luck obscures truth, because it separates an
event from its cause.

The essence of risk management lies in

maximising the areas where we have some
control over the outcome while minimising the
areas where we have absolutely no control over
the outcome and the linkage between effect and
cause is hidden from us.
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 Risk

Definition
 Hazard, danger, chance of loss or injury
 The degree of probability of loss
 Volatility of unexpected outcomes
Nature of risk
 Everywhere – A man crosses the street and
faces it

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 Risk- A contemporary Definition

Probability that the actual return may be at

variance with expected returns

A measure of Risk can be the dispersion of

outcomes due to movements in variables
which have financial implication
(- Use of Std. Deviation)

A loss/profit which is expected is therefore

not a measure of Risk, only an indication of
asset
8-Apr-19 quality 24
 Risks taken by the banks
Business Risks
Capital :Inadequacy or poor quality/composition of capital
Credit Risk : loans and advances, Investments, Off balance
sheet elements, Country Risk.
Market risk :Interest Rate Risk, Forex Risk,
Commodity/Equity Price risk
Earnings :Risk of Loss of/reduction in earnings
Liquidity Management :Liquidity and unsuitable composition
of liabilities
Strategy and Business Environment :Poor business strategies
and adverse business environment
Operational Risk :People, Processes and Technology, Legal
and Reputation:
Group
8-Apr-19Risk :From operations of Group entities 25
 Risks taken by the banks
Control Risks
Internal Control
Risks arising out of inadequacy of
controls or poor functioning of existing controls
Management
Risks arising out of management inadequacies
Organisation
Organisational weaknesses
Compliance
Non compliance with statutory and
regulatory
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provisions and Internal controls 26
 Banking Risks
Credit
Market
 Liquidity
 Interest rate
 Market
 Foreign exchange
Operational
 Solvency
 Legal
 Reputation
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What is Risk Management?
The basic components of risk management
are:
identifying and defining the risks, an
organisation is exposed to;
assessing their magnitude;
mitigating them using variety of
procedures; and
setting aside capital for potential losses.

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Expected & Unexpected
Losses
Provide for Expected Losses
P
R
O
B
Capital for unexpected Losses
A
B
I Expected Loss
L
I Economic Capital
T
Y

Loss

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 Credit Risk

Paramount – Importance of potential loss

Customers default –fail to comply with their

obligation to service debt.

Default triggers a total or partial loss of any

amount lent to the counter party

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 Credit Risk Cont..
Risk of a decline in the credit standing of a
counter party
Such deterioration does not imply default – but the
probability of default increases
Capital Market Valuation
 Higher interest rates on debt issues
 Decline in the value of shares
 Downgrade of agencies’ rating

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 Forms of Credit Risk
1. Counterparty risk
(a) External risk-External Factors-Business cycle risk
(b) Internal risk with respect to counterparty business
risk, financial risk, management risk,project risk,
Settlement Risk, Pre-settlement Risk
2. Country and Transfer Risk-Transfer risk-
Sovereign risk- Non-sovereign or political risk
Cross border risk- Currency risk -
Macroeconomic and Structural Fragility Risk
3. Portfolio Risk- credit distribution, credit
concentration/ investment concentration etc.
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COMPONENTS
BUSINESS RISK
FINANCIAL RISK
MANAGEMENT RISK
GROUP RISK

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 Putting it together - Analytical
Framework
Credit Risk

Business Financial Management Group

Risk Risk Risk Risk

Industry characteristics Level of leveraging Balance Sheet Strength

& outlook Off B/sheet items
Maturity Profile
Issuer’s competitive position Financial Flexibility
Currency exposures
Scale & Risk of new projects
Past Record
Management quality
Financial Position
Size of projects

level & variability of Op Profits level of Net Profits

key determinant of rating cap impacts liquidity position caps overall rating (?)
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BUSINESS RISK
INABILITY TO SERVICE DEBT
-DUE TO INSUFFICIENT INCOME
GENERATION
EXTERNAL ECONOMIC OR MARKET
ENVIRONMENT
IT IS MADE UP OF SYSTEMATIC RISK
AND UNSYSTEMATIC RISK

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COMPRISES OF
SALES RISK
OPERATING RISK
FINANCIAL RISK AND
INDUSTRY RISK

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MEASUREMENT OF
THE VOLATILITY OF SALES OF AN
ENTERPRISE
STUDY THE VARIATION OF ANNUAL SALES
FROM AVERAGE OR MEAN SALES FOR A
GIVEN PERIOD OF TIME
USE STANDARD DEVIATION TO MEASURE
VOLATILITY OR VARIATION IN ANNUAL
SALES
USE COEFFICIENT OF VARIATION
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USE OF
CV HELPS IN SETTING AN OUTER
LIMIT OF CV BEYOND WHICH THE
PROPOSAL IS NOT ACCEPTABLE FOR
FURTHER CONSIDERATION
BANKER CAN SET A RANGE OF CV
BORDERING THE LIMIT PROPOSED
CAN PROPOSE A BOTTOM LEVEL CV
FOR CONSIDERATION
8-Apr-19IT ENABLES COMPARISON 38
EVALUATION
STATISTICAL APPROACH BY SCATTER
DIAGRAM
68% OF THE VALUES FALL WITHIN +
OR - 1 SD FROM MEAN
95% OF VALUES FALL WITHIN + OR -
2 SD FROM MEAN
99% OF VALUES FALL WITHIN + OR -
3 SD FROM MEAN
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DETERMINE
BASED ON RISK CATEGORY
 INTEREST RATE
 MARGIN REQUIREMENT

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 Market Risk
Assessment of market risk based on the
instability of market parameters:
1. Interest rates
2. Stock exchange indexes
3. Exchange rates
Instability measured by market volatilities
coupled with sensitivities of instruments-
changes in market value can be quantified

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 Liquidity Risk

Considered a Major risk

Defined as
The potential inability of a bank to meet it’s

liabilities as they become due, with least cost.

 Stems from

Decline in liabilities or creation of additional assets

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 Liquidity Risk cont..
1. Extreme illiquidity results in bankruptcy
hence a fatal risk
 However they are outcome of other risks
 Massive withdrawal of funds
 Closing of credit lines by other institutions
2. Short term asset values are not sufficient
to match short term liabilities or
unexpected outflows

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Types of Liquidity Risks
Funding Risk
Need to replace net outflows due to unanticipated
withdrawal/ non-renewal of deposits
Time Risk
Need to compensate for non-receipt of expected
inflows of funds - NPAs
Call Risk
Due to crystallisation of contingent liabilities & needs
of new business

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 Interest Rate Risk
Risk of decline of earnings due to
movements of Interest rates
Since Interest rates are unstable so are
earnings
Lender earning at a variable rate has the risk
of seeing revenues reduced through a
decline in interest rates

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 Types of Interest Rate Risk

Gap or mismatch risk

Basis Risk
Yield curve Risk
Embedded Option Risk
Price risk
Reinvestment Risk

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Measurement of Int. Rate Risk
Maturity Gap Analysis- In this analysis
distribution of RSA and RSL into different time
buckets provide NII in various Int. rate scenario
Duration Gap Analysis – duration of a bond
for effective maturity/ weighted average life is
calculated based on PV of the cash flow.
Simulation – Computer based future scenarios
Value at Risk – estimation of potential loss over
a given holding period at a given level of certainty.

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 Foreign Exchange Risk

Currency risk is that of observing losses due

to changes in exchange rates
Variations in earnings are caused by the
indexation of revenues and charges to
exchange rates or the values of assets and
liabilities labeled in foreign currencies

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 Foreign Exchange Risk cont..

Foreign exchange risk is also a component

of market risk
An additional currency risk for all banking
or market transactions labeled in foreign
currency as earnings have to be translated
into a base currency

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Main areas where Operational
Risks are embedded

Cash management
Credit Management
Forex
Derivatives
Investment Management
New product lines
New Operational procedures
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Measuring Operational Risk
Matrix Approach
Categorising Losses according to
 Type of event
 Business line in which the event has
occurred
This will help the banks to identify
which events have most impact and
which business lines are susceptible to
operational risk
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Mitigating Operational Risk
Damages due to natural disasters, fire,
etc- INSURANCE
Losses from Disruptions – electricity/
telecom..-BACKUP
Losses due to internal reasons-STRONG
INTERNAL AUDIT PROCEDURE

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Risk Management
Architecture
i) Risk management policies
ii) Board of Directors and senior
management commitment and
Oversight
iii) Effective organisation structure for risk
management
iv) Effective risk management processes
and systems
v) Human Resources and Training
vi) In-house monitoring
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Building blocks of Risk
Management
Risk Management
Decision Making Top
Policies
Excess Limits and Down
Hedging Guidelines
Portfolio Limits etc.
Management

Risks
Monitoring Bottom
Transactions Up

Operations/Business Unit Management

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 Reference Books
Risk Management in Banking: Joel Bessis
Value at Risk: Philippe Jorion
Risk Management: Framework, Methods and
Practice : Sergio Focardi & Caroline Jonas
The Risk Management Process: Christopher L.
Culp
Operational Risk Measurement and Modelling:
Jack L. King

8-Apr-19 59
 Thank you

and

Wish you all the best

8-Apr-19 60