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Risk Management and Basel II

Indian Institute of Banking and Finance

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How do banks make money?

By playing “term” of funds: Long v/s short.

By playing risk levels- accept lower risk and place in higher risk- play safety as a market mantra

Dispersed source v/s concentrated use. Trading in the market Essentially by taking riskEssentially by taking risk

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Risk Definition and featuresRisk: Event likely to cause loss/variability/damage to

income and reputationFeatures: Fairly known- Cannot be avoidedCannot be avoided. Probabilistic and generic Ascertainable, although not always quantifiable Essential for intermediation process. Risk and Reward go together Interrelated/ Collectively exhaustive but not

mutually exclusive

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Generic and Unique risks

Industry Unit/firm/company related Location specific Ownership related Sector specific HRD/Structure related

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Sources of Risk

Decision ,Indecision

Business cycles/ Seasonality

Economic/Fiscal changes

Policy Changes Market movements Events

Political compulsions

Regulations Human resources,

skill sets Competition Technology Non-availability of

information

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Types of Risks Credit: Default/delay: Impacts Solvency-

Capacity to service obligation, Liquidity: Inability to meet committed

payments, inability to exit an investment. Interest Rate: Changes in the market rate

causing income variability Exchange: Fluctuation in currency rates, prices

becoming adverse for the company Market: Interplay of above on trading profits Legal: Operational: Failure of Men, Machine,

Monitoring, Methods

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The global financial regulatory framework is undergoing important changes…

Operational Operational RiskRisk

Market RiskMarket Risk

Credit RiskCredit Risk

Basel IIBasel II

Risk ManagementRisk ManagementRisk ManagementRisk Management Anti-Money LaunderingAnti-Money LaunderingAnti-Money LaunderingAnti-Money Laundering Corporate GovernanceCorporate GovernanceCorporate GovernanceCorporate Governance

…and money laundering and corporate governance issues have become entwined with operational risk management

USA PATRIOT USA PATRIOT ACTACT

FATF FATF RECOMMENDATIONSRECOMMENDATIONS

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Goals of risk ManagementGoals of risk Management

Safety and soundness of banks.

Ensuring a level playing field.

Capital Adequacy Ratio

(1) own funds (i.e. available capital and reserves)

(2) risk-weighted assets (i.e. the amount of money the bank has put at risk in the course of its business)

A level A level playing playing field !!field !!

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How to manage risk

Hedging Exposure limits Reserves and Provisioning

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Basel I

IRAC norms- uniform across institutions, products and performance

Capital adequacy- Uniform across the commercial banking- coop banking will catch up shortly

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Lessons Of Basel I

Better NPA Management- varieties of ways

New Institutions ( ARC) Laws ( Sarfaesi)

Almost all banks and RRBs in good financial health- meet CRAR nomr

Explosion of new- customer centric products

More employment.

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Basel II Primarily for internationally active banks RBI will take view on other banks- It is

safe that all banks comply CRAR @ 8%on risk weight. But But

weights and loss estimates differ- weights and loss estimates differ- Basel II is capital accord. Other risk Basel II is capital accord. Other risk

management norms will happenmanagement norms will happen F.M says “ Indian Banks will need F.M says “ Indian Banks will need

additional 60,000 Crores in the next additional 60,000 Crores in the next few years”- to meet with growth few years”- to meet with growth needs.needs.

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Advanced methods for capital allocation

Capital charge for operational risk

Advanced methods for capital allocation

Capital charge for operational risk

Focus on internal capabilities

Supervisors to review banks internal assessment and strategies

Focus on internal capabilities

Supervisors to review banks internal assessment and strategies

Focus on disclosure

Focus on disclosure

Three Pillars of Basel II

The new Basel Accord is based on Three Pillars

Minimum CapitalMinimum CapitalSupervisory

ReviewSupervisory

Review Market DisciplineMarket Discipline

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Basle II. Minimum Capital Requirements-Pillar 1

Sets minimum acceptable capital Capital arrived by enhanced approach

with credit ratings External or Public rating Internal rating

Explicit treatment to operational risk ALM risk not treated but included in

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Supervisory Review _ Four Principles- Pillar 2

Banks must attain solvency relative to their risk profile

Supervisors should review each bank’s own risk assessment & capital strategies

Banks should maintain excess of minimum capital

Regulators would intervene at an early stage

Possibility of rewarding banks with better risk management systems.

RBI has already taken steps to conduct supervisory review

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Market Discipline- Pillar 3

Improved disclosure of Capital structure Risk measurement and management practices

Risk profile Capital adequacy

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Credit Risk -ApproachesCriteria Standard I . R. B

Foundation

Advanced

Rating Risk weight

External Calibrated on ratings by Basel Committee

I nternal Function provided by Basel Committee

I nternal Function provided by Basel Committee

Probability of def ault

I mplicitly provided by Basel Committee

Provided by bank on own estimates

Provided by bank on own estimates

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Credit Risk Approaches

Criteria Standardized I .R.B Foundation

Advanced

Exposure at Default

Supervisory values provided by Basel

Supervisory

values provided by Basel

Provided by bank on own estimates

Loss given default

I mplicitly provided by Basel on external estimates

I mplicitly provided by Basel on external estimates

Provided by bank own estimates

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Credit Risk Approaches

Criteria Risk mitigation

Standardized Defined by Regulator.

I .R.B Foundation All included in standardized + Receivables for goods and Services, Other physical Securities subject to criteria

Advanced All types of Collaterals if Bank can prove by internal estimation

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Computation of Capital

Market Risk

Standardized No change over 1988

Foundation No change over 1988 in VaR

Advanced No change over 1988 in VaR

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Computation of Capital

Operational Risk

StandardizedCapital change based on single risk indicator

Foundation Capital based on business lines and industry standards

AdvancedCapital based on business lines and internally calculated standards

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Operational Risk Approaches

Approach Basic I ndicator Standardized AdvancedMeasurement

Calculation ofCapital charge

Average ofGross I ncomefor three yearsas indicator Capitalcharge equals15% of theindicator

Gross incomeper regulatoryline as indicator Depending onbusiness line 12,15 or 18 % of theindictor ascapital charge Total capitalcharge equalssum of chargeper business line

Capital chargeequals internallygeneratedmeasures basedon,I nternal loss dataExternal loss dataScenario analysisBusinessenvironment andinternal controlf actors Recognition ofrisk mitigation(upto 20%)

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Decision areas for Banks

Choice of methodology and convincing the regulators

IT supports needed Software requirements Staff training on compliance Consultancy requirements Risk mitigation opportunities Outsourcing possibilities New jobs creation Implementation cost and time

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BASLE II IS ALL ABOUT A RESPONSIVE AND SOPHESTICATED RISK MANAGEMENT SYSTEM

R = Risk = Function of Uncertainty U U = Function of Quality Information

QI QI = Function of Accuracy/ Timeliness/

Relevance/ Adequacy A, T, R, Ad A = Function of IT T = Function of IT R and Ad = Function of IT,

Management Science, Modeling amenable to establish mathematical relationship

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Risk Management – a data intensive function

Market RiskMarket RiskMarket RiskMarket Risk Operational RiskOperational RiskOperational RiskOperational RiskCredit RiskCredit RiskCredit RiskCredit Risk

Loss Event Data

Causal Data Loss Effect Key Risk

Indicators (KRIs)

Proxies Risk

Inventories Structured Self

Assessment Data

External Data

Data on Exchange Rates

Data on Interest Rates

Data on Security Prices

Data on Correlations

Data on Instruments (non-linear)

Borrower Data Guarantor Data Asset-specific

Data Default Data Data on

Recoveries External Default

Data Data on Rating

and Migration Macro & Industry

Data Correlation Data

BanksBanks

Analytical CRM DataAnalytical CRM Data

Transaction DataTransaction Data

Operational CRM DataOperational CRM Data

Risk Management DataRisk Management Data

Economy & Industry DataEconomy & Industry Data

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Basle Accord and IT

Basle II promises significant business benefits to those who have systems in place to access and utilize far more detailed and precise information

Integration of data on finance, operations and risk management necessary

Opportunity to get out of legacy systems and procedures including IT system

Fundamental rethinking on how a bank’s data and information is provided and controlled

Pillars are interdependent and must be addressed to concurrently

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Basle Accord and ITInternal Rating based approaches revolve around

Probability of defaultLoss given defaultExposure at defaultOther parameters

Main requirements would includeDefining and capturing loss data Capturing and extracting exposure dataIdentifying and capturing risk mitigation data

Data issues would beSources/ Data types/ Quality requirements and Granularity (level of data)

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Basle Accord and IT

Operational Risk Management pre-supposes Framework and systems in data

integration Low frequency-high severity occurrences Structure for risk management and

interaction amongst functionaries Potential for mitigation, outsourcing and

alike issues Shared facilities feasibility More synergy and little overlap

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