BASEL II: Impact & Implications

Roadmap
• BASEL II – Overview
• Credit Risk
• Market Risk
• Operational Risk
BASEL II - Overview
 Banking on Risk

Banking is an art & science of

measuring & managing the risks in
lending and investment activities for
commensurate profits based on the
risk perceptions.
 Simple Bank of India

Liabilities Amt Assets Amt

Capital & reserves 9 CRR/SLR 39
Deposits 130 Loans 100
Total 139 Total 139
Assumption – CRR +SLR = 30%
 What is BASEL II?

• New standard for measurement of risks in

banks and for providing enough capital to
cover those risks.
• Needed for strong, sound and stable
international banking systems.
• Will Change:
– How banks measure risks.
– How banks allocate capital for unexpected losses.
– Information published by Banks
– Regulatory environment.
 Implementation
• Approved by the Basel Committee on Banking
Supervision of Bank for International
Settlements in June 2004.
• Foreign banks in India and Indian banks
operating abroad are to meet norms by March
31, 2008.
• Other scheduled commercial banks will have to
adhere to the guidelines by March 31, 2009.
Three Pillars

Deals with maintenance of
regulatory capital calculated for
three major components of risk that
a bank faces
faces::

• Credit Risk
• Operational Risk
• Market Risk
 Capital Adequacy

Minimum Regulatory capital

Capital >= 9%
Credit RWA + Operational RWA+ Market RWA
• Spells out the capital requirement of a
bank in relation to the credit risk in its
portfolio.
• Sets out the allocation of capital for
operational risk and market risk in the
trading books of banks.
• Provides a tool to supervisors to:
– keep checks on adequacy of capitalization
levels of banks.
– link capital to the risk profile of a bank.
– take appropriate remedial measures, if
required.
– ask banks to maintain capital at a level higher
than the regulatory minimum.
• Provides framework for dealing with other
risks (residual risks) like systematic risk,
liquidity risk, legal risk, etc.
• Provides a framework for improvement of banks’
disclosure standards for financial reporting, risk
management, asset quality, regulatory
sanctions, etc.
• Indicates remedial measures to keep a check on
erring banks.
• Allows banks to maintain confidentiality over
certain information, disclosure of which could
impact competitiveness or breach legal
contracts.
 From Basel I to Basel II
BASEL I BASEL II
Less risk sensitivity More risk sensitivity by
structuring business class
and asset class.
Focus on single risk Focus on operational
measure. components of a bank as
well as market risk.
‘One size fits all’. Flexibility, menu of
approaches, capital
incentives for better risk
management.
Credit Risk
Credit risk has been traditionally defined
as default risk, i.e. the risk of loss from a
borrower / counterparty’s failure to repay
the amount owed (principal or interest) to
the bank on a timely manner based on a
previously agreed payment schedule.
 INTERNAL INTERNAL
STANDARDISED
RATINGS BASED RATINGS BASED
APPROACH
APPROACH - APPROACH -
FOUNDATION ADVANCED

CREDIT RISK SENSTIVITY INCREASES

 Standardized Approach
• Recognizing that different counterparties within
the same loan category present far different
risks to the financial institution lender
• allocates a risk-weight to each of its assets and
off-balance sheet positions.
• It calculates a sum of risk-weighted asset
values.
• The capital charge is equal to 8% of the asset
value
 Key Definitions
• Probability of default or PD - The likelihood that
default will take place over a specified time
horizon
• Exposure at default or EAD - The amount owned
by the counterparty at the moment of default
• Loss given default or LGD - The fraction of the
exposure, net of any recoveries, which will be
lost following a default event
 Internal ratings-based
approach
• Banks use their internal evaluation systems to
assess a borrower’s credit risk
• Foundation
– Banks can estimate the risk of default or the
Probability of Default (PD) associated with each
borrower.
– Additional risk factors such as Loss Given Default
(LGD) and Exposure at Default (EAD) are
standardized by supervisory rules that are laid down
and monitored by regulating authorities.
• Advanced –
– Allows banks with sufficient internal capital to
assess additional risk factors.
– These factors include Exposure at Default
(EAD), Loss Given Default (LGD) and Maturity
(M).
Comparison of Capital
Requirements
 Credit Risk Mitigation
• Collateral - Simple approach
– The bank may adjust the risk weight for its exposure
by using the appropriate risk weight for the supporting
collateral instrument.
– The collateral must be marked-to-market and
revalued at least every six months.
– A risk weight floor of 20 percent will also apply, unless
the collateral is cash, certain Government securities,
or certain repo instruments.
– Eligible collateral includes corporate debt instruments
rated BBB- or higher, equity securities traded on a
main index, and Government instruments.
• Comprehensive approach
– The value of the exposure is reduced by a
discounted value of the collateral.
– The amount of the discount varies with the credit
rating of the collateral.
– The Standardized Approach provides for the amount
of the discount. For example, collateral consisting of
A+ rated debt with a remaining maturity of five years
or less, would be discounted by 6 percent.
Alternatively, the regulatory agencies may permit the
banks to calculate their own discounts based on
internal models that take into account market
volatility, historical performance, and foreign
exchange rate movement.
• Netting
– Banks have legally enforceable netting arrangements
they may calculate capital on the basis of the net
credit exposure
• Guarantees and Credit Derivatives
– Provide equivalent protection are recognized subject
to certain conditions (e.g. the guarantee must be
direct, explicit, unconditional and irrevocable).
– The risk weight of the guarantor is substituted for the
risk weight of actual counterparty.
– Guarantors and credit protection sellers must have a
credit rating of at least A-.
 Market Risk
• Probability of loss to a bank caused by
changes in market variables
– Market level of interest rates
– Prices of securities
– Forex and equities
• Market risk includes liquidity risk
– It is the bank’s ability to meet obligations as
and when they fall due
 Liquidity Risk
• Arises when banks are unable to generate cash
to cope up with the decline in deposits/ or
increase in assets
• Originates from mismatches in the maturity
patterns of assets and liabilities
• Analysis of Liquidity Risk:
– Measurement of liquidity position of the bank on an
ongoing basis
– Examining how funding requirement are likely to be
affected under crisis scenario
– Net funding requirements: determined by analysing
the bank’s future cash flows
 Interest Rate Risk
• It is the risk to earnings or capital arising from
movement of interest rates.
• It arises from
– Repricing Risk: differences between the timing of rate
changes and the timing of cash flows
– Basis Risk: from changing rate relationships among
yield curves that affect bank activities
– Yield Curve Risk: from changing rate relationships
across the spectrum of maturities
 Interest Rate Movements
• Affects a bank’s reported earnings by
changing:
– Net interest income,
– The market value of trading accounts (and
other instruments accounted for by market
value)
– Other interest sensitive income and
expenses, such as mortgage servicing fees.
Minimum Capital requirement
• Specific Risk
– Capital charge for specific risk is designed to
protect against an adverse movement in price
of an individual security due to factors related
to individual issuer. (similar to credit risk)
– The specific risk charges are divided into
various categories such as:
• Investments in Govt securities
• Claims on Banks
• Investments in mortgage backed securities
securitized papers
Minimum Capital Requirement
• General Risk:
– Capital charge for general market risk is
designed to capture the risk of loss arising
from changes in market interest rates.
 Risk Management
• Banks position their balance sheet into:
– Trading Book
– Banking Book
 Trading Book
• It includes:
– Securities included under the Held for Trading
Category
– Securities included under the Available for Sale
category
– Open Gold positions
– Trading position in derivatives
• Held Primarily for generating profit on short term
differences in prices/yields
• Valued on a daily basis on mark to market basis
 Portfolio of Investments
• 3 categories:
– Held to Maturity –
• should not exceed 25% of the total investments
• Not Marked to Market
– Available for Sale – (MTM)
– Held for Trading – (MTM)
 Banking Book
• It includes assets and liabilities which are
contracted for steady income and statutory
obligation and are generally held till
maturity.
• It mainly accounts for Earning and
Economic value changes.
• Earning’s perspective:
– This is with respect to net interest income.
– NII has impact on overall earnings of the bank
– Fee based income & non interest income
– These activities also sensitive to market interest rate.
• Economic value Perspective:
– Variation in market interest rates affect the economic
value of the bank’s assets and liabilities
(economic value: assessment of present value of expected net cash flows,
discounted at market rates)
 Market Risk

Standardized Internal Model

Approach Based approach
 Value at Risk (VaR)
• VaR is the worst case scenario
– Theoretically the entire portfolio is at risk, because markets have no
guarantees.
– However this doesn’t mean that portfolio can vanish anytime
• Consider a trading portfolio. Its market value-
– Today – known
– Tomorrow – not known
• The bank holding that portfolio might report that it has a 1 day VaR
of $4mn at the 95% confidence level.
• It implies that
– With a probability of 95%, a change in the portfolio would not result in a
decrease of more than $4mn during 1 day
– With a probability of 5%, the value of its portfolio will decrease by more
than $4mn during a day
 Capital Charge
• Market risk for entire portfolio : 2.5%
• Equities:
– Specific risk : 9% of the Bank’s gross equity position.
– General Market risk charge: 9%.
• Thus the bank will have to maintain capital equal
to 18% of investment in equities (twice the
present minimum requirement).
(internationally banks use VaR models for the management of
Equity position risk)
 Capital Charge
• Foreign Exchange Risk
– Risk weight at 100%
– Charge : 9%
Operational Risk Management
 Risk Management
I. Risk Definition
II. Identification of Sources of Risk
III. Risk Measurement
IV. Create Risk Management Policy
V. Implementation
 Operational Risk
• The Basel Committee on Banking Supervision defined
Operational Risk as,

“the risk of loss resulting from inadequate or failed

internal processes, people and systems or from
external events”.
 Major Exclusions
• The definition does not include:

– Strategic risk: The risk of a loss arising from a poor

strategic business decision.

– Reputational risk: The damage to an organisation

through loss of its reputation or standing.
Major Sources of Operational
Risk

BUSINESS
BUSINESS PROCESSES
PEOPLE
ENVIRONMENT

OPERATIONAL
BUSINESS CONSTANT
RISK CHANGE
STRATEGY

CONTROL
IT SYSTEMS SYSTEMS
Risk Measurement Methods
 Basic Indicator Approach
KBIA = [Σ(GI1…n x α)]
n

Where,
• GI=net interest income + net non-interest income.

• This measure should:

(i) be gross of any provisions (e.g. for unpaid interest);
(ii) be gross of operating expenses, including fees paid
to outsourcing service providers;
(iii) exclude realised profits/losses from the sale of
securities in the banking book; and
(iv) exclude extraordinary or irregular items as well as
income derived from insurance.
 Standardized Approach
• Banks’ activities are divided into eight business lines:
– corporate finance,
– trading & sales,
– retail banking,
– commercial banking,
– payment & settlement,
– agency services,
– asset management, and
– retail brokerage.
Standardized Approach (contd.)
K TSA= {Σ years 1-3 max[Σ(GI1-8 x β1-8),0]}
3
Where,
 Advanced Measurement
Approach
• Under this Approach, banks will be permitted to
use their own internal model to calculate required
capital.

• However three forms of models for estimating

operational risk have been identified:
– Internal Modeling Approach,
– Loss Distribution Approach,
– Score Card Approach.
 Operational Risk Policy
• Analysis of bank’s operational risk profile.
• Risks that it is willing to accept and the risks that
it is not prepared to accept.
• How it intends to identify, assess, monitor and
control its operational risks.
• An overview of the people, processes and
systems being used.
• Assessment of bank’s risk exposure for
allocating capital.
 Risk Monitoring
• The top management should call for an appropriate
report at regular intervals on the operational
exposures, loss experience and deviations from the
bank’s operational risk policy.

• They should also ensure to maintain the records of :

– Results of risk identification, measurements and monitoring

activities.
– Action taken to control identified risks.
– Assessment of the effectiveness of the risk control tools
that are used.
– Actual exposures against stated risk tolerance as defined
by the assigned capital.
 Risk Mitigation
• Personnel: adverse impact of
• Insurance improper personnel policies,
These facilities are internal fraud, etc.,
not yet available in • Technology: risk of loss resulting
India. from systems unavailability, poor
data quality, system errors, or
Yet, banks have to software problems;
put an efficient • Physical assets: risk of damage
system in force to or loss of physical assets that
avail the existing
insurance coverage negatively impact operations;
for all the risks that • Relationships: risk of loss
can be transferred resulting from relationship issues
to the insurers well such as sales practices, etc.;
in time and monitor
for their timely • External: risk of loss from
renewals. external fraud, and offering
structured coverage.