Chapter 8

Risk Management

1. Introduction

Commercial banks play an important role in the functioning of any economy and are a
significant catalyst for growth. However, banks are highly leveraged organizations. They
accept deposits from the public and take risks while creating financial assets. They are exposed
to various kinds of risk like credit risk, market risk, operational risk and liquidity risk. The
purpose of this chapter is to explain in detail the various risks faced by a bank, outline methods
for risk management and examine the regulatory framework. Treasury managers need to be
aware of the various kinds of risks, should be able to design risk mitigation measures, devise
hedging strategies and comply with the regulatory framework.

The chapter also highlights some risk management tools that banks can use for risk
management. These tools are also subject to regulatory guidelines and a reading of the Basel
guidelines/framework or the Reserve Bank of India guidelines is suggested.

The aim of the chapter is to enable the reader to

i. understand the various risks that a bank faces like credit risk, market risk,
operational

risk and liquidity risk

ii. understand the relation between risk and capital

iii. estimate the probability of default

iv. to find out the level of economic capital for a bank

v. understand the implications of prudential norms like income recognition, asset

classification, provisioning and capital adequacy

vi. understand risk management techniques followed by banks

vii. understand the various reasons behind assets turning non-performing
 viii. develop appreciation of the Basel guidelines.

2. What is risk?

Before getting into risk management in banks, the chapter will start with definition of risk and
what it means. The difference between risk and uncertainty will be discussed. Risk
management is only possible if risk can be identified, quantified and measured. Then only it
can be controlled. There cannot be any activity without risk. Question is, how best to control it.
It is also important to understand the relationship of credit rating with risk.

Risk arises when there are various outcomes of an event, and where there is a probability
associated with each outcome. In tossing a coin or throwing a dice, the outcomes are known
with certainty, like head or tail and 1 to 6. However, which side of the coin will show up after
the coin lands, or which number will show up after a dice is rolled, has a definite probability
associated with it.

Uncertainty, on the other hand, is a situation where the outcomes are known, but it is difficult
to assign probabilities. That is why there is insurance for protection. There cannot be any
insurance for risk. Activities like horse racing, stock market investing, gambling etc. cannot be
insured. However, insurance is available for mudslides, air travel, earthquake, death, illness
etc. In case of uncertain events, neither can definitive probability be assigned to the outcomes,
nor can the extent of impact be forecast. That is why, expenses for medical treatment can be
insured, but with limits.

3. Various Kinds of Risks a Bank is Exposed to - Credit Risk, Market Risk,

Operational Risk & Liquidity Risk

Credit Risk
Credit risk arises when a borrower fails to repay either interest, or principal, or both. Banks
accept deposits from individuals and on lend these funds for investment purposes. Borrowers
of these funds are at times unable to pay interest, or repay these loans on time. This default risk
is known as credit risk.

Market Risk
Banks also deploy deposits received from customers in traded securities and financial assets.
Examples would be bonds, government securities, treasury bills and currency. The risk banks
face due to any deterioration in value of these assets due to changes in market price is called
market risk. For example if the rate of interest rises, then there is a fall in the value of the debt
securities held. If the there is an adverse movement in the exchange rate, then the value of
currency holdings fall. These are examples of market risk.

Operational Risk

Any financial loss to a bank arising from lapses in systems and procedures is called operational
risk. It can arise from violation of internal codes of conduct leading to fraud or overextension
of exposure. It can arise from customer data deletion due to fire, or any natural calamity or
breakdown of the IT infrastructure.

Liquidity Risk

Against deposits of customers, banks hold financial assets on their books which generate
returns. At times, banks are unable to sell such assets to meet liquidity requirements of
depositors, as there may not be any buyers. Further, there are situations when banks knowingly
do not sell as they feel that any effort on their part to sell will lead to reduction in prices of
these assets and they will not get any value. This is liquidity risk. It is a risk arising out of the
inability of the banks to sell assets in the market to generate liquidity.

4. Relation between Risk and Capital

Consider the following tables.

Table 1

Funding Rs. Lending Probability

pattern rate 6% pa of default

Equity 10 0% 5% 10% 15%

Debt 90 Return 106 95 90+ 85 +

(borrowing + 95*.06 90*.06 = 85*.06 =
rate 5% pa) 90+5.4 =
= 95+5.7 = 95.4 85 + 5.1
100.7 = 90.1

Total 100 Repayment 90*1.05 = 94.5 94.5 94.5

of debt with
 interest 94.5

Surplus 106 – 94.5 = 100.7 – 95.4 - 94.5 90.1 –

11.5 94.5 = 6.2 = .9 94.5 =
-4.4

Table 2

Funding Rs. Lending Probability

pattern rate 6% pa of default

Equity 5 0% 5% 10% 15%

Debt 95 Return 106 95 90+ 85 +

(borrowing + 95*.06 90*.06 = 85*.06 =
rate 5% pa) 90+5.4 =
= 95+5.7 = 95.4 85 + 5.1
100.7 = 90.1

Total 100 Repayment 95*1.05 = 99.75 99.75 99.75

of debt with 99.75
interest

Surplus 106 – 99.75 100.7 – 95.4 – 90.1 –

= 6.25 99.75 99.75 = 99.75 =
= .95
- 4.35 -9.65

In both the tables, total amount of Rs.100 is being deployed in the market at a rate of interest of
6% pa. In Table 1, Rs.100 is being raised by of equity capital of Rs.10 and debt (deposits in the
case of a bank) of Rs.90 at a rate of interest of 5% pa. In Table 2, Rs.100 is being raised by of
equity capital of Rs.5 and debt of Rs.95 at a rate of interest of 5% pa. If debt cannot be repaid
with interest, then the bank itself will be a defaulter in the market. If the bank is unable to
repay the depositors even their deposit amount, then the bank will have to declare bankruptcy.

Observe that

a. In table 1, debt can be repaid with interest up to a probability of default of 10%.

b. In table 1, only principal can be repaid with a probability of default of 15%.
c. In table 2, debt can be repaid with interest up to probability of default of 5%.
d. In table 2, only principal can be repaid with interest with a probability of default of
10%.
 e. A higher level of equity funding can absorb a higher level of default.

The probability of default of a borrower increases with the riskiness of the venture of the
borrower. However, rates of return of risker ventures are also higher than those of less risky
ventures. Thus, to increase returns, banks have to acquire some risky assets in their portfolio.
The above two tables show that, in order to earn higher returns from riskier ventures that have
higher probability of default, banks need to have higher equity capital to absorb the
incremental risk. Thus, the moral is: have capital, take risk.

(The above tables assume the same rate of return from less risky and more risky ventures. The
reader can perform their own exercise with higher rates of return with higher default rates.)

5. Expected Loss

Expected Loss (EL) is defined as

EL = Probability of Default (PD) * Exposure at Default (EAD) * Loss Given Default (LGD)

EAD is the amount of loan outstanding of the borrower at the time of default. Generally, loans
are advanced against collateral or security. For example, term loans are secured by mortgage
on land and building and hypothecation of plant and machinery. Working capital loans are
secured by hypothecation of current assets. At the time of default, the assets of the company
will have some value. The total outstanding loan, minus the recovery value, in % is LGD. PD
is the probability that a loan account will default. This is related to the credit rating of the loan.
It can be calculated as the ratio of total loans defaulting in this category to total loans in this
category. Not every loan in a BBB credit rating category defaults. Again, not all loans in the
AA category pay. Probability of default of a loan is the ratio as defined above.

Consider a numerical example. Let Rs.100 be the amount of loan outstanding. Let 60% be
LGD and 3% be PD. Then

EL = 100*.6*.03 = Rs.1.80.

When a company starts to default and the market learns about its distressed state, then the
value of plant of machinery falls and LGD rises. Generally, plant and machinery has little sale
value in the market unless the buyer is in the same line of business. It fetches little price. The
value that can be expected to be received is that of land and building.

Probability of Default

The difficulty generally lies with calculation of PD and the following provides methods of
calculating PD.

Method 1

Let the entire loan accounts of a bank, consisting of 500 accounts, be divided according to the
payment record of the borrowers. Suppose there are five categories, and let the frequency
distribution be as under:

Number of 0 1 2 4 More than

defaults 5

Number of 375 75 30 12 8
accounts

The expected number of defaulting units is 0*375+1*75+2*30+4*12+5*8 divided the total

number of units equal to 375+75+30+12+8 = 500. This is equal to (75+60+48+40)/500 =
223/500 = .446. So on an average, the expected number of defaulting units is less than one
account. As the number of defaults is low in relation to the total number of accounts, the
probability distribution is that of a Poisson Distribution. So the expected number of units with
zero default is e (-.446)
x(.446)0 / 0! and so on. If we map this with the total outstanding in the
accounts, then we can get the expected default amount in each category. The problem arises if
the amount involved in the few accounts that default more, is large. In recent years we have
witnessed in India large borrowers defaulting in their payments.

Method 2

This is based on the options approach and has been elucidated in Galati (2003). Consider an
entrepreneur starting an enterprise with equity capital equal to E. Let the enterprise borrow an
amount of loan equal to B. Then the total assets that can be created E+ B. Consider the pay-off
Figure 1for the borrower. It resembles the pay-off function of a long call where E is the
premium paid in the form of equity capital. If the value of the company exceeds B+E, then the
company can expect some return on equity. If it falls significantly below B, then the
entrepreneur loses E, which is the premium paid, or the equity capital. This is the concept of
limited liability. If we now write the option premium equation of Black and Scholes, then

E = f(B, A, t, r, σ) (1)

Where E is the option price, B is the strike price, A is the market price or the value of the asset,
t is the residual tenure of the loan, r is the rate of interest and σ is volatility. If the company is a
listed company, or if we take the share price movement of a company involved in similar
business, then σ can stand for volatility of returns from the share. The above equation (1)
would then generate a value of A. E is the value of equity that is put upfront by the promoters.

Once we get a value of A and σ, assuming the default distribution is normal, we can take

(A - 2σ) to be the lower bound. If (A - 2σ) is less than B, then we have a situation of default.
On the basis of this we could calculate the probability of default as the area under the density
function between B and (A - 2σ). An empirical probability of default can be obtained from

[Number of borrowers that defaulted within a year with asset values of (A - 2σ) < B] / [Total
number of borrowers with asset values of (A - 2σ) < B in the year]

Method 3

The third method uses the CreditMetrics approach of J P Morgan. The examples shown in
Figure 2 and Figure 3, taken from Gallati (2003), is for a loan which is rated BBB, the
exposure to the loan being $100 million, 6% is the borrowing rate and the tenure being 5 years.
Figure 1 gives the transition probabilities of a BBB loan being upgraded, remaining in the
same grade, or being downgraded in one year’s time. Loans of different credit ratings enjoy
different rates of discount in the market. Better the credit grade, lower is the discount rate.
Thus the maximum present value of a BBB $100 million loan, if it gets upgraded to AAA, is
$109.37 million. If it remains in the same grade, the value would be $107.55 million. If it
moves to the default category, the value would fall to $51.13 million.

Figure 2 gives the diagrammatic form of the data from Figure 2. We can check that there is a
6.77 per cent probability that the loan value will fall below $102.02 million and a 1.47 per cent
probability that the loan value will fall below $98.10 million. From the data it emerges that the
expected (mean) value of the loan is $107.09 million and the standard deviation is $2.99
million. Thus, using the normal distribution, the 5% lower limit is 1.65*2.99 = $4.93 million
and 1% lower limit is 2.33*2.99 = $6.97 million. These would be extent of the fall in the value
of the $100 million loan in case of a downgrade. These values would come close to the values
derived from the table of actual default percentage.

In this third method, we have used the transition probabilities published by J P Morgan. If
banks use the same credit rating and transition probability structure that is published, then it
would be easy to assign a default probability to each asset category and calculate expected loss.

Figure 1

E
Figure 2

Source: Gallati (2003)

Figure 3
Source: Gallati (2003)

6. Value at Risk (VaR)

This concept is generally used in estimating market risk. We explain this concept with the help
of the following example.

Let us consider stock prices of Bharat Forge, a mid-cap company listed in the National Stock
Exchange and the Bombay Stock Exchange, for the last 200 days. If we calculate the daily
stock returns, and then construct a frequency distribution of the relative frequency, the result is
shown in Figure 4.

Figure 4: Relative Frequency Distribution of daily returns of Bharat Forge

 Range of
Returns

Source: Author’s own construction

Such a diagram can be drawn for any company, and the reader can check that the distributions
would look almost like a normal distribution. Only the mean and variance would change. Since
this a relative frequency distribution, the long term approximation of which is a probability
density function, the sum of the bars would be equal to one. If we put our finger on the
horizontal axis and move the finger from right to left, up to the range (minus 2 to minus 1),
95% of the area is covered. Only 5% remains to the left. This implies that with 95% probability
we can say that there would be a loss of around 2 to 3 percent on any given day. Or in other
words, in the next hundred trading days, on five days, an exposure of Rs.1000 can lead to a
loss of Rs.20 or more. This is defined as Value at Risk (VaR), and in the example this is 95%
VaR.

As we have observed, stock returns tend to be normally distributed, and number of times the
standard deviation would give a fairly good idea about the VaR with the required probability.
Standard deviations are usually quoted on an annual basis. If we assume that there are 254
trading days in a year, then to convert annual standard deviation into 1 day standard deviation
would involve multiplying the standard deviation (sd) by square root (1/254) = sd*1/16. Hence,

Factor Push VaR = Sum of All Single Factor VaR

Single Factor VaR = Exposure * Maximum Likely Adverse Move

Maximum Likely Adverse Move = Number of standard deviations * standard deviation * time
horizon.
If we are calculating daily standard deviation, then for daily VaR, time horizon is equal to one.
In this case, portfolio VaR is the sum of all individual VaRs. However, in the delta normal
method, the correlation between the asset returns become important. For example, if there are
two assets, then

VaR portfolio = Square Root (VaR12 + VaR22 + 2ρ12VaR1VaR2) where ρ is the correlation
between the two asset returns.

This approach can be used to measure market risk. One can also modify this approach and
migrate to a Delta Gamma VaR. Here, both the first derivatives and the second derivatives
come into play. For bonds, this would mean a combination of Duration and Convexity. For
options positions, it would be Delta and Gamma along with other Greeks.

7. Risk Adjusted Performance and RAROC

a. Risk Adjusted Performance

Data:

Total Loan – Rs.100 crore (Rs.10000 lakh)

Borrower rated BB – PD or Probability of Default is .05%

Profit margin of 6%, i.e. 600 basis points

Loss given default 20%

Capital Charge fixed by Treasury – Rs.2crore

Overhead allocation – Rs.50 lakh

Calculation

Expected Loss = 10000*.05*.20 = Rs.100 lakh

Total Revenue = 10000*.06 = Rs.600 lakh

Risk Adjusted Return (RAR) = 600 – 100 = Rs.500 lakh

Economic Revenue = RAR – Capital Charge = 500 – 200 = Rs.300 lakh

Economic Profit = 300 – 50 = Rs.250 lakh

 b. RAROC (Risk adjusted return on capital)

Income 6.1% - Expected Loss 0.50%

= Risk Adjusted Income 5.6% - Costs 3.40%

= Risk adjusted Net Income 2.20% - Tax 0.45%

= Risk Adjusted After Tax Income 1.75%

If total assets created are Rs.100000, then Risk Adjusted Net Income = Rs.1750

Total Risk Capital = Credit Risk Capital 4.40% + Market Risk Capital 1.60% + Operational
Risk Capital 2.00% = 8%

With total assets created Rs.100000, capital required is Rs.8000. If cost of capital is taken as
18%, then capital charge is Rs.1440 = 8000*.18.

Economic Value Added (EVA) = Risk Adjusted Net Income 1750 – Capital Charge 1440 =
Rs.310

RAROC = Risk Adjusted Net Income / Risk Capital = 1750/8000 = .22 or 22%.

8. Risk Based Supervision and Risk Management Techniques – A Synthesis

Chart 1 provides an overview of the need for risk management by banks in today’s
environment. Banks are in the business of taking risk as they accept deposits from the public
and deploy them in financial assets for returns. While deposits have to be returned to depositors
on demand, returns from assets are uncertain. Customers have become demanding and they
want higher returns. With technological change, newer products with different risk profile are
available in the market. Competitive pressure has forced banks to adapt to this dynamic
environment and pressure on spreads has made them move to riskier instruments. The need for
adoption of risk management techniques has increased and new accounting norms and
accounting principles has led to the evolution of risk based organizational structure. Growth in
volumes has opened up opportunities for fraud. Technology has opened up creation of complex
financial instruments which few people understand. Thus, need for controls have gone up and
reporting and MIS has become crucial for decision taking.

Chart 1

Source: Author’s own construction

Advances in technology, ability of money to move across the globe at the speed of light,
innovative products, interrelationships across markets, has led to the evolution of risk based
management. Banks have moved from traditional supervision (TS) to risk based supervision
(RBS). TS is quantifying problems and minimizing risks in individual institutions. RBS is risk
based management and recognition of systematic risks across the banking system. As a result
we have observed two changes – Basel Accord and CAMELS.

The core Basel principles are effective supervision, licensing structure, prudential norms,
methods of supervision, information requirements and adoption of technology. The full form of
CAMELS includes capital adequacy, asset quality, management, earnings appraisal, liquidity
appraisal, systems and controls – corporate governance.
The broad parameters of RBS include a risk based organizational structure, a comprehensive
risk management approach, risk management policies, setting of prudential limits, strong MIS,
procedures for effective control, separation of risk management from operations and periodical
review. A specimen organizational structure is shown in Chart 2.

Chart 2

Source: Author’s own construction

The various dimensions of risk management would include

1. identifying the risks – credit risk, liquidity risk , market risk , operational risk , interest
rate risk, forex risk;

2. measuring risk – size, duration, probability of adverse consequences;

3. controlling risks – limits, mitigation, offsetting;

4. monitoring changes in risks and controls;

Management of credit risk would involve

 1. setting prudential limits;

2. credit rating/scoring;

3. estimation of loan losses;

4. risk pricing;

5. portfolio management;

6. loan review mechanism;

7. having a credit rating framework

While acquiring various financial assets, the following would be the scope of credit risk
analysis of each of asset.

1. sector risk – intensity of competition, industry returns, cyclicality of earnings,

government policy, regulatory changes;

2. business risk – relative position;

3. financial risk – operating margin, Returns on Capital Employed (ROCE), interest cover,
liquidity ratios, future cash flows, DSCR, leverage;

4. management risk – track record, quality of personnel, payment record, financial

accounting practices, credibility, support from group companies;

5. project risk – size of the project relative to net worth, probability & extent of overrun,
implementation risk, technology risk, market risk, statutory clearances, financial
closure

In managing market risk, banks need to focus on

1. liquidity risk – funding risk, time risk, call risk;

2. interest rate risk – gap risk, basis risk, option risk, yield curve risk, price risk,
reinvestment risk;

3. forex risk;

4. commodity price risk;

5. equity price risk

For control on operational risk, banks need to have in place

1. processes and systems;

2. clear delegation of power;

3. supervision of action at all levels;

4. a strong human resource base;

5. awareness of legal provisions of the country of operation;

6. state of the art technology;

7. a strong Management Information System;

8. awareness of regulatory requirements;

9. assessment of business capacity

9. Prudential Norms: Income Recognition, Asset Classification, Provisioning and

Capital Adequacy

The Reserve Bank of India (RBI) guidelines on the above are available in detail in various
master circulars of RBI issued from time to time (see www.rbi.org). These circulars
incorporate the Basel guidelines and the changes that have taken. As the master circulars are
easily avaiable, there is no need to repeat them here. However, the logic behind the concepts
and also the transition from Basel I to Basel II and Basel III needs explanation.

As per the income recognition norms, income is to be reckoned if income is received.

Accrual/accrued income is not treated as income. Once this in place, asset classification
becomes easy. If income is received on time, the asset is a standard asset. If not, then according
to the delay in receipt of payment, that is principal and/or interest, assets are to be classified as
sub-standard, doubtful or loss assets. The latter three comprise non-performing assets (NPAs).
The question that arises at this stage is, so what if asset classification is required? This is where
provisioning comes in. For every NPA created, there is a penalty in the form of provisioning,
and this has to come out of after tax income of banks. Profit can be declared, after setting aside
the provisioning charges. Higher the NPAs, lower is the declared profits of the bank.

Eventually, if the surplus income is not high enough to cover provisions, the latter has to be
carved out of net worth, and the equity capital of the bank drops. This affects the last prudential
norm, capital adequacy. Capital adequacy, defined as the ratio of capital and risk weighted
assets restricts the asset creating capacity of banks, by fixing the ratio at 9% currently.
Understand the dilemma of the banks. Deposits flow in regularly and they have to be converted
into assets. If the capital adequacy norm is not met and the level of capital is not enough to
cover for the NPAs, then these deposits have to be channeled to zero risk assets like cash or
central government securities. This reduces the yield and hurts profitability of the bank. NPAs
lead to provisioning, and this affects capital adequacy and restrict opportunities for exploring
high yield assets by banks. One way out is to access the capital market for equity. With
deteriorating financial health, it becomes increasingly difficult for banks to raise equity capital
from the market. In the case of nationalized banks in India, the onus falls on the central
government to infuse capital in these banks and restore capital adequacy.

The above was defined by the Basel I guidelines and incorporated in the Narasimhan
Committee Report. The other elements included inducting professionals in the Board of the
banks to improve governance. Basel II first introduced the concept of economic capital, as
opposed to regulatory capital laid down by the central bank. The three pillars of Basel II
consisted of Minimum Capital Requirements, Supervisory Review Process and Market
Discipline. Recognition of credit risk, market risk and operational risk was explicitly made and
suggestions were given on how to derive economic capital. Banks were advised to derive their
own figures of capital by assessing the risk and calculating the cover for such risks. The
interested reader can refer to the BIS Working Papers for detailed investigation.

Basel III guidelines were a fall out of the sub-prime crisis that generated financial instability all
over the world. The basic differences between the Basel II and Basel III guidelines are given in
Table 3. A quick look at the two standards will reveal that besides enhancement in capital
requirements and disclosure, there are stipulations regarding liquidity requirements and risk
management along with capital planning. During sub-prime crisis period, with special
reference to Lehman Brothers, it was observed that the company had assets on its books, but
there were no takers of these assets. The company was also unwilling to part with the assets at
throwaway prices. Further, the company was unable to raise short term funds from the market
against these assets. There was, at the end, a liquidity crisis which led to its bankruptcy. The
Basel Accord recognized this additional source of risk and included provisions for liquidity
enhancement. Besides, capital adequacy, Basel III has emphasized on capital planning and in
the following we provide some details.

Table 3

Basel II Capital Standards Basel III Capital Standards

Pillar 1: Minimum Capital Requirements Pillar 1: Enhanced Minimum Capital and

Liquidity Requirements

Pillar 2: Supervisory Review Process Pillar 2: Enhanced Supervisory Review

Process for Firm-wide Risk Management
and Capital Planning

Pillar 3: Disclosure and Market Discipline Pillar 3: Enhanced Risk Disclosure and
Market Discipline

In addition to higher capital requirements, the new elements in Basel III are New Capital
Conservation Buffer, Countercyclical Capital Buffer, Liquidity Standard and Leverage Ratio.
These have been stipulated to help financial institutions in times of economic crisis. The idea is
to shore up the capital base, beyond capital adequacy standards, such that they can be used as a
cushion in times of stress.

Liquidity Standard includes

i. Liquidity Coverage Ratio (LCR): to ensure that sufficient high quality liquid resources are
available for one month survival in case of a stress scenario.

ii. Net Stable Funding Ratio (NSFR): to promote resiliency over longer-term time horizons by
creating additional incentives for banks to fund their activities with more stable sources of
funding on an ongoing structural basis.
iii. Additional liquidity monitoring metrics focused on maturity mismatch, concentration of
funding and available unencumbered assets.

With enhanced capital requirements and leverage ratio, the total capital requirements of the
banks have gone up.

10. Capital charge for operational risk

Operational risk has been defined by the Basel Committee on Banking Supervision as the risk
of loss resulting from inadequate or failed internal processes, people and systems or from
external events. These are risks associated with day to day functioning of a bank and cannot be
precisely modelled statistically. It is possible to draw a heat map and then focus on the ones
that need to be managed actively.

According to the RBI guidelines, certain changes have taken place in the financial sector
environment which has made explicit recognition of operational risk more relevant.

“Examples of these new and growing risks faced by banks include:

 Highly Automated Technology - If not properly controlled, the greater use of more
highly automated technology has the potential to transform risks from manual
processing errors to system failure risks, as greater reliance is placed on integrated
systems.

 Emergence of e-Commerce – Growth of e-commerce brings with it potential risks (e.g.

internal and external fraud and system securities issues)

 Emergence of banks acting as very large volume service providers creates the need for
continual maintenance of high-grade internal controls and back-up systems.

 Outsourcing – growing use of outsourcing arrangements and the participation in

clearing and settlement systems can mitigate some risks but can also present significant
other risks to banks.

 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, derivatives, 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). ”

While elaborating on the manifestations of this risk, the RBI guidelines state that the Basel
Committee has identified the following types of operational risk events that can lead to
substantial losses. These are

• Internal fraud. For example, intentional misreporting of positions, employee theft, and insider
trading on an employee’s own account.

• External fraud. For example, robbery, forgery, cheque frauds, 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 bank’s 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. For example, hardware and software failures,
telecommunication problems, and utility outages.

• Execution, delivery and process management. For example: data entry errors, collateral
management failures, incomplete legal documentation, and unauthorized access given to client
accounts, non-client counterparty misperformance, and vendor disputes

In view of the above, RBI has identified the various business lines of a bank and has stipulated
total capital charge which is calculated as the simple summation of the regulatory capital
charges across each of the business lines. The total capital charge may be expressed as:

KTSA = {Σ1-3 years Max [∑ (GI1-8*β1-8),0]}/3

Where:
KTSA = the capital charge under the Standardised Approach

GI1-8 = annual gross income in a given year, for each business lines

β1-8 = a fixed percentage, set by the Committee, relating the level of required capital to the level
of the gross income for each of the 8 business lines. The values of the β are detailed in Table 4.

Table 4

Business Lines Indicator Beta factors (%) Beta values (%)

Corporate finance Gross income β1 18

Trading and sales Gross income β2 18

Retail banking Gross income β3 12

Commercial banking Gross income β4 15

Payment and Gross income β5 18

settlement

Agency services Gross income β6 15

Asset management Gross income β7 12

Retail brokerage Gross income β8 12

Source: www.rbi.org

11. Credit Derivatives

Traditionally, banks can reduce risk in a loan portfolio either through diversification with
exposure limits, or through occasional sale of the loan assets through creation of a special
purpose vehicle and issuance of pass through certificates. In either of the two, the risk of the
asset and the asset remained on the books of the lending bank. There was no separation
mechanism of credit risk from the asset itself. Credit derivatives enable this separation and the
first example is that of a Credit Default Swap (CDS). Figure 4 provides the structure of a CDS.

Figure 4: Credit Default Swap (CDS)

 Premium leg

Protection Protection
Buyer Seller

Protection leg of
Contingent Payment

Source: The J P Morgan Guide to Credit Derivatives

The structure of the CDS shown indicates that the protection buyer, who is the lender/owner of
the loan asset/a bank, enters into an agreement with a protection seller to receive payment from
the protection seller in the event of a default on the part of the borrower. So the default risk is
covered, while the loan asset remains on the books of the lender. In return for this protection,
the lender has to pay a premium to the protection seller. The terms of the contingent payment
would be clearly stated and an event of default would be clearly defined. In case of a default
and a contingent payment taking place, the asset would be transferred to the protection seller.
The value of this payment would be market linked. The premium to be paid looks like a put
premium as it is linked to a right to sell. Note, that during the transaction, the borrower has no
information of the transaction. So transaction costs are lower.

The second example is that of a Total Return Swap (TRS) and the nature of the transaction is
shown in Figure 5.

Figure 5: Total Return Swap (TRS)

Total Return of Asset

Total return Total return

Payer Receiver

Libor + bps

Source: The J P Morgan Guide to Credit Derivatives

The total return means interest and fees and any change in value of the loan. The principal does
not enter the transaction. In the case, the original holder of the asset pays the total return and in
exchange receives a payment linked to the Libor. In case there is depreciation in the value of
the total return, the TR payer receives payment from the TR receiver. The structure provides
for insurance against depreciation in value of the total return.

The third example is that of Credit Options (CO) and the structure of the transaction is given in
Figure 6. This strategy combines the characteristics of both a CDS and a TRS. We have
observed that the structure of a CDS is that of a put option. The protection seeker is the long
put, and pays a premium to the protection seller, the short put. The CO combines this with the
put buyer simultaneously entering into a swap by which it pays Libor + spread in return for a
total return from the asset. The put seller can afford to pay this as it receives put premium on
the other leg. In case of default in the underlying asset, the put seller pays the settlement
amount and the asset get transferred to the put seller.

Figure 6: Credit Put Option

Premium leg

Put Buyer Put Seller

Cash Payment Contingent on Default

Total Return of Asset

Put Buyer Put Seller

 Libor + bps

Source: The J P Morgan Guide to Credit Derivatives

Credit Linked Notes (CLN) are interesting instruments for yield enhancement and default
protection, and the basic structure is shown in Figure 7.

Figure 7: Credit linked notes

Protection premium payment Credit linked notes

Put Buyer Special Purpose Investors

Vehicle (SPV)

Settlement payment IA LP Investment amount

AAA
Securities

Source: The J P Morgan Guide to Credit Derivatives

As in CDS, the owner of the assets with credit risk, say a bank, buys protection from a SPV for
a premium. The SPV in turn issues credit linked notes to investors, the cash from which is
invested in AAA securities (IA). In case the underlying assets default, the SPV liquidates the
AAA securities (LP) and pays the bank. Whatever is gained from sale of the underlying assets
and also what is left after selling the AAA securities, goes to the investor. The investor bears
two sets of risk. First, risk due to default by the underlying asset. Second, due to default of the
AAA securities. That is why these credit linked notes have high yield, and the SPV can bear it
as it also receives premium on sale of protection.

Figure 8 gives the full structure of a Credit Default Obligation (CDO). This structure builds in
the features of the above discussed four different methods of credit risk management and
highlighting why it is financially beneficial for all concerned. It also allows for gradation of
investors on the basis of their exposure to risk.
Figure 8: Collateralized Debt Obligations (CDO)

Subordinate swap premium Notes Issued

Senior
Super premium

Special Purpose Vehicle

Higly rated Put Buyer (SPV) (10% protection) Mezzanine
Counter party
(90%
protection) Equity
Settlement payment IA LP
Investment
Super Senior Credit
Protection AAA
Securities

Source: The Lehman Brothers Guide to Exotic Credit Derivatives

The structure has various components. First, against a portfolio of assets, the bank (put buyer)
seeks protection from two sources. First, it seeks protection from a SPV for a part of the total
assets and pays subordinate swap premium. It is subordinate because a large highly rated
counterparty offers the maximum protection and receives super premium. The SPV then floats
CLNs to three classes of investors namely, senior class, mezzanine and equity and the proceeds
are invested in AAA securities as before. If any of the underlying loan assets default, then the
securities are liquidated and any shortfall from the value of the underlying loans is made up
first by writing off the equity, then the mezzanine notes and then the senior notes. After that,
the super senior protection comes in. As they come in after 10% of asset value erosion, the
premium amount is lower.

12. Theoretical Frameworks for Understanding and Estimating the Relationship

Between Risk and Capital
In this section, we examine the relation between risk and capital. What emerged was “have
capital, take risk”. Risky projects have higher probability of default, and hence, a higher capital
support is necessary to cover loss arising out of risk. Again, if risk is not taken, the opportunity
of earning higher returns cannot be there. The following 2x2 matrix brings this out quite
clearly.

Chart 3

RISK RETURN MATRIX

RISK

HIGH LOW
RETURN HIGH Risk taking Does not exist

LOW No takers Risk aversion

Source: Author’s own construction

Any investment has some amount of risk associated with it. If the Risk is higher, the Returns
that are expected should also be higher. Thus, a high Return low Risk asset cannot exist as
everybody will start acquiring such assets pushing up their prices and lowering their returns. A
high Risk low Return asset would have no takers as everyone would be selling these assets and
price would fall and Returns would rise. There can be thus two classes of assets as shown in
Chart 3: assets with low risk and low return, and assets with high risk and high return.

We now turn to different theoretical frameworks for understanding the relation between risk
and capital.

a. Risk Taking in Indian Banks – A Simultaneous Equations Approach

I. Introduction

First, we will consider the interrelationship between four variables namely actual capital,
desired capital, actual risk and desired risk. These variables have been considered in Shrieves
and Dahl (1992) and on its extensions by Jacques and Nigro, 1997; Aggarwal and Jacques,
1998, 2001; Rime, 2001; Hassan and Hussain, 2004; Heid et al., 2004; Murinde and Yassen,
2004; Godlewski, 2004; Van Roy, 2003, 2005, and Bouri & Ben Hmida (2006). However, we
will build a simultaneous equation model with the above mentioned variables. Indian banks
have been exposed to the Basel norms for quite some time. With the opening up of the
financial sector, many of them accessed the market for equity capital more than once to shore
up their Tier I capital to boost capital adequacy. The first exercise is to show whether Indian
banks have been judicious in their risk taking and whether their risk taking has been in line
with the capital requirements.

Before we proceed with the model specification, it is important to understand the implication
of Capital Adequacy Ratio (CAR) as a single parameter for monitoring banks by the regulator.
It is defined as a ratio with some definition of capital funds in the numerator and total risk
weighted assets (RWA) in the denominator. Capital funds would include the components Tier I
capital and Tier II capital. Tier I capital includes paid-up capital (ordinary shares), statutory
reserves, and other disclosed free reserves, Perpetual Non-cumulative Preference Shares
(PNCPS) eligible for inclusion as Tier I capital, Innovative Perpetual Debt Instruments (IPDI),
and capital reserves representing surplus arising out of sale proceeds of assets. Tier II capital
includes undisclosed reserves, revaluation reserves, general provisions and loss reserves,
hybrid capital instruments, subordinated debt and investment reserve account.

As of today, CAR is 9% in India, which implies that banks can have around eleven times its
capital as RWA. As banks are naturally positioned for resources, deposits keep flowing into a
bank. These have to be converted to assets, with the overall restriction of 9%. The better the
quality of assets, lower is RWA, even with a large actual asset base. The quest for banks is thus
for quality assets to lower RWA. On the other hand, greater the credit rating of an exposure,
lower is the yield and thus profitability. To look at higher returns, banks have to turn to riskier
assets, which would increase the denominator. Thus the other thrust area for the banks is to
increase the numerator. If banks cannot access the market for equity for various reasons, they
raise Tier II bonds to shore up their capital base and protect their capital adequacy.

CAR and risk are interdependent. It is postulated that greater risk taking ability is determined
by CAR i.e., greater risk taking has to be backed by a larger capital base. Again, greater risk
taking leading to acquisition of risky assets, can boost revenue and lead to an increase in
reserves and hence Tier I capital. An empirical investigation is then performed to examine the
relation between capital and risk taking in private sector banks and nationalized banks and their
ability to adjust to unexpected risk. The model introduces the concept of a co-efficient of
indexation and we derive values of this from our model.

II. The Model

The structural form of equations that we consider are given by

RISKt = RISK t-1 + m(CARtact – CARtreg) … (1)

CARtact = CARt - 1act + n(RISKt – RISKt - 1) + (1-n)(RISKte – RISKt - 1) + kCRRISKt-1

= CARt - 1act + (RISKte – RISKt - 1) + n(RISKt – RISKte ) + kCRRISKt-1 … (2)

RISKte = RISKt - 1 + b(RISKt - 1 – RISKt - 2) + cVULNERt-1 + d CLSTATEt-1 + eSIZEt-1

… (3)

where

RISK – Risk Weighted Assets/Total assets

CARact – Actual Capital Adequacy Ratio
CARreg - Regulatory Capital Adequacy Ratio
CRRISK – Credit Risk defined as Provisions/Total Advances
SIZE – Level of Bank Deposits
VULNER – Ratio of Deposits to Risk Weighted Assets
CLSTATE – Ratio of Government Security Holdings to Total Assets
t – Time
e – Expected value

Regulatory capital is expressed through the required capital adequacy ratio as fixed by the
central bank. It is different from economic capital, which explains the amount of capital
required to absorb a default. Although the ultimate purpose of regulatory capital is absorption
of loss in the event of default, it primarily restricts overexpansion of risk weighted assets in
relation to the capital of the bank. If actual capital adequacy ratio exceeds the regulatory capital
adequacy ratio, then there is a buffer which leads banks to take more risks which gets reflected
in the ratio of risk weighted assets to total assets. This follows from the usual risk return trade-
off. If there is flexibility in the banks to take risk, they would take risk, and this is the basis of
Equation 1. It also reflects the dynamic nature of portfolio allocation and its relation to capital
allocation.

Equation 2 gives an indexation specification of the actual capital adequacy ratio. The equation
indicates that actual capital adequacy is fully indexed to expected risk and partly indexed to
unexpected risk, n lying between zero and one. Estimation of the indexation co-efficient is of
interest by itself, as it would show to what extent Indian banks have been able to estimate
unexpected risk and adjust capital accordingly. The results would be even more interesting as
we would be estimating this parameter for both private sector banks and public sector banks
separately. The equation also includes CRRISK, which denotes the cover for risk that is
already there in the portfolio.

Equation 3 specifies that the expected level of risk that a bank can take is determined by past
risk taking by the bank given by a lag structure and also by VULNER and CLSTATE. Greater
the value of VULNER, lower would be the expected risk taking by the bank as, with a similar
distribution of returns, the impact of probability of default increases. With respect to
CLSTATE, the expected sign is negative as greater proportion of funds in Government
Securities implies greater liquidity and lower risk. Larger the SIZE, greater is the expected risk
taking as the bank is confident of raising capital any time it needs. It has a relation with
goodwill and market perception.

Equations 1, 2 and 3 give a simultaneous equation structure to capital adequacy and risk taking
by a bank. There are three equations in three unknowns RISK t, CAPtact and RISKte. The other
variables are treated as exogenous for the model. From here we derive two reduced form
equations in RISKt and CAPtact and the estimation results are given in Tables 1 to 4 in Section
3.

III. The Results

The three equations of our model bring out the interdependence between risk and capital,
which is the basis of risk management. The data for the study has been taken for the period
2000 to 2007 on twenty-four nationalized banks and sixteen private sector banks. From the
structural equations in Section 2, we derived two reduced form equations in CARt and RISKt .
We then ran a regression on the pooled cross section time series data and the estimation results
are given in Tables 1 to 4.

Table-1

Public sector banks. Dependent variable: CARt

Variables coefficient t-value R-square
       
CARt-1 0.66 10.463 0.519
Riskt-1 0.332 0.957  
Riskt-2 0.219 0.343  
CRRISKt-1 0.154 1.396  
VULt-1 0.28 1.619  
CLSTATEt-1 -0.487 -1.659  
SIZEt-1 0.009 0.581  

Source: Authors’ own construction

Table-2

Public sector banks. Dependent variable: Riskt

Variables coefficient t-value R-square

CARt-1 0.628 0.109 0.451

Riskt-1 0.342 1.976
Riskt-2 1.097 0.939
CRRISKt-1 0.834 1.12
VULt-1 -1.32 -1.127
CLSTATEt-1 -0.65 -0.328
SIZEt-1 -0.0073 -0.259

Source: Authors’ own construction

The R-square for the public sector banks, where CARt is the dependent variable, is .519 and the
coefficient of CARt-1 is statistically significant. That is current period’s capital adequacy is
dependent on last period’s level. This is not surprising as year to year variations in this balance
sheet figure is not very large. The co-efficient of CLSTATE t-1 is marginally significant, but has
the right sign. In Table 2, where RISKt is the dependent variable, only RISKt-1 is statistically
significant. Size is not a significant determinant of capital adequacy or risk taking behaviour in
public sector banks. However, when we calculate the structural form co-efficients from the
reduced from co-efficients, the value of “n”, i.e. the indexation co-efficient for public sector
banks is around .4. That is, during the period under consideration, public sector banks have
been able to adjust partly to unexpected risk. Their systems and procedures for risk assessment
and prediction have been relatively slow to adjust to market variations.

The estimation results for the private sector banks are given in Tables 3 & 4.
Table-3
Private sector banks. Dependent variable: CARt
Variables coefficient t-value R-square
       
CARt-1 0.615 6.933 0.512
Riskt-1 0.124 1.843  
Riskt-2 -0.735 -1.433  
CRRISKt-1 0.522 2.381  
VULt-1 0.569 1.89  
CLSTATEt-1 -0.112 -1.984  
SIZEt-1 0.0079 0.861  
Source: Authors’ own construction
Table-4
Private sector banks. Dependent variable: Riskt

Variables coefficient t-value R-square

       
CARt-1 -0.712 -0.211 0.801
Riskt-1 0.288 1.571  
Riskt-2 -0.484 -0.091  
CRRISKt-1 -0.205 -0.333  
VULt-1 -0.216 -3.449  
CLSTATEt-1 0.228 1.437  
SIZEt-1 0.027 1.037  
Source: Authors’ own construction
In Table 3, although the R-square is not very high at 0.512, almost all the coefficients are
statistically significant. Past period’s capital adequacy and risk taking behaviour has affected
current period’s capital adequacy significantly. These banks, whenever they have taken more
risk, have also shored up their capital base. The co-efficients of VULNERt-1 and CLSTATEt-1
are also statistically significant indicating the fact that while these banks have gone on deposit
mobilization drives, it has also exposed them to more risk and hence they have raised their
capital base and also gone for safer investments in G-Secs. In Table 4, the negative sign of the
coefficient of VULNERt-1 indicates that higher the ratio of deposits to total risk weighted
assets, lower is the risk taking by the banks. This is intuitive as with higher deposits, the bank
is more vulnerable to defaults, and hence takes less risk. Again, when we calculate the
structural form co-efficients from the reduced from co-efficients, the value of “n”, i.e. the
indexation co-efficient for private sector banks is around .7. That is, during the period under
consideration, private sector banks have been able to adjust a great deal to unexpected risk.
Being new entrants into the banking business, they have been able to introduce systems and
procedures for risk assessment and prediction from the very beginning which has allowed them
to react fast to market variations.
IV. Concluding Remarks

The model and the estimated results enable us to distinguish between the performance of public
sector banks and private sector banks in their risk taking behaviour and the rate of adjustment
in capital requirements. The results show that, while for public sector banks, capital adequacy
is better explained, for private sector banks, risk is better explained. The interesting and
important result that we obtain is where we find private sector banks are more equipped to
handle unexpected risk. That is their systems and procedures are quite adept in handling
variations in the market and also in forecasting repayment patterns of borrowers. Their
operational structures allow them the flexibility and the technology platform the required speed
of adjustment.

b. Risk Taking Expectations, Role of Capital and their Impact on Returns – a Study
of Indian Banks

I. Introduction

The purpose of the second exercise is to provide a framework for expectation formation of risk
taking by banks, incorporating the role of capital, and their impact on returns. Risk taking is an
operational matter for commercial banks. They do it on a regular basis while acquiring
financial assets, every moment of time, within norms specified by the management. It is a flow
activity of a bank. This activity gives rise to a stock of financial assets, calculated annually, and
at times monitored quarterly. Capital, on the other hand, is a stock concept and is not an
actively managed on a day to day basis. It is calculated yearly, and at times quarterly, to arrive
at the capital adequacy of a bank. It is a variable which determines the risk taking ability of a
bank.

In the first exercise we have presented a theoretical structure where capital is a function of risk
and vice versa, and other variables affect the relationships through the desired levels of risk and
capital. Here, we incorporate an operational standpoint that it is expectation formation
regarding risk that drives a bank and besides capital, other variables influence this expectation.
Actual risk taking is a daily affair by a bank, and this in turn determines income. Although
periodically capital adequacy is calculated to determine the health of a bank, capital is not
something that banks monitor on a daily basis. The following model presents a stylized version
of this line of thinking.

II. The Model

We define a pair of equations

RISKte = RISKt - 1 + b(RISKt - 1 – RISKt - 2) + cCRRISKt-1 + d(CARt-1act – CARt-1reg) +

eVULNERt-1 + fSIZEt-1 + ut (1)

ROA or ROE or NIM = k + n(RISKt – RISKt - 1) + (1-n)(RISKte – RISKt - 1) + vt (2)

where

RISK – Risk Weighted Assets/Total assets

CARact – Actual Capital Adequacy Ratio

CARreg – Regulatory Capital Adequacy Ratio

CRRISK – Provisions/Total Advances

SIZE – logarithm of level of Bank Deposits

VULNER – Ratio of Deposits to Risk Weighted Assets

t – Time

e – Expected value

ROA - Returns on Assets

ROE - Returns on Equity

NIM - Net Interest Margin

u and v - Random disturbance terms with the usual properties

The explanation for expectation formation specification in equation 1 is as follows. As

specified in various guidelines of RBI, the top management of banks needs to arrive at their
risk taking appetite in the beginning of a financial year. The corporate plan would lay down the
activity based allocation of capital and risk and hence a forecast for the resultant level of
income. This would be monitored and reviewed periodically and necessary calibrations made.
Equation 1 lays down a basis for expected risk taking of a bank at the beginning of time t,
RISKte.

It states that if the regulator has not shut down a bank or issued a warning that its risk taking is
out of line with its stock of capital, then it would take at least that much risk as it did last year,
calculated at the end of period 1, RISK t - 1. Further, from the point of view of growth, the bank
would build in some incremental risk, (RISKt - 1 – RISKt - 2).

As per prudential norms specified by RBI, every bank has to make provisions for non-
performing assets (NPAs). These NPAs are in turn a result of risk taking appetite of a bank. If
a bank has made sufficient provisions for its existing stock of NPAs, then it has adequate
capital cover for its stock NPAs. Thus it can take incremental risk. This is incorporated by
including CRRISKt-1 in risk expectation formation.

As having more capital should prompt a bank to take more risk, the variable

(CARt-1act – CARt-1reg) states that if a bank’s actual capital adequacy at the end of period t – 1 is
more than what the regulator has specified, then it is expected that the bank would take more
risk in period t.

Besides the above explanatory variables, the expected level of risk that a bank can take is
determined also by VULNER. Greater the value of VULNER, lower would be the expected
risk taking by the bank as, with a similar distribution of returns, the impact of probability of
default increases. On the other hand, larger the SIZE, greater is the expected risk taking as the
bank is confident of raising capital any time it needs. It has a relation with goodwill and market
perception.

Risk taking by banks means allocation of funds between financial assets. This is turn
determines the revenue flow and profitability. Equation 2 specifies that that profitability of a
bank depends on its existing asset base given by the term k, and on both expected incremental
risk, (RISKte – RISKt - 1) and on unexpected risk, (RISKt – RISKt - 1). In the beginning of period
t, banks start off with an expected risk level, but eventually may end up taking more or less risk
than they desired. Actual risk taking is dependent on day to day movements in the market and
on macroeconomic policy changes both at home and abroad. Our model builds in an indexation
coefficient “n” to incorporate the effects of expected risk and unexpected risk on profitability
of a bank.

Equations 1 and 2 complete the model. The relationship between return and risk is specified in
equation 2, and the interaction between risk and capital is incorporated in formation of
expected risk. Thus the level of capital and its difference with regulatory capital forms risk
taking expectations. This forms the framework within which a bank, through its day to day
activities, engage in asset acquisition. Day to day changes in macroeconomic conditions and
policy measures lead banks to take opportunities in asset acquisition as and when they arise.
Thus actual risk taking may differ from expected risk taking. Both, taken together, determine
the profitability of bank. Substituting equation 1 in equation 2 and rearranging will generate a
reduced form equation given by equation 3, which we will estimate.

ROAt/ROEt/NIMt = Constant + αRISKt + βRISKt - 1 + γ RISKt - 2 + δCRRISKt-1 + η(CARt-1act –

CARt-1reg) + ηVULNERt-1 + λSIZEt-1 + εt (3)

India is a country where both nationalized banks and private sector banks exist side by side. In
our study we will estimate the reduced form equations for both sets of banks, separately, on
pooled cross section time series data. Our data is on 27 public sector banks and 23 private
sector banks over the period 2007-2012. We present results for all three definitions of returns
namely ROA, ROE and NIM.

II. The Results

The results of our regression are summarized in Tables 1 and 2.

Table 1: Regression coefficients for public sector banks for different specifications of returns

CONST. RISKt RISKt-1 RISKt-2 (CARtact CRRISK VULNER SIZE R2

- t-1
t-1
t-1

CARtreg)

ROA .04 -.002 -.02 .005 .045 -.103 -.01 -.02 .21

(3.37) (-.48) (-1.48) (1.48) (1.57) (-.93) (-2.51) (-2.0)

ROE .84 -.10 -.32 .10 .38 -2.51 -.18 -.05 .26
 (4.64) (-1.68) (-1.92) (2.01) (.81) (-1.41) (-3.20) (-2.8)

NIM .03 -.006 -.011 .006 .11 .13 -.004 0 .08

(.02) (-.09) (-.61) (1.02) (2.05) (.66) (-.64) (.04)

Source: Authors’ own construction

Table 2: Regression coefficients for private sector banks for different specifications of returns

CONST. RISKt RISKt-1 RISKt-2 (CARtact CRRISK VULNER SIZE R2

- t-1
t-1
t-1

CARtreg)

ROA .03 -.005 -.02 -.013 -.14 -.34 -.01 .005 .36
(5.06)
(1.90) (-.82) (-1.75) (-2.14) (-1.41) (-3.09) (-2.12)

ROE .73 -.09 -.52 -.2 -.44 -4.54 -.20 .05 .40

(3.59) (-1.39) (-3.1) (-2.43) (-1.43) -(3.55) (-3.2) (4.32)

NIM .05 -.005 -.023 -.007 .04 .113 -.01 .001 .06

(2.62) (-.69) (-1.66) (-.77) (1.19) (.75) (-1.27) (1)

Source: Authors’ own construction

Observe that the regression results with NIM as the dependent variable is very weak for both
sets of banks. However, for ROA and ROE, the explanatory power of our equation, given by
the value of R2, is much better for private sector banks than public sector banks. Overall, we
may say that our equation formation explains risk taking behavior of private sector banks better
than public sector banks.

For both sets of banks, VULNER is statistically significant with the right sign. The results
show that as the ratio of Deposits to Risk Weighted Assets rises, banks tend to take lower risk
and hence end up with lower returns.

The way risk is defined in this paper, it is a ratio of two cumulative figures. Thus the
contemporaneous relation between risk and return is not statistically significant for both sets of
banks. However, lagged values of risk are. In particular, the extent of significance is greater for
private sector banks than public sector banks.

The relationship between risk and return should be positive. However, we observe a negative
sign for both sets of banks for the coefficients of lagged risk. This may indicate that greater risk
taking by banks in the past has led to lower returns on assets. Or returns have not increased
commensurately with creation of risk weighted assets.

The difference between actual capital adequacy and regulatory capital adequacy is not
statistically significant for both sets of banks. This may indicate that Indian banks have not
been proactive in exploiting this difference, but has been more inclined to satisfy the regulator
about their balance sheet strength.

The sign of the coefficient of CRRISK is negative for both sets of banks, but is statistically
significant only for private sector banks. This is a bit disturbing as greater provisions to total
advances should make a bank comfortable in taking incremental risk and hence give better
returns. A negative sign may mean that increased non-performing assets leading to higher
provisioning has, both, led to lower returns and also lower risk taking by banks.

It is interesting to observe that SIZE is statistically significant for both sets of banks, but the
coefficients are of opposite sign. Greater deposit mobilization has made income generation
easier for private banks. Their goodwill has played a role in their confidence in taking risk and
income generation. Private sector banks do enjoy a better valuation in the Indian stock market.
Public sector banks, on the other hand, do not enjoy good valuations, and there is a pressure of
NPAs. The central government needing to pump in funds to shore up the equity base of public
sector banks has made matters worse in the eyes of the public at large.

IV. Concluding Remarks

In this exercise we have provided an alternative specification of the relationship between risk
and capital and their impact on returns. We have done the exercise with three different
dependent variables representing returns, namely ROA, ROE and NIM. Our model postulates
that all the explanatory variables including capital base, size, past risk taking, cover for non-
performing assets affect current risk taking expectations. These, along with actual risk taken,
influences returns. Our model explains the overall behavior of private sector banks better than
public sector banks. The signs of the coefficients of risk are negative, which is opposite to the
direct relationship between risk and returns in theory.

13. Resolution Strategies for Maximizing Value of Non-Performing Assets (NPAs)

After providing frameworks for understanding the relationship between risk, return and capital,
we now turn to ways and means for recovery from NPAs. For this, we examine the various
reasons behind an asset turning into a Non-Performing Asset (NPA) and alternative resolution
strategies that can be adopted for recovery from such NPAs. We provide a “state resolution
mapping” whereby the reasons for an asset turning NPA and the resolution strategy are shown
to be linked together. It is shown that reasons like management inefficiency, industry
slowdown, technology, capital structure and product failure will, to a large extent, determine
the recovery strategy to be adopted by the bank or financial institution.

1. Introduction

The issue of Non-Performing Assets (NPAs) in the financial sector has been an area of concern

for all economies and reduction in NPAs has become synonymous to functional efficiency of

financial intermediaries. From the early nineties till date, the regulators in India, under the

general recommendations of the Narasimhan Committee Reports (1 & 2), Verma Committee

Report, Basle I, II & III guidelines have continuously provided directives addressed at reducing

NPAs. A perusal of the Reserve Bank of India (RBI) circulars in this regard will give the

reader a comprehensive idea about the extent of detail in which norms and guidelines have

been formulated to arrest the growth in NPAs. It started off with introduction of prudential

norms and has delved into adoption of a risk based management system. The Indian financial

sector has responded well and adopted the directives given, and the overall health has shown

considerable improvement.
Presence of NPAs indicates asset quality of the balance sheet and hence future income

generating prospects of a bank or financial institution. This also requires provisioning which

has implications with respect to capital adequacy. Declining capital adequacy adversely affects

shareholder value and restricts the ability of the bank/institution to access the capital market for

additional equity to enhance capital adequacy. If this happens for a large number of financial

intermediaries, then, given that there are large interbank transactions, there could be a domino

kind of effect. Low capital adequacy will also severely affect the growth prospects of banks

and institutions.

With weak growth outlook and low functional efficiency, the sector as a whole will not be able

to perform its role and will adversely affect the savings investment process. Once we realize

this, it is evident that a micro problem of a bank translates into a macro problem of the

economy. Capital market development takes a back seat and GDP growth rate weakens. The

adverse effects of fiscal deficit loom large and a balance of payments crisis also cannot be

ruled out. Banking crisis and foreign exchange crisis get interlinked.

Besides putting in place checks and balances for acquiring good quality assets, it is true that

once an asset turns non-performing, if a resolution strategy for recovery of dues is not put in

place quickly and efficiently, these assets would deteriorate in value over time and little value

would be realized at the end, except may be its scrap value. That is why, asset securitisation

has gained popularity among financial sector players. The literature, however, has not

specifically discussed about the various resolution strategies that could be put in place for

recovery from NPAs, and in particular, in which situation which strategy should be adopted.

The purpose of this paper is to indicate the various considerations that one has to bear in mind

before zeroing on a resolution strategy. The details of the strategy would follow after that.
2. Reasons for an asset turning NPA

The various reasons, either singly or jointly, behind an asset turning NPA can be classified as

follows

 Reasons from the economy side

 Reasons from the industry side

 Reasons from the borrower’s side

 Reasons from the banking system side

 Reasons from the loan structuring side

 Reasons from the security side – collateral vs cash flow

 Reasons from the regulatory side

From the above, it may be surprising to many that only the borrower is not always at fault. At

times, systemic faults can also adversely affect the profitability of financial intermediaries. The

following discussion will clarify our position.

 Reasons from the economy side

a. Political – mindset regarding paradigm, proactive, fiscally responsible (national income

accounts)

b. Economic – growth, distribution, efficient allocation of resources

c. Social – acceptability, mobility, education

d. Technological – advances in use of IT

e. Legal – Enforceability of loan contracts

 f. Environmental – liberalization & globalisation

If loan contracts are not easily enforceable, there will naturally be a tendency to default.

Opening up of the economy can render companies uncompetitive. Lack of adaptation of IT will

make data processing difficult and information dissemination will be impossible. Objective

analysis of risk would be difficult and appraisal would remain a subjective matter. Similarly,

directed programs of lending can be counterproductive.

 Reasons from the industry side

a. Global competition

b. Cyclical downswing

c. Sunset industry

d. Frequent changes in regulatory norms

 Reasons from the borrower’s side

a. Misconceived project

b. Poor governance

c. Product failure

d. Inefficient management

e. Diversion of funds

f. Dormant capital market

g. Regulatory changes

 Reasons from the banking system side

a. Parameters set for their functioning were deficient: incorrect goal perception

and identification – lazy banking

 b. Directed banking and lack of freedom to choose products and pricing

c. Being unexposed to international marketing methods and products, people

lacked training and knowledge resources

d. Ownership and management were not distinguished – composition of Board of

Directors

e. Lack of systems and procedures – audit and inspections

f. Banks lacked the ability to handle enormous growth in liabilities and assets

g. Lack of a mechanism of credit information dissemination

h. Lack of an effective judicial system for recovery from defaulters

i. Collateral based lending leading to idle assets

j. Fixing of price and quantum of loans

k. Lack of an effective IT system and MIS

 Reasons from the loan structuring side

a. High debt equity ratio

b. Timing of raising equity

c. Discrepancy between the rate of interest charged and the realistic rate of return

d. Inconsistency between revenue generation and the loan repayment schedule

e. Lack of binding penal clauses and performance guarantees

 Reasons from the security side – collateral vs cash flow

There is a tendency among banks and institutions to depend excessively on collateral for

advancing of loans. While this is important, it presumes from the very beginning that the

borrower would default and the security would need to be encashed for recovery of the

loan. Clearly, this logic is unacceptable. Emphasis should then be on cash generation and a

charge on this should be built into the loan contract through some escrow mechanism.
  Reasons from the regulatory side

Frequent regulatory changes can turn assets non-performing. Accounting reason like reduction

in income recognition norms from 180 days to 90 days could be one such reason. Pollution

related issues could be the other reason. Distance between two sugar mills could be a third.

3. Recovery Strategies

The various resolution strategies for recovery from NPAs include financial restructuring,

change in management, one time settlement, merger, sale to an asset reconstruction company,

securitisation of receivables and filing of legal suit. The details under each strategy are given in

the following.

a. Financial restructuring

 Reschedulement of the principal repayment

 Reduction in the rate of interest

 Funding of past due interest into loan or instruments (debt or equity or quasi equity)

 Funding of future interest

 Waiver of past simple interest, compound interest or liquidated damages

 Conversion of loan into equity or quasi-equity

 Reduction in equity

 Debt write-off

 Funds infusion by way of equity or debt for project completion

 Funds infusion for working capital purposes

 Escrowing of receivables – Trust & Retention Account

 b. Change in management

 Change in the promoters

 Induction of professionals

c. One time settlement (OTS)

 Full principal with all past interest and future interest with prepayment

premium

 Full principal with all past interest

 Full principal with part interest

 Full principal with full or part interest converted to equity or quasi equity

instrument

 Part principal with the remaining part converted to some equity or quasi

equity instrument

 Part principal and remaining part written off

d. Merger with another company

 Nature of the industry – sunrise or sunset

 Synergy issues

 Valuation

 Share swap ratio

 Tax implications

e. Sale to an Asset Reconstruction Company (ARC)

  Nature of the industry

 Valuation – vintage of machinery, land

 Provisioning made

 Failed negotiations

 Multiple bankers

The mechanism of sale of a loan to an ARC is as follows. In the Indian context, the time

the ARC has for executing a strategy is 5 years. The ARC sells Security Receipts (SRs) to

the bank, who invests in them. With these proceeds, the ARC buys the loan from the bank.

This asset is then restructured and sold down the line to an investor and the SRs are

redeemed. Thus a loan in the books of the bank gets replaced by an instrument, which

would be redeemed within five years. The SRs would get valued on NPV basis.

e. Securitisation of receivables

This goes under the names of CLOs (collaterlised loan obligations), MBS (mortgage based

securitisation) and ABS (asset based securitisation). The basic concept is to convert a loan into

an instrument, which can be independently traded. This has gained popularity for NPA

resolution as it allows lumping of many NPAs or NPAs along with Standard Assets into a

single pool and tradeable securities are issued on their behalf. This ensures liquidity and early

exit option.
The originator (bank) floats a Special Purpose Vehicle (SPV) and transfers the asset to it. The

SPV then issues securitised notes to an investor whose proceeds go to the originator as

payment against the assets transferred to the SPV. The principal and interest payments by the

underlying asset get deposited with a Trust, which services principal & interest to the investor.

Securitization allows issuers to lengthen the maturities of their debt, improve risk management

and balance sheet performance, and tap a broader class of investors. It provides liquidity,

improved asset liability management and better reinvestment options.

f. Filing of suit and recovery through liquidation proceedings

This is an option of last resort. It is time consuming and chances of asset value deterioration are

very high.

4. State-Resolution Mapping (SRM)

We now discuss, as a lender, which strategy to apply and when. Although we will be giving

specific options, there may be a non-unique answer to the state. But we will argue what is the

best strategy available.

Any individual company can be understood and analyzed in terms of

a. The overall state of the economy

b. Nature of the industry to which it belongs

 c. Overall market growth

d. Competitive position in the market

e. Vintage of machinery used

f. Technology in use

g. Skill set required and gaps, if any

h. Management quality

i. Liability structure (Debt-Equity Ratio)

j. Outstanding liabilities

k. Asset quality and provisioning made in the books of the lender

We will take the above characteristics, two at a time, and design alternative scenarios and

associated strategy.

Case 1

Market growth Competitive position

High Low

High Restructuring/Sale to an Restructuring/management

ARC change

Low One Time Settlement (OTS) OTS, liquidation

For a company whose competitive position is good and also market prospects are bright,

clearly, the lender should stay with the company and provide necessary financial restructuring.
On the other hand, a company whose overall market growth prospects are poor and its

competitive position is also weak, the lender should do an OTS and exit. The terms of OTS we

will discuss in the next section. It is perfectly possible that the borrower may not come forward

for a negotiation, and in that case the only option would be to file a suit. An OTS is a highly

desirable strategy for a company whose current competitive position is quite good, but where

the future market growth prospects are dim. Further, for a company, whose market growth is

high, but competitive position is weak, there a financial restructuring should be accompanied

by a change in management.

Clearly we can see how the discussions in Sections 2 & 3 can combine to generate a resolution

strategy. In the remainder of the section, we will present various other cases in tabular form. It

is left to the reader to analyse the strategy recommended.

Case 2

Skill set Management Quality

High Low

High Restructuring Change in management

Low Merger OTS

Case 3

Management quality Outstanding liabilities

High Low

High Merger Restructuring/Merger

Low OTS Restructuring/ Change in

Management
Case 4

Debt-equity ratio Nature of the industry

Growing Declining

High Restructuring Liquidation

Low Merger/Sale to ARC OTS

Case 5

Growth prospects of the Overall macroeconomic

industry condition outward looking,

competitive

Growing Stagnating

High Restructuring OTS

Low OTS Liquidation

Case 6

Outstanding liabilities Asset quality &

provisioning

Substandard, Doubtful,

Low provisioning High Provisioning

High OTS Liquidation

Low Restructuring OTS

6. Concluding remarks

In conclusion, it is again emphasized that a conceptual distinction has to be made between past

NPAs and future NPAs. Past NPAs are stock. The value is known and recovery has to be

maximized. For these assets the recovery strategies are detailed above. However, it is obvious

that any asset, when acquired, can turn non-performing. It is this risk for which financial

intermediaries are compensated. In order to minimize future risk, the strategies should include

1. Introduction of a risk based management system

2. Adoption of Corporate governance practises

3. Human Resources Management

4. An efficient Management Information System

5. Proper IT environment

6. Adoption of credit rating modules and risk based loan pricing

7. Securitisation

8. Market research
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