MODULE B REVISION_25867414_2024_07_08_07_35

BFM
MODULE B
COMPLETE
REVISION PDF
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Risk Introduction:
 Arises from deviations between planned and actual

outcomes.
2. Appointment Example:
 Uncertainties in getting ready, transport, and travel impact
reaching appointments.
3. Definition of Risks:
 Uncertainties leading to adverse outcomes compared to
plans.
4. Inherent Business Risks:
 All business involves varying levels of unavoidable risk.
5. Banking History Perspective:

 Banking has always recognized and dealt with risks.
6. Cash Flow Uncertainties:

 Net cash flow depends on uncertainties in sales, costs, and
inflows/outflows.
1. Cash Flow Uncertainties:

 Sales, purchase price, and expense variations impact
profits.
 Results can be favorable or unfavorable.
2. Uncertainty vs. Risk:
 Uncertainty is imprecise knowledge.
 Risk is assessable with measurable probabilities.
3. Managing Risk:
 Uncertainty precedes risk management.
 Risk elements affect net cash flow.
4. Business Risk Example:

 Commodities trading has high variability.
 Higher risk means potential for higher gains or losses.
5. Lower vs. Higher Risk:
 Lower risk has limited variability.
 Higher risk implies greater potential for gains or losses.
6. Zero-Risk Investment:
 Example of a retired person's RBI bond.
 Zero-risk means stable cash flow with lower returns.
1. Trinities of Risk Management:
 Risk, Capital, and Return are interlinked in managing risks.
2. Capital's Role:
 Trading in equity markets requires capital for potential
losses.
 Minimum capital should cover maximum potential loss to
avoid bankruptcy.

3. Risk and Net Cash Flow:
 Businesses with wide cash flow variations have higher risk.
 Capital requirements depend on potential losses.
4. Linkage Between Risk and Capital:
 Returns expected relate to business risks.
 Higher-risk businesses need more capital for potential
losses.
5. Example - Risk and Return:
 Two investments with equal returns may have different
risks.
 Risk-adjusted return accounts for risks in comparing
investments.
1. RAROC Significance:
 RAROC guides investments, considering risk.
 Outperforms traditional metrics like ROA and ROE.

2. Capital and Return Link:
 Capital needs tied to business risks.
 RAROC allows comparing diverse risk profiles.
3. Why Manage Risk:
 Uncertainties impact cash flow.
 Severity of adverse variations varies.
4. Criticality of Risk Management:
 Essential for survival in adverse situations.
 Severe situations can impact cash flows and threaten
survival.
1. Risk and Business Continuity:
 Uncontrolled loss potential leads to bankruptcy.
 Managing risk exposure is vital for limiting losses.
2. Measuring and Managing Risk:

 Methods to measure risk aid in understanding potential
losses.
 Crucial to ensure adequate capital or limit risk exposure.
3. Treating Loss as a Cost:
 Losses from risks are considered a business cost.
 Probability of loss factored into pricing.
4. Essence of Risk Management:
 Control risk to the organization's capacity.
 Requires identification, measurement, control, and cost
estimation.
5. Specialized Setup:
 Risk management needs special skills and a defined
framework.
 A dedicated setup guides the risk management function.

1. Top Management Involvement:
 Successful risk management begins with top management
commitment.
 Balancing risks and returns is crucial within capital
constraints.
2. Risk Identification and Quantification:
 Managing risks starts with identifying and quantifying
them.
 Decision-making involves accepting, mitigating, or
reducing risks.
3. Specialized Risk Management:
 Risk management requires special skills and a dedicated
setup.

 A well-articulated framework covers organization,
identification, measurement, pricing, monitoring, and
control.
1. Risk Management Organization:
 Typically includes the Board, Risk Management
Committee, senior-level executives, and support
departments.
2. Board Responsibilities:
 Sets overall risk management policies and limits.
 Articulates procedures, reviews mechanisms, and ensures
reporting systems.
3. Risk Management Committee (RMC):
 Board-level sub-committee responsible for:
 Guideline setting and reporting.
 Conformance of risk processes to policy.

 Prudential limit establishment and review.
 Ensuring robust risk measurement models.
4. Senior-Level Executives (Sub-Groups):

 ALCO:
 Oversees liquidity risk.
 Monitors and improves Net Interest Margin (NIM).
 Recommends lending rates to the Board.
 CRMC:
 Ensures robust credit risk, including rating processes.
 Conducts portfolio analysis for retail loan assets.
1. Committee Sub-Groups Responsibilities:

 ALCO:
 Monitors liquidity risk and NIM, recommends lending
rates.
 Clears new credit products/processes.

 CRMC:
 Ensures robust credit risk, conducts portfolio analysis.
 Clears new credit products/processes.
 ORMC:
 Ensures operational risk robustness, analyzes frauds.
 Clears new products/processes (excluding credit).
2. Risk Management Support Group/Department:

 Headed by a Chief Risk Officer (CRO).
 Comprises departments for Market Risk, Treasury
Operations, Credit Risk, and Operational/Residual Risk.
 Analyzes, monitors, and reports risk profiles to senior
executives.
 Responsible for independent risk monitoring,
measurement, analysis, and reporting.
3. Risk Identification:

 All transactions involve major risks (liquidity, interest rate,
market, credit, operational).
 Risks managed at transaction and portfolio levels.
 Corporate-level guidelines guide risk-taking at transaction
level.
 New products or deviations require corporate-level
clearance.
 Risk identification involves assessing impact on portfolio
and capital requirements.
1.
2. Risk Identification Example:
 Loan scenario with funding, time, basis, gap, reinvestment,
embedded option, credit, and operational risks.
 Risks impact liquidity, interest rates, and potential
defaults.

3. Risk Measurement Categories:
 Sensitivity: Deviation of a target variable due to a unit
movement in a single market parameter.
 Volatility: Captures variations in target variables.
 Downside Potential: Measures losses due to uncertainties
in risk elements.
4. Sensitivity Measure Example:
 Change in market value due to a 1% change in interest
rates.
 Relevant for parameters driving the target variable (e.g.,
exchange rates, stock prices).
1. Statistical Measures:
 Mean: Sum of observed values divided by the number of
observations.

 Variance: Sum of squared deviations divided by the
number of observations.
 Volatility: Square root of the variance.
2. Volatility Characteristics:
 Captures stability or instability of a random variable.
 Common measure of dispersion for variables like earnings,
market values, and losses due to default.
3. Historical Volatility:
 Calculated using historical data.
 Can be based on any distribution, not just normal.
 Implied volatility is forward-looking, based on option
prices and Black-Scholes formula.
4. Time Series and Volatility:
 Calculation based on defined time series.
 Period and frequency of observation determine volatility.

 Example: Daily, weekly, or monthly volatility based on
stock prices.
5. Conversion and Equation:
 Convert daily volatility to weekly or monthly using the
square root of time rule.
 Volatility over time 'T' = Daily Volatility × Square root of
'T'.
1. Volatility Conversion:
 Monthly volatility calculation: Daily volatility × Square
root of time (e.g., 1.5% × √30 = 8.22).
 Example: If 36 days volatility is 18%, daily volatility is 3%
(18% ÷ 6).
2. Volatility and Risk Measurement:
 Volatility captures variations around the average of a
variable.

 Measures both upside and downside potential.
 Downside potential focuses on adverse deviations,
integrating sensitivity, volatility, and uncertainty.
 Value at Risk (VaR) is a downside risk measure used in
banking and finance.
3. Risk Pricing:
 Banks need capital to cover regulatory requirements,
incurring costs.
 Transaction pricing must generate surplus to cover capital
costs.
 Probability of loss associated with risks should be factored
into pricing.
 Example: If 100 credit accounts have an average loss of
2%, pricing should consider this probability.
1. Risk Pricing:

 Includes capital charge, loss probabilities, and a risk
premium.
 Considers actual costs and profit margin.
 Crucially transaction-based for effective risk measurement.
2. Interest Rate Determinants:
 Includes deposit costs (average or marginal per RBI
norms).
 Considers negative impact from CRR contribution.
 Incorporates operating expenses and default probability.
3. RBI's Rate Mechanism:
 Evolution from BPLR to Base Rate to MCLR.
 Encourages linking rates to external benchmarks (like
Repo Rate).
 New loans tied to external benchmarks for transparency.
4. Challenges in RBI's Mechanism:

 MCLR is an internal benchmark; RBI suggests external
benchmarks for transparency.
 Banks must load costs (deposits, CRR impact, expenses)
into lending rates.
1. Risk Monitoring and Control:

 Objective: Enhance risk-adjusted return on capital
(RAROC).
 Implementation Focus:
 Organizational structure.
 Comprehensive risk measurement approach.
 Consistent risk management policies at corporate and
branch levels.
 Guidelines for risk-taking with prudential limits.
 Execution:

 Strong Management Information System (MIS).
 Effective control and risk reporting framework.
 Independent risk management framework.
 Periodical review, evaluation, and robust audit system.
 Reporting:
 Regular reports to senior management or board of
directors.
 Evaluate material risks, assumptions, and adjust the
strategic plan accordingly.

2. Risk Management Essence:
 Balanced view on risks and returns within capital
constraints.
 Modern best practices include economic measures for risk
limits.

 Focus on feedback, monitoring, and control to align
planned and actual performance.
 Clear delineation of responsibilities in an independent risk
management framework.
1. Control Structure:
 Essential for effective risk management.
 Involves independent reviews and audits.
 Board oversight through a dedicated Committee.
2. Risk Management Review:
 Periodic checks for integrity and accuracy.
 Monitored by the Board Committee on Risk Management.
3. Mitigation Strategies:
 Aim to reduce uncertainties.
 Involves contracts and financial instruments.

 Provides stability but limits upside potential.
4. Impact of Mitigation:
 Reduces downside variability.
 Simultaneously limits upside potential.
 Ensures stability in cash flow and business continuity.
1. Counterparty Risk:
 Mitigated through exchanges and clearing corporations.
 Exchanges act as central counterparties, reducing risk.
 In India, Clearing Corporation of India (CCIL) handles inter-
bank settlements.
2. Diversification and Portfolio Risk:
 Risks can be reduced through diversification.
 Example: Multiple businesses of Mr. X.
 Portfolio risk is lower due to negative correlation among
businesses, achieving risk diversification.

1. Portfolio Risk and Diversification:
 Portfolio risk is less than the weighted average of
individual risks.
 Example with Mr. X's businesses illustrates risk reduction
through diversification.
 Similar concept applies in banking; a portfolio of risks has
lower overall risk due to diversification.
2. Enterprise-Wide Risk Management (EWRM):
 Continuous process addressing business and financial
objectives.
 Identifies, prioritizes, mitigates, and monitors external and
internal risk factors.
 Involves people at all levels, covering all aspects of the
organization for holistic risk management.

1. Evaluation of Existing Risk Management:
 Review internal environment, assess risk philosophy, and
culture.
 Examine objective-setting, identify risk factors, and
evaluate risk assessment processes.
 Assess response mechanisms, control processes, adequacy
of MIS, and risk monitoring.
2. Implementation of EWRM:
 Formulate an implementation plan to address gaps in risk
management.
 Many banks adopt COSO's ERM Framework for
comprehensive risk management beyond Basel norms.
 COSO ERM Framework includes eight key components and
addresses four business objectives.

 ERM helps identify and respond to risks effectively,
ensuring compliance and protecting the entity's
reputation.
1. Banking Business Lines:
 Various and diverse, including commercial banking,
corporate finance, retail banking, trading, investment
banking, and financial services.
2. Sub-Groups and Activities:
 Within each business line, sub-groups exist with a range of
financial activities catering to different client segments.
3. Client Segments:
 Clients vary from retail consumers to mid-market
corporate, large corporate, and financial institutions.
4. Examples of Specialized Finance:

 Extends from standard practices like exports and
commodities financing to complex structured financing for
projects or corporate acquisitions.
5. Table Overview:
 Table 12.1 illustrates the extensive range of business lines
in the banking industry, covering corporate finance, retail
banking, and more.
6. Business Lines Overview:
 Includes corporate finance activities like mergers,
underwriting, and securitization, as well as retail banking
services, project finance, and government finance.
1. Payments and Settlement:

 Activities involve payments, collections, funds transfer,
and clearing and settlement for external clients.

2. Agency Services:
 Includes custody, escrow, depository receipts, securities
lending (customers), and corporate actions.
3. Corporate Trust:
 Involves issuer and paying agents' activities in the
corporate agency and corporate trust sectors.
4. Asset Management:
 Encompasses discretionary fund management with various
types like pooled, segregated, retail, institutional, closed,
and open.
5. Retail Brokerage:
 Activities include execution and full-service retail
brokerage.
6. Product Lines and Client Segments:

 Varied product lines tailored for different client segments,
such as lending products, consumer loans, guarantees,
letters of credit, deposit products, and market products.
7. Operational Risk:
 A significant risk in banking, emphasizing the importance
of effective operational risk management through
anticipating potential issues.
8. Common Goal:
 Enhancing risk-adjusted expected return serves as the
common driver across all business lines.
9. Risk Management Categories:
 Banking business lines categorized broadly into the
banking book, trading portfolio, and off-balance sheet
exposures.
10. Risk Variability:

 Risk management practices vary due to differing
profitability and associated risk factors across various
business lines and activities.
Banking Book:
1. Holds assets until maturity.

2. Uses accrual accounting.
3. Faces liquidity, interest rate, credit, and operational risks.
Trading Book:
1. Trades marketable assets.

2. Applies mark-to-market, not held until maturity.
3. Daily/periodic valuation reflects market value.
Off-Balance Sheet Exposures:

1. Contingent nature—guarantees, credit lines, letters of
credit.
2. No initial cash outflow but payment obligations
contingent on events.
3. Also known as 'Non-fund based exposures.'
4. Contingencies affect revenue generation.
5. Derivatives like swaps, futures, forwards, options are off-
balance sheet market exposures.
6. May lead to fund-based exposure in the banking or
trading book.
7. Involves liquidity, interest rate, market, credit, and
operational risks.
Banking Risks - Definitions:
1. Liquidity Risk:

 Arises from funding long-term assets with short-term
liabilities.
 Inability to obtain funds at a reasonable rate.
 Types:
 Funding Risk: Unanticipated withdrawal/non-renewal
of deposits.
 Time Risk: Non-receipt of expected inflows of funds.
 Call Risk: Crystallization of contingent liabilities.
Interest Rate Risk (IRR):
1. Definition:
 Exposure to adverse movements in interest rates affecting
Net Interest Income, Net Interest Margin, or Market Value
of Equity.

 Risk of changes in financial value due to interest rate
fluctuations.
2. Forms of IRR:
 Gap or Mismatch Risk:
 Arises from holding assets, liabilities, or off-balance
sheet items with different principal amounts or

repricing dates.
 Basis Risk:
 Interest rate changes in different magnitudes for
assets, liabilities, or off-balance sheet items.

 Pronounced in volatile interest rate scenarios.
3. Examples:
 Mismatch risk: Asset maturing in two years funded by a
liability maturing in six months, causing changes in net
interest income.

 Basis risk: Variation in interest rates on assets and
liabilities leading to changes in net interest income.
4. Current Scenario (Basis Risk Example):
 Banks accepting fixed-rate term deposits (e.g., 6%) and
deploying funds in assets linked to variable Repo-Linked
Lending Rates.
 Changes in Repo Rate (varying six times a year) impact Net
Interest Margin, creating basis risk for banks.
Yield Curve Risk:
1. Scenario:
 Banks price assets and liabilities based on different
benchmarks in floating interest rate situations.
 Non-parallel movements in yield curves affect Net Interest
Income (NII).
2. Example:
 Liability linked to 91 days T-Bill funds an asset linked to
364 days T-Bill, causing variation in net interest earned.
 Yield curve risk is a type of basis risk.
3. Embedded Option Risk:
 Significant market interest rate changes lead to
prepayment, exercise of call/put options, or premature
deposit withdrawal.
 Higher and faster interest rate changes increase embedded
option risk, reducing projected cash flow and income.
4. Reinvestment Risk:
 Uncertainty in reinvesting future cash flows due to varying
market interest rates.
 Mismatches in cash flows expose banks to NII variations.
 Example: Different rates offered by banks for the same
deposit tenor.

5. Net Interest Position Risk:
 Arises when banks have more earning assets than paying
liabilities.
 Interest rate decline reduces NII, while rate increase raises
NII.
 Impact on earnings or economic value of assets, liabilities,
and off-balance sheet positions.
6. Market Risk (Price Risk):
 Risk of adverse deviations in mark-to-market value of the
trading portfolio due to market movements.
 Results from adverse market price movements in interest
rate instruments, equities, commodities, and currencies.
Price Risk:
1. Definition:
 Occurs when assets are sold before stated maturities,
particularly affecting the trading book.
 Bond prices and yields are inversely related.
2. Market Risk Components:
 Part of Interest Rate Risk (IRR) affecting interest rate
instruments' prices.
 Pricing Risk for assets in the trading book (excluding
commodities in India).
 Foreign Currency Risk (Forex Risk).
Forex Risk (Exchange Risk):
1. Definition:
 Loss risk due to adverse exchange rate movements during
an open position in foreign currency.

 Rupee depreciation is a long-term trend; short-term
volatility affects exporters and importers differently.
Market Liquidity Risk:
1. Definition:
 Arises when a bank struggles to conclude a large
transaction near the current market price.
Default or Credit Risk:
1. Credit Risk:
 Potential of a borrower or counterparty failing to meet
obligations.
 Loans and corporate bonds are major sources of credit risk
for banks.
2. Counterparty Risk:

 Variant of credit risk related to non-performance by
trading partners.
 Often seen in unsecured Call money borrowing between
banks.
3. Country Risk:
 Type of credit risk where non-performance results from
constraints imposed by a country.
 External factors beyond the borrower's or counterparty's
control contribute to non-performance.
Operational Risk:
1. Definition:
 Risk of loss from inadequate internal processes, people,
systems, or external events.
 Excludes strategic and reputation risks per Basel
Committee on Banking Supervision (BCBS).
2. Scope:
 Encompasses various risks, including fraud,
communication, documentation, competence, model,
cultural, external events, legal, regulatory, and system
risks.
Transaction Risk:
1. Definition:
 Arises from fraud (internal and external), failed business
processes, and challenges in maintaining business
continuity and information management.
Compliance Risk:
1. Definition:

 Risk of legal, regulatory, financial, or reputation loss due
to non-compliance with applicable laws, regulations, codes
of conduct, and standards.
 Emphasizes adherence to principles of integrity and fair
dealing.
Strategic Risk:
1. Definition:
 Arises from adverse business decisions, improper
implementation, or lack of responsiveness to industry
changes.
 Reflects the gap between strategic goals, business
strategies, deployed resources, and the quality of
implementation.
Reputational Risk:

1. Definition:
 Arises from negative public opinion due to the
crystallization of credit, market, or operational risks.
 Treated as an indirect risk, potentially leading to litigation,
financial loss, or a decline in customer base.
Model Risk:
1. Definition:
 Models predict values based on specific parameters
influencing the variable's value.
Model Risk:
1. Definition:
 Gap between predicted and observed values in models.
 Affects profit and loss in pricing models and risk
assessment in risk measurement models.
2. Reasons for Model Risk:
 Incorrect or irrelevant assumptions.
 Omissions of parameters for simplification.
 Statistical errors, insufficient data, and misjudgment in
handling outliers.
3. Validation:
 Models validated through back testing.
 Validation conducted by personnel not involved in model
design.
Summary of Risks:
 Banking and financial services face diverse risks.

Climate Risk:
1. Definition:
 From climate change and mitigation.
 Impacts: Physical and transition risks.
2. Physical Risks:
 Acute (floods) and chronic (rising sea levels).
 Varies geographically.
 Results in economic and financial damage.
3. Transition Risks:
 Shift to low-carbon economy.
 Drivers: Climate policies, tech advances, sentiment shifts.
 Examples: Valuation reduction, tech-driven energy
transition.
 Influences economy and financial system.
Regulation of Banking Industries: Necessities and Goals
1. Importance:

 Global banking and financial services regulation is typically
led by the Monetary Authority.
 Essential for economic backbone and prosperity.
2. Risk Management:
 Banks inherently face various risks.
 Proper regulation crucial to prevent failures and protect
economies.
3. Leveraged Business:
 Banking involves lending from depositors' funds, making
it highly leveraged.
 Regulation, like in India by the Reserve Bank, safeguards
depositor interests.
4. Regulatory Impact:
 Influences risk management practices, internal models,
and processes.

 Aims to enhance safety, ensure fair competition, and
promote sound practices.
5. Goals of Regulations:
 Improve banking safety through risk-based capital
requirements.
 Standardize benchmarks for fair competition.
 Encourage sound business and supervisory practices.
 Control systemic risk and safeguard depositor interests.
6. Systemic Risk:
 Risk of the entire banking system's failure.
 Individual bank failures contribute to systemic risk due to
high inter-relations.
Systemic Risk:

1. Inter-Relations:
 Mutual lending and commitments among banks create
ongoing inter-relations.
 Failure of one bank can trigger a systemic risk affecting all
interconnected banks.
Need for Risk-Based Regulation:
1. Stabilizing Factors (Seventies):

 Strong regulations ensured stability, limited competition,
and reduced risks.
2. Deregulation Impact:
 Deregulation aimed at faster growth increased
competition and global transactions, raising risks.
3. Competition and Globalization:

 Basel Committee on Banking Supervision (BCBS) emerged
to reconcile risk control and fair competition.
4. Role of Bank for International Settlements (BIS):
 BIS fosters international monetary stability, overseeing
BCBS for banking regulations.
5. Basel Committee Origins:
 Formed in 1974 post-Herstatt incident to address
disturbances in currency and banking markets.
 Initially named the Committee on Banking Regulations
and Supervisory Practices.
6. Herstatt Incident:
 BCBS formed due to Herstatt incident, where currency and
banking market disturbances led to regulatory needs.
Herstatt Incident and BCBS Formation:
1. Herstatt Risk:
 Time lag in dollar payments led to Herstatt Risk.
 German regulators liquidated Bank Herstatt before
payments completed.
2. Formation of BCBS:
 G-10 countries formed BCBS in 1974 post-Herstatt
incident.
 BCBS under BIS, with Central Bank Governors from
participating countries.
 G-20 now includes major economies; accepted Basel-III at
5th G-20 summit (Nov 2021).
3. G-20 Meetings:
 G-20, major economies coordinating global policies.
 Recent meeting in Rome (Oct 2021) focused on COVID-19
response.
4. Basel Committee Evolution:

 Expanded from G10 to 45 institutions in 28 jurisdictions.
 Introduced Basel standards (I, II, III) for global banking
regulations.
5. BCBS Groups:
 Policy Development, Supervision, Basel Consultative,
Macroprudential, and Accounting Experts groups.
 Groups report to BCBS Chairman, contributing to global
regulatory standards.
1. Support Measures:
 Aid for lending, funding, market operations, and ensuring
operational continuity.
2. FSB's Role:
 FSB promotes global financial stability through
coordination.
3. Systemic Risk and Regulation:

 Systemic risk from interconnectedness requires deposit
insurance and capital regulations.
4. Basel I (1980s):
 Emerged post-deregulation, focusing on bank capital
requirements.
1. 1988 Basel Accord:
 Addressed capital adequacy, set 8% capital-to-risk-
weighted-assets ratio.
2. Risk Classification:
 Assets grouped into 0%, 10%, 20%, 50%, 100% risk
buckets.
3. Capital Components:
 Defined Tier 1 (equity, disclosed reserves) and Tier 2
(supplementary) capital.
4. Cooke Ratio:

 Introduced 8% CRAR benchmark, a precursor to
standardized capital regulations.
5. Impact:
 Paved the way for increased focus on measuring,
understanding, and managing banking risks.
1. Cooke Ratio:
 Measures total credit exposure against capital.
2. 1996 Market Risk Amendment:
 Introduced proprietary models for market risk.
 Included VAR with back-testing.
 Allowed short-term subordinated debt for market risk.
 Applied to banking and securities firms.
3. BCBS Enforcement:
 Lacks formal supervisory authority.
 Provides non-binding standards.

 Encourages convergence on common standards.
1. Basel II Accord (2004):
 Replaced 1988 Accord.
 Comprised three pillars:
 Minimum capital requirements (expanded from 1988).
 Supervisory review of capital adequacy and internal
assessment.
 Effective use of disclosure for market discipline.
 Aimed to improve risk sensitivity, address financial

innovation, and reward risk control improvements.
2. Development Process:
 Proposed in 1999, released in 2004.
 Six years of preparation and consultation.
 Revised in 2006 for comprehensive integration.
3. Challenges Under Basel II:

 Approval challenges for risk measurement approaches
across jurisdictions.
1. Basel II Accord (2004):
 Three pillars: Capital minimum, Supervisory review, Market
discipline.
 Enhanced approvals and cooperation between home and
host supervisors.
 Guidance on information sharing and supervisory
cooperation (2006).
2. Pillar 1 – Minimum Capital:
 Credit Risk: Standardised, IRB Foundation, IRB Advanced.
 Market Risk: Standardised (Maturity, Duration), Internal
Models.
 Operational Risk: Basic Indicator, Standardised, Advanced
Measurement.

3. Pillar 2 – Supervisory Review:
 Evaluate risk assessment.
 Ensure internal process integrity.
 Maintain minimum capital with PCA.
 Prescribe differential capital as needed.
4. Pillar 3 – Market Discipline:
 Enhance disclosure.
 Core and supplementary disclosures.
 Timely, semi-annual reporting.
5. CRAR Norms in India:
 Minimum CRAR: 8% until March 1999.
 Minimum CRAR: 9% from March 2000 onward.
1. Pre-Lehman Crisis:

 Basel II weaknesses: Excessive leverage, inadequate
liquidity buffers, poor governance.
 Basel Committee response in September 2008: Issued
principles for sound liquidity risk management.
2. Post-Lehman Enhancements (July 2009):
 Strengthened Basel II capital framework.
 Focus on complex securitisation positions, off-balance
sheet vehicles, and trading book exposures.
3. Basel III Announcement (September 2010):
 GHOS announced higher global minimum capital
standards.
 Basel III aimed at reforming capital and liquidity standards
for commercial banks.
4. Global Agreement (November-December 2010):
 G20 Leaders' Summit in Seoul endorsed new standards.

 Basel III framework issued in December 2010, emphasizing
resilience and revising the three pillars.
5. Innovations in Basel III:
 Introduction of capital conservation buffer.
 Countercyclical capital buffer to restrict bank participation
during economic upswings.
1. Basel III Innovations:
 Introduced leverage ratio for minimum loss-absorbing
capital.
 Liquidity requirements: LCR and NSFR.
 Proposals for systemically important banks.
2. Implementation Monitoring (Jan 2012):
 GHOS endorsed RCAP for Basel III monitoring.
 Focus on timely adoption and standards' consistency.
3. Transitional Arrangements (Sep 2010):

 Phased approach for smooth transition.
 Adaptation to new standards without hindering recovery.
4. Phased Capital Standards (2013-2017):
 Strengthened standards gradually implemented.
 Higher minimums for Common Equity, Tier 1, and leverage
ratio.
 Conservation buffer phased out by Oct 2021.
1. LCR Implementation:
 Phased from Jan 2015 to 100% by Jan 2019.
 Pandemic led to a temporary relaxation, reinstated to
100% from Apr 2021.
2. NSFR Implementation (Jan 2018):
 Introduced as a minimum standard from Jan 2018.
 Focuses on longer-term funding and stable sources.
3. Basel III in India:

 Introduced by BCBS for banking resilience.
 Implemented in India from April 1, 2013.
 Full implementation expected by March 31, 2019.
 COVID-19 led to CCB implementation deferral to Oct 1,
2021.
1. Basel-III Compliance (Oct 1, 2021):
 Full CCB: 2.50%
 Min. CRAR: 11.50%
2. Discontinuation: Basel II Implementation:
 Parallel run/prudential floor stopped.
3. Basel III Pillars & Options:
 Pillars: Capital, review, discipline.
 Credit Risk: Std., Foundation IRB, Adv. IRB.
 Operational Risk: Basic, Std., Adv. Measurement.
4. Implementation in India (Since April 1, 2013):

 Std. Approach for credit risk.
 Basic Indicator for operational risk.
5. Advanced Approach Adoption:
 Choose own date, risk category.
 RBI approval needed.
6. Effective Date & Scope:
 Started April 1, 2013.
 Compliance at consolidated, standalone levels.
 Overseas branches included.
1. Minimum CRAR Requirement (Pillar 1):
 Ongoing: 9% (excluding capital conservation buffer).
 RBI considers risk factors and internal assessments.
2. Pillar 2 Framework:
 Higher minimums based on individual bank risk profiles.

 Banks expected to operate well above minimum
requirements.
3. Basel III Capital Ratio Calculation:
 Common Equity Tier 1 (CET1) Ratio.
 Tier 1 Capital Ratio (CET1 + AT1).
 Total Capital Ratio (CRAR).
4. Components of Regulatory Capital:
 Going-concern capital (Tier 1).
 Common Equity Tier 1 (CET1).
 Additional Tier 1 (AT1).
 Gone-concern capital (Tier 2).

5. Limits and Minima:
 Scheduled commercial banks (excluding specific banks).
 Maintain a minimum total capital ratio.
1. Minimum Capital Requirements:

 CRAR: 9% of total RWAs.
 CET1: 5.5%, Tier 1: 7%, Total Capital: 9% of RWAs.
 Maximum Additional Tier 1: 1.5%, Maximum Tier 2: 2%.
2. Capital Conservation Buffer (CCB):
 CCB: 2.5% of RWAs, comprised of Common Equity Tier 1.
 Total Capital with CCB: 11.5% of RWAs.
3. Capital Charge for Credit Risk (Standardised Approach):
 External credit rating agencies determine credit risk.
 RBI-identified agencies and guidelines are followed.
Note: Detailed capital adequacy guidelines provided by RBI.

1. Credit Risk Categories:
 (a) to (o): Various categories including sovereigns, public
entities, banks, corporates, and more.
 (p) Capital Adequacy for Credit Default Swap (CDS)
Positions.
2. Eligible Credit Rating Agencies:
 Domestic agencies: CARE, CRISIL, ICRA, India Ratings,
Acuite Ratings, INFOMERICS.
 International agencies: Fitch, Moody’s, Standard & Poor’s.
3. Risk Weight Assignments:
 Based on ratings from eligible agencies.
 Risk weights determine capital adequacy requirements for
different types of exposures.
1. IRB Approach Overview:
 Foundation (FIRB) and Advanced (AIRB) versions.
 Banks' internal assessments drive capital calculation.
 More risk-sensitive due to internal risk parameter use.
2. Capital Charge Computation:
 Parameters: PD, LGD, EAD, Maturity.

 Risk-weighted assets derived from capital charge
computation.
3. Risk Weights Determination:
 Example: AAA-rated borrowers may have different risk
weights.
 Determined by capital requirement, not uniform weights.
4. IRB Calculation for Risk-Weighted Assets:
 Based on PD, LGD, EAD, Maturity.
 Quantitative inputs from banks combined with
Committee-specified formulae.
5. Parameters Explanation:
 PD: Likelihood of borrower default.
 LGD: Proportion of exposure lost in default.
 EAD: Likely drawn amount in default for commitments.

 Maturity (M): Remaining economic maturity of the
exposure.
6. Foundation vs. Advanced IRB:
 Differences in who provides inputs for PD, LGD, EAD, and
Maturity.
1. Credit Risk Mitigation (CRM) Overview:
 Banks employ techniques like collateral, guarantees, etc.
 Basel III widens the range of recognized mitigants.
 Applicable to banking book and counterparty risk in
trading book.
2. General Principles:
 Capital requirement for CRM transactions should not
exceed identical non-CRM transactions.
 No double counting of CRM effects.
 No principal-only ratings allowed in CRM framework.

 CRM may reduce credit risk but increase other risks
(residual risks).
3. Residual Risks:
 Residual risks include legal, operational, liquidity, and
market risks.
 Banks must implement robust procedures to control these
risks.
 Considerations: strategy, underlying credit, valuation,
policies, systems, roll-off risks, and concentration risk
management.
1. Supervision:
 RBI may act if risks from Credit Risk Mitigation (CRM)
aren't controlled.
 Basel III guidelines' disclosure rules for capital relief must
be followed.

2. Legal Certainty:
 Legal docs in collateral transactions must be binding and
enforceable.
 Ongoing legal reviews are essential for enforceability.
3. Collateralized Transactions:
 Involves credit exposure hedged by collateral.
 Specific lien on collateral is necessary.
4. CRM Framework:
 India adopts Comprehensive Approach for collateral
offset.
 Eligible collateral reduces credit exposure.
 Capital relief requires meeting legal and liquidation
criteria.
 'Haircuts' adjust for market volatility: premium for exposure,
discount for collateral.

 RBI's rule applies to eligible collateral, not credit exposure.
 Repo-style transactions get a haircut for market volatility.
 8% downward adjustment for currency mismatch.
 Calculate risk-weighted assets if exposure exceeds collateral.
 On-balance sheet netting allowed for loans/deposits with
enforceable agreements.
 Conditions include legal enforceability, ability to determine
netting, monitoring exposures, and controlling roll-off risks.
 Net exposure used for capital calculation with zero haircuts,
except for currency mismatch.
 Follow RBI Circular on Basel III for additional requirements.
 Recognized guarantors: sovereigns, certain entities, and

externally rated entities.

 Eligible entities include those with a lower risk weight,
excluding SPEs in securitization.
 Market risk involves losses from interest rate instruments,
equities, and foreign exchange.
 Capital charge for market risks covers trading book items like
securities and derivatives.
 Banks must manage and maintain market risk capital
requirements daily.
 Capital for market risk doesn't apply to matured unpaid
securities, only credit risk.
 After 90 days delinquency, these securities are treated like
NPAs for credit risk.
 Capital charge for interest rate-related instruments is based
on the current market value.

 It includes a "specific risk" charge for individual securities and
a "general market risk" charge for interest rate risk.
 Banks can use the standardized duration method for
measuring general market risk.
 General market risk capital charge includes net positions,
matched positions, and charges for options.
 Maturity ladders used for each currency, with no offsetting
between positions of opposite sign.
 For currencies with less than 5% turnover, separate
calculations aren't needed.
 Instead, slot net long or short positions within each time-band
and sum them.
 Gross positions in each time-band subject to assumed change
in yield, no further offsets.

 Under Standardized Duration method: calculate modified
duration, apply assumed yield change, slot into maturity
ladder, apply vertical disallowance for basis risk, and carry
forward net positions for horizontal offsetting.
 Derivatives create short positions in portfolios, mitigating
interest rate risk.
 Rising interest rates impact long positions negatively but
benefit short positions.
 Short positions in derivatives offset adverse effects, reducing
overall capital charge.
 Basis risk arises as interest rate changes for assets and
liabilities may not fully offset.
 Vertical disallowance (5%) accounts for basis risk in netted
positions within a maturity band.

 Horizontal disallowance (30% to 100%) addresses yield curve
risk in netted positions across maturity bands.
 Example clarifies adjustments required for portfolios with
short positions from derivatives.
1. Securities (2-year maturity): Rs. 100 Cr capital charge.
2. Securities (5-year maturity): Rs. 450 Cr capital charge.
3. Derivatives (6-month short position): Rs. 100 Cr capital
charge.
4. Derivatives (2-year short position): Rs. 50 Cr capital
charge.
5. Net position: Rs. 400 Cr.
6. Vertical Disallowance: Rs. 2.5 Cr.
7. Horizontal Disallowance:
 Zone 1 (6 months): Net balance - Rs. -100 Cr.
 Zone 2 (2 years): Net balance - Rs. 50 Cr.

 Zone 3 (5 years): Net balance - Rs. 450 Cr.
 Disallowance percentages: Zone 1&2 - 40%, Zone 2&3 -
40%, Zone 1&3 - 100%.
 Horizontal Disallowance: Rs. 70 Cr.
 Total Capital Charge for Market Risk: Rs. 472.5 Cr.
 Vertical Disallowance: Rs. 2.5 Cr (5% of netting in 1.9 to 2.8
years maturity band).
 Horizontal Disallowance (Zone 1&2): Rs. 20 Cr (40% of Rs. 50
Cr netted).
 Horizontal Disallowance (Zone 1&3): Rs. 50 Cr (100% of Rs. 50
Cr netted).
 Capital charge is the sum of all items, totaling Rs. 472.5 Cr.
 Note: For available-for-sale securities, the higher of specific
and general market risk charges is taken.

 Note: For shares, the market risk charge is 18% of the market
value.
 Note: Market risk charge for open positions in foreign
exchange and gold is 9% of limits or actual, whichever is
higher.
 Capital charge for derivatives is computed like securities,
considering specific and general market risk.
 Total market risk capital charge consolidates specific and
general risk charges for all portfolio items.
 Consolidated capital charge breakdown includes Interest Rate,
Equity, and Foreign Exchange and Gold.
 Total market risk capital charge can be converted to risk-
weighted assets by dividing by 0.09.

 Operational risk is the risk of loss from internal processes,
people, systems, or external events, excluding strategic and
reputational risk.
 Three methodologies for calculating operational risk capital
charges: Basic Indicator Approach (BIA), Standardised
Approach (TSA), and Advanced Measurement Approaches
(AMA).
 BIS is considering repealing AMA and introducing a new
approach called 'Standardized Measurement Approach'
(SMA).
 Banks should progress to advanced operational risk

measurement.
 Internationally active banks use advanced approaches for
operational risk.

 Indian banks start with Basic Indicator Approach (BIA) for
operational risk capital.
 Reserve Bank reviews BIA for credibility; considers Pillar 2
supervisory action if needed.
 BIA capital charge: KBIA = [Σ (Positive GI × 15%)]/Number of
positive years (last three years).
 Gross income in BIA includes net interest and non-interest
income, excluding specific items.
 Gross income is gross of provisions, write-offs, operating
expenses, and extraordinary items.
 Exclusions from gross income: reversal of provisions, income
from property disposal, profits/losses from "held to maturity"
securities, legal settlement income, and insurance-related
income.

 Compute operational risk capital under Basic Indicator
Approach (BIA).
 BIA: Average of [Gross Income * 15%] over the last three years
(exclude negative or zero gross income years).
 Gross income includes net profit, provisions, contingencies,
operating expenses, minus specific items.
 Proposed accord provides different approaches: Basic
Indicator, Standardised, Advanced Measurement (AMA).
 Standardised: Average gross income divided into business
lines with specific capital charges (12%, 15%, 18%).
 AMA: Internal loss data, external loss data, scenario analysis,
business environment factors contribute to capital charge.
 Total capital charge in AMA is the sum across business lines
with up to 20% risk mitigation.

 AMA requires a conceptually sound operational risk
management system, five years of loss data, and compliance
with BCBS "Sound Practices."
 Pillar 2 (SRP) complements Pillar 1 in the New Capital
Adequacy Framework.
 Banks must have a Board-approved policy for Internal Capital
Adequacy Assessment Process (ICAAP).
 The framework consists of Pillar 1 (Minimum Capital Ratio),
Pillar 2 (SRP), and Pillar 3 (Market Discipline).
 SRP ensures adequate capital, encouraging better risk
management through ICAAP.
 ICAAP involves dialogue between banks and RBI to assess and
assure capital adequacy.
 SRP covers risks not fully captured by Pillar 1, external factors,
and those not considered by Pillar 1.

 Additional capital may be necessary due to under-estimation
and actual risk exposure.
 Risks like interest rate, credit concentration, liquidity,
settlement, reputational, strategic, and under-estimation of
credit risk may not be fully addressed in Pillar 1.
 Pillar 2 covers model risk, credit-risk mitigants, securitization
risk, and others.
 Banking problems often stem from lax credit standards and
poor risk management.
 The 2007-08 crisis emphasized the importance of effective
credit risk management.
 Comprehensive credit risk management involves environment
setup, sound processes, and monitoring.
 Effective capital planning requires assessing risks, capital
adequacy, and stress testing.

 Rapid growth, like "originate-to-distribute," poses challenges
in risk management.
 Managing risks from securitization and derivatives is complex,
especially in declining markets.
 Inadequate risk identification can lead to unintended
exposures and losses.
 Demand for structured products led to challenges in risk
management strategies.

1. Pillar 2 Focus:
 Includes model risk, credit-risk mitigants, and
securitization.
2. Causes of Banking Problems:

 Stem from lax credit standards, poor risk management,
and neglect of economic changes.
3. Credit Risk Management:
 Crucial for financial stability.
 Involves creating the right environment, sound processes,
and vigilant monitoring.
4. Capital Planning:
 Essential for resilience.
 Requires rigorous stress testing.
5. Challenges in Rapid Business Growth:
 Noted in models like "originate-to-distribute."
 Poses difficulties in identifying risks.
1. Pillar 2 Responsibilities:
 ICAAP and SREP are critical.

 Banks must establish processes and operate above
minimum ratios.
2. Supervisors' Responsibilities:
 Review and evaluate ICAAP.
 Ensure compliance with ratios.
 Have authority to demand excess capital.
 Intervene early to prevent shortfalls.
 Require rapid remedial action.
3. ICAAP Definition:
 Involves risk identification and capital adequacy.
 Develops suitable risk management systems.
4. SREP Definition:
 Supervisory process covering ICAAP.
 Includes risk profile assessment and prudential measures.
1. Sound Risk Management:

 Active oversight.
 Appropriate policies.
 Comprehensive risk measures.
 Effective information systems.
 Internal controls.
2. Review and Validation:
 Regular, independent audit.
 Comprehensive and proportionate risk assessment.
 Periodic reviews of risk processes.
3. ICAAP Characteristics:
 Forward-looking, risk-based.
 Includes stress tests.
4. Capital Models Usage:
 No mandate for complex models.
 Encouraged for international banks.

 Requires well-documented specifications.
1. CCB Objective:
 Build capital in normal times.
 Use in stressed periods.
2. Utilization Rules:
 Only during stress.
 Not for competitive gain.
3. Supervisory Oversight:
 RBI monitors.
 Serious if buffer falls unjustifiably.
4. Replenishing:
 Plan for drawdown.
 Time limit set by RBI.
5. Framework's Purpose:
 Strengthen banks.

 Enhance sector resilience.
 Reduce pro-cyclicality.
6. Capital Requirements:
 Maintain 2.5% buffer.
 Imposed on 9% minimum.
 Constraints on distribution.
7. Distribution Constraints:
 Increase near minimum.
 Allows normal operations.
 Rebuilds capital in recovery.
1. Capital Conservation Ratio (CCR):
 Linked to CET1 Ratio.
 Specifies earnings payout limits.
2. Payout Limits:
 Gradual reduction with higher CET1.

 Example: 80% conservation for CET1 of 6.125%-6.75%.
3. Transition Period (Basel III):
 Gradual implementation.
 RBI phased reserve creation.
4. Phased Reserve Creation:
 March 2016: 0.625% of RWAs.
 Incremental increases up to March 2019.
5. Deferred Implementation:
 Pandemic impact.
 Last tranche deferred from April 2021 to October 2021.
6. RBI Relaxation:
 Eased stress due to COVID-19.
 Supported banks in the recovery process.
1. Leverage Ratio Introduction:

 Addresses financial crisis leverage issues.
 Basel III's non-risk-based leverage ratio.
2. Objective of Leverage Ratio:
 Prevent destabilizing deleveraging.
 Acts as a simple, transparent backstop.
3. Leverage Ratio Calculation:
 Leverage ratio = Capital Measure/Exposure Measure.
 Expressed as a percentage.
4. Minimum Tier 1 Leverage Ratio:
 Basel Committee tests 3% minimum.
 Indian banks operate at over 4.5%.
5. Indian Leverage Ratio Adjustment:
 RBI's June 6, 2019 circular.
 Reduced leverage ratio to 4% for DSIBs and 3.5% for
others.

6. Leverage Ratio in Prompt Corrective Action:
 One of four indicators.
 Part of RBI's framework.
7. Countercyclical Capital Buffer (CCCB) Objective:
 Build capital in good times.
 Ensure credit flow during economic downturns.
1. CCCB Objective:
 Restrict lending in excess credit periods.
 Prevent system-wide risk.
2. CCCB Framework:
 0-2.5% of RWA as CET 1 capital.
 Pre-announced with lead time.
 Indicators: credit-to-GDP, GNPA, C-D ratio, Industry
Outlook, and interest coverage ratio.
3. Thresholds and Activation:

 Lower (L) at 3% credit-to-GDP.
 Upper (H) at 15% credit-to-GDP.
 Gradual increase between 3-15%.
4. Distribution Restrictions:
 If CCCB isn't met, restricts dividends, buybacks, and
bonuses.
 Conservation ratio linked to CET1 capital.
1. D-SIB Framework:
 Addresses TBTF concerns.
 Based on BCBS methodology with modifications.
 Indicators: size, interconnectedness, substitutability, and
complexity.
2. Assessment Methodology:
 Computes a composite systemic importance score.
 Cut-off score determines D-SIB status.

 Five buckets with additional CET1 capital requirement
(0.20% to 1.00%).
3. Supervisory Measures:
 D-SIFIs face higher supervisory requirements.
 Intensity based on systemic risks they pose.
 Higher capital requirements phased in from April 1, 2016,
fully effective by April 1, 2019.
4. Current Requirements (April 1, 2019):
 Bucket 5: 1.00%
 Bucket 4: 0.80%
 Bucket 3: 0.60%
 Bucket 2: 0.40%
 Bucket 1: 0.20%
5. Identified D-SIBs:
 State Bank of India and...

(Note: Incomplete information regarding additional D-SIBs
due to truncation.)
1. D-SIB Updates (March 2018):

 3 D-SIBs in India: SBI (Bucket 3), ICICI Bank (Bucket 1),
HDFC Bank (Bucket 1).
2. Risk Based Supervision (RBS):
 Shift from transaction-centric to RBS.
 Committee chaired by Dr. K. C. Chakrabarty.
 Recommendations: 'Supervisory Relationship Manager,'
off-site/on-site tools, six-step process, stress testing,
thematic reviews.
 Focus on soundness in supervisory rating framework.
1. Market Risk Overview:

 Mr. X invests Rs. 10,000 in ABC Ltd. shares, creating a
portfolio.
 Portfolio value drops 5%, leading to a direct capital loss
for Mr. X.
2. Leverage Impact:
 With 9x leverage, Mr. X's total resources are Rs. 100,000.
 Investing full resources in ABC Ltd. shares results in a 50%
capital loss.
3. Extended Risks:
 Mr. X faces asset liquidity risk as he must liquidate
holdings to repay borrowings.
 Illiquidity in the market can lead to further losses and
depletion of capital.
 Poor market liquidity compounds risks, especially in
adverse conditions.

1. Individual Risk:
 Mr. X faces market risks, with potential profits or losses.
 Profits motivate participation, but losses pose challenges.
2. Risk Management Framework:
 Mr. X needs a framework for risk management.
 Essential for understanding and mitigating downside
potential.
3. Bank's Market Exposure:
 Banks have market exposure in the trading book.
 Includes proprietary positions in various financial
instruments.
4. Trading Book Risks:
 Banks' trading books entail:
 Market Risk
 Liquidity Risk

 Asset Liquidity
 Market Liquidity
 Credit and Counterparty Risks
5. Market Liquidity Risk:

 Different from funding liquidity risk.
 Arises from adverse market conditions impacting asset
values.
1. Market Risk:
 Risk of mark-to-market deviations during liquidation.
 Longer liquidation periods increase adverse deviations.
 Earnings tied to market portfolio variations.
2. Liquidation Period:
 Varies by instrument type (e.g., 1 day for forex, longer for
derivatives).

 Operational risk if monitoring neglects potential
deviations.
3. Trading Liquidity:
 Ability to transact without affecting market prices.
 Crucial for liquidating positions without impacting
counterparties.
4. Liquidity Risk Factors:
 Adverse deviations due to poor liquidity.
 Challenges in attracting attention without compromising
quality.
 Different price volatility levels in high and poor liquidity
situations.
5. Market Liquidity Risk:
 Differs from 'pure' market risk.

 Critical in emerging markets with prices diverging from
fair value.
6. Liquidation Risk:
 Arises from poor trading liquidity.
 Results in adverse market price changes.
 Inability to liquidate at fair prices or any price.
1. Asset Liquidation Risk:
 Asset faces trading liquidity shortage.
2. Market Liquidation Risk:
 General market liquidity crunch impacts trading.
3. Credit Risk:
 Assessed through credit ratings.
 Default or rating downgrade impacts prices.
 Derivatives' credit risk interacts with market risk.
 Settlement risk occurs if either party defaults.

 Mitigated by systems like RTGS.
1. RTGS for Settlement:
 RTGS isn't used for settlement; central counterparties like
Clearing Corporation of India handle it.
2. Market Risk Management Framework:
 Addresses risks, measures quantum, monitors and
controls, and explores risk reduction.
3. Organizational Structure:
 Top management's role is crucial.
 Consists of Board, Risk Management Committee, ALCO,
ALM Support Group, and Middle Office.
1. Board of Directors:
 Top-level responsibility.
 Sets policies, limits, and oversees systems.
2. Risk Management Committee:

 Board Sub-Committee.
 Guides, ensures conformity, sets limits, and oversees
staffing.
3. ALCO (Asset-Liability Management Committee):
 Implements policies and business strategy.
 Decides on pricing, NIM protection, funding, etc.
4. ALM Support Groups:
 Reports risk profiles to ALCO.
 Recommends actions based on market changes.
5. Middle Office:
 Monitors treasury risk independently.
 Reports to ALCO, validates prices.
6. Risk Identification:
 Analyzes all products for associated risks.
 Closer scrutiny for non-standard products.

1. Product Programmes:
 Guidelines for standard products.
 Defines procedures, limits, controls, and risk measurement.
2. New/Non-Standard Products:
 May operate under a temporary 'Product Transaction
Memorandum.'
 Requires corporate-level clearance for risk-related
deviations.
3. Risk Measures:
 Depend on quantitative methods.
 Include sensitivity and downside potential.
4. Sensitivity:
 Captures market value deviation for a unit change in a
single parameter.
 Commonly used despite limitations.

5. BPV (Basis Point Value):
 Measures interest rate sensitivity.
 Provides a specific value for interest rate risk.
6. Duration:
 Another measure for interest rate sensitivity.
 Represents weighted average time to receive portfolio
cash flows.
7. Downside Potential:
 Measures potential losses beyond a defined threshold.
 Offers a comprehensive view of risk.
8. Corporate-Level Clearance:
 Required for new products or deviations.
 Emphasizes standardized risk content and informed
decision-making.
9. Impact on Portfolio Risk:

 Critical in corporate-level clearance.
 Evaluates how transaction-level risk affects overall
portfolio risk.
1. Basis Point Value (BPV):
 Measures risk due to a 1 basis point change in yield.
 Higher BPV indicates higher bond risk.
 Computed as the change in value per basis point.
2. Example Calculation:
 5-year 6% bond with market yield change from 8% to
7.95%.
 BPV = Rs. 2,000 per crore face value.
 Quick calculation for profit/loss.
3. Duration:
 Macaulay’s Duration reflects a bond's price sensitivity to
yield change.

 Represents the average time for the present value of cash
flows.
 Duration as the "centre of gravity" for cash flows.
4. Calculation Example:
 RBI's 3-year bond with a coupon of 8% and interest paid
annually.
 Duration calculation based on cash flows.
5. Modified Duration:
 Macaulay’s Duration discounted by 1 period yield to
maturity.
 Measures the bond price change for a 1% yield change.
 Example to illustrate Modified Duration.
1. Modified Duration:
 Formula: Modified Duration = Duration / (1 + r).

 Example calculation: Modified Duration = 2.7834 / 1.08 =
2.57.
 Indicates the price change for a 1% yield change.
2. Price Change Estimation:
 Longer duration implies higher price sensitivity.
 Approximate % change in price = -Modified Duration ×
Yield Change.
 Example: Price change from 8% to 7% yield.
3. Downside Potential:
 Captures possible losses, ignoring profit potential.
 Downside risk is comprehensive, integrating sensitivity,
volatility, and uncertainty.
4. Value at Risk (VaR):
 Answers "How much can we expect to lose?"

 Predicts worst-case loss at a confidence level over a
specific time.
 Example: 1-day VaR of Rs. 10 crore with 99% confidence
means a 1% chance of exceeding this loss.
5. VaR Limitations:
 Applies under normal trading conditions.
 Doesn't estimate losses in abnormal situations.
 Confidence level and time horizon considerations.
1. VaR Factors:
 Uses volatility and correlations.
 Longer horizon increases VaR.
2. Yield vs. Price Volatility:
 Yield: Unaffected by time.
 Price: Affected by time and duration.
3. VaR Approaches:

 Correlation, Historical Simulation, Monte Carlo Simulation.
 Parameters: Holding period, confidence interval, historical
time.
4. Correlation Method:
 Deterministic.
 Uses sensitivity, variance/covariance matrix.
5. Historical Simulation:
 Uses actual historical movements.
 Sensitive to chosen historical period.
6. Monte Carlo Simulation:
 Uses randomly generated scenarios.
 Requires assumptions about market factors.
7. Model Importance:
 Model accuracy crucial for VaR.
 Closer models fit economic reality.

8. VaR Variability:
 No guarantee of alignment between methods.
 Model-dependent variations in VaR estimates.
VaR Usefulness:
1. Protects stakeholders and overall business.

2. Translates exposures to P&L impact.
3. Aggregates diverse exposures into one number.
4. Meets external risk disclosure expectations.
5. Integral to current risk measurement practices.
6. Accepted by practitioners, regulators, academics.
7. Valuable as a probabilistic measure of losses.
VaR Usefulness:
1. Shields stakeholders and business.

2. Translates exposures to P&L impact.

3. Aggregates diverse risks into one figure.
4. Meets external risk disclosure norms.
5. Integral in current risk practices.
6. Accepted by practitioners, regulators.
7. Valuable as a probabilistic loss measure.
Limitations:
1. Not a worst-case measure.

2. Doesn't cover losses under specifics.
3. Needs complementary risk methods.
4. Back testing, scenario analysis compensate.
Role in Control and Monitoring:
1. MIS tool for risk analysis.

2. Slices risk by levels, products.

3. Sets trading portfolio risk limits.
4. Guides strategic business decisions.
5. Requires back testing for alignment.
6. Complements sound management.
Estimating Volatility:
1. Uses past data for volatility.

2. Arithmetical, exponential methods.
3. Varies historical data periods.
4. May miss unexpected events.
5. Combined with back testing, stress tests.
6. Stress tests cover worst scenarios.
7. Conditional VaR addresses limitations.
8. Captures severe losses beyond VaR.
CVaR (Conditional Value at Risk):

1. Beyond regular VaR measure.
2. Calculated from VaR values.
3. Average of values beyond VaR.
4. Fine-tuning by risk experts ongoing.
5. Potential regulator switch expected.
Back Testing:
1. Compares model VaR with actual.

2. Evaluates new or assesses existing models.
3. Continuous basis for new models.
4. Monthly or quarterly for existing models.
5. Checks model prediction accuracy.
6. BIS outlines back testing best practices.
Stress Testing:

1. Assesses abnormal market condition risks.
2. Determines impact of non-normal movements.
3. Identifies stressed market parameters.
4. Applies stress to assess portfolio impact.
5. Various techniques:
 Simple Sensitivity Test
 Scenario Analysis
 Maximum Loss
 Extreme Value Theory
Scenario Analysis:
1. Simultaneously assesses multiple factors.

2. Based on historical or hypothetical events.
3. Leading stress testing technique.
4. Plausible extreme state of the world.

Maximum Loss:
1. Identifies most potentially damaging moves.

2. Instructive but not systematically relied upon.
3. Arbitrary character in capturing shocks.
Extreme Value Theory (EVT):
1. Captures risk in extreme circumstances.

2. Focuses on tails of probability distributions.
3. Accommodates skewed and fat-tailed distributions.
4. Attaches a probability to stress test results.
5. Challenges with adapting to multiple risk factors.
Good Stress Test:
1. Relevant to current position.

2. Considers changes in all relevant market rates.

3. Examines potential regime shifts.
4. Considers market illiquidity.
5. Considers interplay of all risks, especially market and
credit.
Use of Stress Test by Risk Managers:
1. Summarizes exposure to extreme circumstances.

2. Assembles information for senior management.
3. Forward-looking disaster management.
4. Consideration of market factors for decision-making.
Ways Stress Tests Influence Decision-Making:
1. Managing funding risk.

2. Checking modeling assumptions.
3. Setting limits for traders.
4. Determining capital charges on trading desks’ positions.
Stress Test Influence:
1. Manages funding risk.

2. Checks modeling assumptions.
3. Sets trader limits.
4. Determines capital charges.
Stress Test Limitations:
1. Lacks transparency.
2. Relies on practitioner choices.
3. No attached probabilities.
4. Limited role in IT investments.
Risk Monitoring & Control:
1. Implements policies.
2. Sets risk-adjusted limits.

3. Controls portfolio variations.
4. Uses guidelines, procedures.
5. Monitors portfolio risk.
6. Specifies mark-to-market policy.
Role of Risk Measurement:
1. Sets limits and triggers.

2. Monitors positions.
3. Reports to authority.
4. Utilizes models for measurement.
Limits & Triggers:
 Set by authority.
 Daily sensitivity measures.
 Stop-loss triggers.
 Basis risk limits.
Risk Monitoring:
 Verify transactions at market rates.

 Independent model validation.
 Quarterly stress tests.
 External model validation.
Models Analysis:
 Approved control policy.

 Documented financial models.
 Validation by designated and external entities.
 Prevent unauthorized changes.
Risk Reporting:

 Timely and accurate.
 Highlights concentrations.
 Includes exceptional events.
 Concise with commentary.
Managing Trading Liquidity:
 Avoid large market share.

 Avoid infrequently traded instruments.
 Avoid unusual tenors.
 Be cautious with one-sided liquidity.
Risk Terminology:
 Shares purchased: 1,000 at Rs. 600.

 Total position: Rs. 600,000.
 Daily potential loss: Rs. 41,868.
 VaR Limit calculation using z-scores.
Risk Mitigation:
 Volatility of financial instruments is key.

 Strategies to reduce portfolio volatility.
 Challenges associated with risk mitigation.
Credit Risk Management:
1. Identification: Recognize risks.

2. Measurement: Quantify risks.
3. Monitoring: Oversee risks.
4. Mitigation: Reduce risks.
Organization:
 Board: Overall responsibility.

 Risk Committee: Sets guidelines, reviews models.

 Credit Policy Committee (CPC) / CRMC:
 Formulates credit policies.
 Manages bank-wide credit risk.
Credit Risk Management Dept.:
 Executes strategies.
 Implements policies.
 Manages day-to-day activities.
Credit Risk Management Department (CRMD):
 Independent from Credit Administration.

 Enforces CPC/CRMC risk parameters.
 Monitors compliance.
 Manages loan portfolio quality.
 Conducts audits and evaluations.

People & Training:
 Critical input: skilled, knowledgeable staff.

 Evaluate and enhance competency.
 Source from reputed institutions.
 Align with HR policies.
Risk Identification (Credit Risk):
1. Default Risk:
 Borrower fails to make payments.
 Involves recovery rate.
2. Credit Spread Risk:
 Worsening credit quality.
 Reflected in credit spread widening.
 Firm-specific, often through rating downgrade.

Loan Risks:
 Not marked-to-market.
 Default event crucial.
 Capital market portfolios marked-to-market.
 Exhibit credit spread volatility.
Portfolio Risk Components:
1. Systematic (Intrinsic) Risk:

 General market conditions.
2. Concentration Risk:
 Exposure to specific sectors/segments.

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BFM

 Arises from deviations between planned and actual

5. Banking History Perspective:

6. Cash Flow Uncertainties:

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1. Cash Flow Uncertainties:

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 Conformance of risk processes to policy.

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4. Senior-Level Executives (Sub-Groups):

 Monitors and improves Net Interest Margin (NIM).

 Recommends lending rates to the Board.

 Conducts portfolio analysis for retail loan assets.

1. Committee Sub-Groups Responsibilities:

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 Clears new credit products/processes.

 Clears new products/processes (excluding credit).

2. Risk Management Support Group/Department:

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1. Risk Monitoring and Control:

 Comprehensive risk measurement approach.

 Consistent risk management policies at corporate and

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 Independent risk management framework.

 Periodical review, evaluation, and robust audit system.

strategic plan accordingly.

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1. Payments and Settlement:

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1. Holds assets until maturity.

1. Trades marketable assets.

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 Call Risk: Crystallization of contingent liabilities.

Interest Rate Risk (IRR):

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sheet items with different principal amounts or

assets, liabilities, or off-balance sheet items.

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Forex Risk (Exchange Risk):

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Market Liquidity Risk:

Default or Credit Risk:

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