The document discusses the key risks faced by banks - credit risk, market risk, and operational risk. It provides details on how each risk arises and the components that make it up. It then covers the Basel regulations which require banks to hold a minimum level of capital as a percentage of risk-weighted assets to provide a cushion against unexpected losses from these risks. The capital requirement and risk weights for different asset classes are specified in the Basel Accords. The document traces the evolution of the Basel regulations from Basel I to Basel II and III.
The document discusses the key risks faced by banks - credit risk, market risk, and operational risk. It provides details on how each risk arises and the components that make it up. It then covers the Basel regulations which require banks to hold a minimum level of capital as a percentage of risk-weighted assets to provide a cushion against unexpected losses from these risks. The capital requirement and risk weights for different asset classes are specified in the Basel Accords. The document traces the evolution of the Basel regulations from Basel I to Basel II and III.
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The document discusses the key risks faced by banks - credit risk, market risk, and operational risk. It provides details on how each risk arises and the components that make it up. It then covers the Basel regulations which require banks to hold a minimum level of capital as a percentage of risk-weighted assets to provide a cushion against unexpected losses from these risks. The capital requirement and risk weights for different asset classes are specified in the Basel Accords. The document traces the evolution of the Basel regulations from Basel I to Basel II and III.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
Credit risk Risk arising due to default or deterioration of the credit quality of the obligor/borrower Market risk Risk arising due to market movement of different benchmark rates. Operational risk Loss resulting due to errors instructing payments or setting transactions. Credit Risk Component Arises at two levels Transaction level At the sanction level – issues of appraisal, credit worthiness of the obligor etc. Portfolio level How to manage risk once the bank has built up its portfolio – does the individual obligor default? – if so, what is the probability of default? – in the event of default what is the expected and unexpected loss? – any cushion required? Market Risk Component Can arise due to movement of rates (e.g. interest rate, stock prices, exchange rate etc.) in different markets. Bank may have exposure to different markets such as equity, foreign exchange, commodity etc. By far, interest rate risk is the most prominent component because Most of the banks’ assets are benchmarked to interest rates which are deregulated. Market Risk Contd.. Investment portfolio of banks consists of a substantial investment on treasury bonds (G- secs) which are interest rate sensitive. Reasonable exposure to international benchmark interest rate such as LIBOR (London Interbank Offer Rate) Operational Risk Component Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Internal fraud
External fraud
Employment practices & workplace safety
Clients, products & business practices
Damage to physical assets
Business disruption & system failures
Execution and delivery
Risk Based Capital Standard Why do banks need to hold capital in order to do business? Provides a cushion against unexpected loss that may arise due to credit/market/operational risk. Capital that needs to be maintained as a proportion of risk based assets is termed as risk based capital – otherwise termed as capital adequacy ratio (CAR). e.g., bank does not maintain any capital towards credit risk component of GoI bonds as it is non- existent. Evolution of Capital Standard Originated in July 1988 under the auspices of Bank for International Settlement (BIS) in Basle, Switzerland – popularly termed as Basle Committee. Basel I defines a common measure of solvency, called the Cooke ratio which covers only credit risk – one size fits all policy. Specifies 8% (9% in India) capital charge on all exposures. Exposures being defined by respective risk weights 1988 accord is termed as Basel – I. Evolution of Capital Standard
June Jan Sept
1999 2001 2001 1988 1992 1996 1998
1988 Basel Introduction of 1st Consultative Working Paper on
Accord capital charge Document: Operational Risk Capital Charge for Market Risk A New Capital Adequacy for Credit Risk Framework Proposed new framework to replace existing Accord and introduced capital charge Implementation Discussion for operational risk.2nd Consultative of 1998 Accord Paper: Package: Operational Risk The New Basel Capital Accord including capital charge for Operational Risks Risk Weights and Capital Allocation Risk weight (%) Asset Category (On-balance sheet)
0 Cash and gold held in bank/Obligation on
OECD government and US treasuries
20 Claims on OECD banks/securities issued
by US government agencies/Claims on municipalities 50 Residential mortgages
100 All other claims such as corporate
debt/Claims on non-OECD banks/Less developed countries’ debt etc. Risk Weights and Capital Allocation Risk weight (%) Asset Category (Off-balance sheet)
0 OECD governments
20 OECD banks and public sector entities
50 Corporate and other counterparties
Note: OBSIs include undrawn portion of the loans,
Letters of credit, guarantees, derivatives etc. A Closer Look into Basel I Capital in regulatory context Tier 1 Capital Shareholders’ equity and disclosed reserves Tier 2 Capital (Supplementary) Perpetual securities, unrealized gains on investment securities, hybrid capital instruments, long term subordinated debt. Total of tier 2 capital is limited to a maximum of 100% of the total tier 1 capital. Basel I requires tier 1 and tie 2 capital to be at least 8% of the total risk weighted assets. 1996 Amendment to Incorporate Market Risk 1996 amendment treats trading positions in bonds, equity, foreign exchange and commodity in the market risk framework. Provides explicit capital charges on bank’s open position in each instrument Provides scope for BIS ‘standardized approach’ and ‘internal models approach’. Banks can either choose BIS prescribed model or their own internal model (e.g. Value at Risk) to assess market risk subject to supervisory compliance. 1996 Amendment Contd.. Capital charge is to be made on the following Held for trading (HFT) category Available for sale (AFS) Foreign exchange positions Trading positions on derivatives
Note: Any position which is marked to the market
carries a capital charge. 1996 Amendment Contd.. Allows banks to use new ‘Tier 3’ capital Includes short term subordinated debt to meet the market risk. Tier 3 capital being restricted only to market risk. No such capital can be repaid if that payment results in a bank’s overall capital being lower than a minimum capital requirement. Basel I in India Basel I was implemented in India by 1996 (Process got started in 1992-93 and was spread over 3/4 years). However, capital charges for market risk under Basel I got implemented in June 2004. Banks in India are statutorily required to maintain capital for credit risk and market risk. In India, Capital adequacy ratio, termed as Capital to risk assets ratio (CRAR) is set at 9%. However, banks are not allowed, at present, to use Tier III capital towards market risk capital charge. CRAR of Indian Public Sector Banks CRAR of Public Sector Banks in India (1995-1996 to 2004-2005) (Percent) 1995- 1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- Banks 96 97 98 99 0 1 2 3 4 5 Nationalized Banks 10.2 10.9 12.2 13.1 13.2 Andhra Bank 5.07 12.05 12.37 11.02 13.36 13.4 12.59 13.62 13.71 12.11 Bank of Baroda 11.19 11.8 12.05 13.3 12.1 12.8 11.32 12.65 13.91 12.61 Bank of India 8.44 10.26 9.11 10.55 10.57 12.23 10.68 12.02 13.01 11.52 Bank of Maharashtra 8.49 9.07 10.9 9.76 11.66 10.64 11.16 12.05 11.88 12.68 Central Bank of India 2.63 9.41 10.4 11.88 11.18 10.02 9.58 10.51 12.43 12.15 Corporation Bank 11.3 11.3 16.9 13.2 12.8 13.3 17.9 18.5 20.12 16.23 Dena Bank 8.27 10.81 11.88 11.14 11.63 7.73 7.64 6.02 9.48 11.91 Indian Bank Neg. -18.81 1.41 Neg. Neg Negative 1.7 10.85 12.82 14.14 Indian Overseas Bank 5.95 10.07 9.34 10.15 9.15 10.24 10.82 11.3 12.49 14.2 Oriental Bank of Commerce 16.99 17.53 15.28 14.1 12.72 11.81 10.99 14.04 14.47 9.21 Punjab National Bank 8.23 9.15 8.81 10.79 10.31 10.24 10.7 12.02 13.1 14.78 Syndicate Bank 8.42 8.8 10.49 9.57 11.45 11.72 12.12 11.03 11.49 10.7 Union Bank of India 9.5 10.53 10.86 10.09 11.42 10.86 11.07 12.41 12.32 12.09 State Bank Group 12.7 13.3 13.4 13.4 12.4 Public Sector Banks 11.2 11.8 12.6 13.2 12.9 Problems with Basel I Does not distinguish among different credit exposures Both AAA and BBB assets attract the same capital charge. No capital charges for short term instruments. Does not allow any capital charge for operational risk. Basel II Will replace 1988 Basel Accord. Based on the consultative paper issued by Basel Committee on Banking Supervision (BCBS). Based on three mutually enforcing pillars. Specific reference to operational risk in banking. Implementation scheduled for 2005 (By 2007 in India). The New Basel Capital Accord PILLAR I PILLAR II PILLAR III Minimum capital Supervisory Market requirements Review Discipline Credit risk Review of the
Market risk institution’s Enhancing
Operational risk capital adequacy transparency Review of the through rigorous internal disclosure assessment norms. process The New Basel Capital Accord Total Capital = Capital Ratio (minimum 8%) Credit + Market + Operational Risk Risk Risk
Revised Unchanged New
The new Accord focuses on revising only the denominator (risk-
weighted assets), the definition and requirements for capital are unchanged from the original Accord. The New Basel Capital Accord Credit Risk Standardized approach Internal Rating Based (IRB) approach Foundation vs. Advanced Operational Risk Basic indicator approach Standardized approach Advanced measurement approach Credit Risk and Standardized Approach Risk weights of sovereigns
AAA to A+ to BBB+ to BB+ to B- Belo Unrated
AA- A- BBB- w B-
Risk 0 20 50 100 150 100
weights (%) Credit Risk and Standardized Approach Risk weights of corporates
AAA to AA- A+ to BBB+ to Below Unrated
A- BB- BB-
Risk weights 20 50 100 150 100
(%) Credit Risk and IRB Approach IRB approach determines the economic capital whereby banks are allowed to use an approach for determining capital requirement for a given exposure that is based on their own internal assessment. Exclusively driven by Internal credit rating system (best examples are PNB, SBI, OBC and a number of new generation private sector banks in India). Provides separate schemes for retail banking, project finance etc. Operational Risk Basic indicator approach Sets the charge for operational risk as a percentage of gross income, defined to include net interest income and net non- interest income, but excludes extraordinary or irregular items. Links to the risk of an expected loss due to internal or external events. Operational Risk Basic indicator approach KBIA = EI*α Where KBIA = the capital charge under the Basic Indicator Approach EI = the level of an exposure indicator for the whole institution, provisionally gross income α = a fixed percentage, set by the Committee, relating the industry-wide level of required capital to the industry-wide level of the indicator Operational Risk Standardized approach Requires that the institution partition its operation into different lines of business. The capital charge is estimated as an exposure indicator for each line of business multiplied by a coefficient. Provisionally, the Basel committee intends to use gross income for this purpose. Operational Risk Advanced measurement approach (AMA) Capital requirement is based on bank’s internal operational risk measurement system. Focuses on both measurement and management of operational risk. Requires supervisory approval based on qualitative and quantitative standards. Supervisory Review Process Four basic principles Banks should have a process for assessing their overall capital Supervisory review of bank’s internal capital adequacy and compliance Supervisor must expect the banks to operate above the minimum capital requirements. Appropriate intervention on behalf of the supervisor before it gets too late! Market Discipline Comprehensive disclosure is essential for market participants to understand the relationship between risk profile and capital of an institution. Includes the disclosure of capital structure, capital adequacy, risk exposure such as market, credit and operational etc. Basel II in India Reserve Bank of India circular on ‘Prudential guidelines on capital adequacy – Implementation of new capital adequacy framework’. The banks are required to adopt new Basel II norms by March 31, 2007. Basel II compliance is expected to increase the capital requirement as it captures operational risk. The cushion available in the system, which at present has a Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort (as a survey made by FICCI shows). However, keeping in mind a sustainable requirement of capital, the Reserve Bank has, for its part, issued policy guidelines enabling issuance of several instruments by the banks - innovative perpetual debt instruments, perpetual non-cumulative preference shares, redeemable cumulative preference shares and hybrid debt instruments. Basel II Norms in India: An Overview Credit risk Adopts standardized approach Operational risk Adopts the basic indicator approach Market risk Banks are allowed to use their internal models to assess the market risk (i.e., status quo has been maintained in this respect). However, RBI’s guideline on Basel II remains silent on the issue of Tier III capital in Indian context.