Transcript ASSET-LIABILITY MANAGEMENT SYSTEM

Risk Management in Banks
[Module B]
Live Interactive Learning Session
Presentation by S P Dhal, Faculty Member,
SPBT College
What is Risk?
• Risk is the probability that the realised return
would be different from the anticipated/expected
return on investment.
• Risk is a measure of likelihood of a bad financial
outcome.
• All other things being equal risk will be avoided.
• All other things are however not equal and that a
reduction in risk is accompanied by a reduction in
expected return.
What is Risk?
The uncertainties associated with risk
elements impact the net cash flow of any
business or investment. Under the impact of
uncertainties, variations in net cash flow
take place. This could be favourable or unfavourable. The un-favaourable impact is
‘RISK’ of the business.
Anatomy of Bank Risk
Financial Risk
Non-Financial Risk
Business
Risk
Strategic Delivery (of Financial
Balance
Risk
Services) Risk
Sheet Risk
Operational
Risk
Legal Risk
Reputational Risk
Balance Sheet Risk
Credit Risk
Market Risk
Concentration Intrinsic
Risk
Risk
Interest
Rate Risk
Liquidity
Risk
Currency
Risk
Commodity
Risk
Interest Rate Risk
Price Risk
Reinvestment
Risk
Yield
Curve Risk
Gap Risk
Basis Risk
Risk in Traditional Sense

Systematic Risks
Affects
all Industry/ All securities
Non-controllable
Non-diversifiable

Unsystematic Risks
Affects
specific Industry/ Specific Securities
Controllable
Diversifiable
Risk in Banking Business
Banking business is broadly grouped
under following major heads from Risk
Management point of view:
1. The Banking Book
2. The Trading Book
3. Off-Balance-sheet Exposures
The Banking Book
All assets & liabilities in ‘banking book’
have following characteristics:
1. They are normally held until maturity
2. Accrual system of accounting is applied
Since assets & liabilities are held till maturity,
their mismatch may land the bank in either excess
cash in-flow or shortage of cash on a particular
time. This commonly known as ‘Liquidity Risk’.
The Banking Book
Due to change in interest rates, assets and
liabilities are subjected to interest rate risk
on their maturities/re-pricing.
Further, the assets side of the banking book
generates credit risk arising from defaults in
payment of interest and or installments by
the borrowers.
In addition to all these risk, banking book
also suffers from ‘Operational Risk’.
The Trading Book
The trading book includes all the assets that
are held with intention of trading that are
marketable. They are normally held for a
short duration and positions are liquidated
in the market. Trading Book assets include
investment held under ‘Held for Trading’
category.
They are subjected to Market Risk and are
marked to market.
Off-Balance-Sheet Exposure
• Off-balance sheet exposure is contingent in
nature- Guarantees, LCs, Committed or back up
credit lines etc.
• A contingent exposure may become a fund-based
exposure in Banking book or trading book.
• Therefore, Off-balance sheet exposures may have
liquidity risk, interest rate risk, market risk, credit
or default risk and operational risk
RISKS IN BANKING
• Risk is inherent in Banking
• Banking is not avoiding risks but managing
it
• Risks in banking can be of Broadly 3 types:
– Credit Risk
– Market Risk
– Operational Risk
ALM addresses to Market Risks
Risk Management in Banks
& Basel Accord –I, 1988
In 1988, Basel Committee on Banking Supervision,
published a framework for a minimal capital
requirement for credit exposure. The bank books
were classified into 5 buckets i.e. grouped under 5
categories according to credit risk weights of zero,
ten, twenty, fifty and one hundred percent.
Assets required to be classified into one of these
risk buckets based on the parameter of counter
party.
Banks required to hold capital equal to 8% of the
risk-weighted value of assets. In India, the
minimum capital requirement is 9% as decided by
RBI.
1996 Amendment to include Market Risk
In 1996, BCBS published an amendment to
provide an explicit capital cushion for ‘Market
Risk’ to which banks are exposed.
Market Risk is the risk of adverse deviations of
the marked-to-market value of the assets due to
market movements as a result of change in interest
rates, market price or exchange rate.
Basel II Accord- Need & Goals
Linking of risks with capital in terms of Basel
Accord I needed a revision for the following
reasons:
- Credit assessment under Basel I is not risk
sensitive enough. ‘One Suit fit all’ approach was
applied all types of entity with 100% risk
weightage.
- Risk arising out of operation were ignored
though it has potential of affecting the bank’s
survival.
Basel Accord II
The Basel II Accord is based on three
pillars:
• Minimum Capital Requirement
• Supervisory review process &
• Market discipline
The New Basel Capital Accord
Three Basic Pillars
Minimum
Capital
Requirement
Supervisory
Review Process
Market
Discipline
Requirements
1. Minimum Capital RequirementsCredit Risk (Pillar One)
• Standardized approach
(External Ratings)
• Internal ratings-based approach
Minimum
Capital
Requirement
• Foundation approach
• Advanced approach
• Credit risk modeling
(Sophisticated banks in the future)
The New Basel Capital Accord
Standardized Approach
•
•
•
•
•
Provides Greater Risk Differentiation than 1988
Risk Weights based on external ratings
Five categories [0%, 20%, 50%, 100%, 150%]
The loans considered past due be risk weighted at
150 percent unless a threshold amount of specific
provision has already been set aside by the bank
against the loan
Special treatment for ‘retail’ & ‘SME’ sectors
The New Basel Capital Accord
Capital for Credit Risk- Internal Rating Based
Approach:
•Three elements:
– Risk Components [PD, LGD, EAD]
– Risk Weight conversion function
– Minimum requirements for the management of policy
and processes
– Emphasis on full compliance
Definitions;
PD = Probability of default [“conservative view of long run average (pooled) for borrowers assigned
to a RR grade.”]
LGD = Loss given default
EAD = Exposure at default
Note: BIS is Proposing 75% for unused commitments
EL = Expected Loss
The New Basel Capital Accord
Market Risk:
(a) Standardised Method
(i) Maturity Method
(ii) Duration Method
(b) Internal Models Method
The New Basel Capital Accord
Capital Charge for Operational RiskAs in credit, three alternate approaches are
prescribed:
- Basic Indicator Approach
- Standardised Approach
- Advanced Measurement Approach
Capital Charge for Operational Risk- Basic
Indicator Approach
To begin with, RBI has advised bank to
follow Basic Indicator Approach in India
which is 15% of the average Gross Income
over three year.
KBIA = [ ∑ (GI*) ] / n,
Where
KBIA = the capital charge under the Basic Indicator Approach.
GI = annual gross income, where positive, over the
previous three
years
=
15% set by the Committee, relating the industry-wide level of required
capital to the industry-wide level of the indicator.
15% set by the Committee, relating the industry-wide level of required
capital to the industry-wide level of the indicator.
n=
number of the previous three years for which gross income is
positive
Gross income = Net profit (+) Provisions & Contingencies (+) operating
expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from
insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM
investments.
New Basel Accord II:
supervisory review process• Defines the role of supervisors
with regard to capital adequacy
Pillar II
New Basel Accord II:
Market Discipline
• Disclosure requirements that
allow market participants to
assess key information about a
bank’s risk profile and level of
capitalisation.
Pillar-III
Value at Risk
VaR is defined as the predicted worst-case
loss at a specific confidence level over a
certain period of time assuming normal
trading conditions.
That means, we can incur loss a maximum
of Rs. X (the VaR) over the next one week
(time period) and, may expect with 99%
confidence level (i,.e. it would be so 99
times out of 100).
Advantages of VaR
• It captures an important aspect of risk
in a single number
• It is easy to understand
• It asks the simple question: “How bad can
things get?”
Q. A Bank reports a one-week VaR of $1M at the
95% confidence level. Which of the following
statements is most likely to be true?
(a)
follows a
could be
is
The daily return on the company portfolio
normal distribution so that a one-week VaR
computed.
(b)
The one week VaR at the 99% confidence level
$5M.
(c)
With probability 95%, the company will not
experience
a loss greater than $95M in one week.
$1M
(d)
or
With probability 5%, the company will loose
more in one week.
Q.
Risk
Weight
of
2.5%
on
Government Bonds is introduced
to address:
(a). Credit Risk
(b). Operational Risk
(c). Market Risk
(d). Counter Party Risk
Q.
Reserve Bank of India has advised Banks to
build up an Investment Fluctuation Reserve
(IFR) of a minimum 5 per cent of their
investments in the categories “Held for
Trading” (HFT) and “Available for Sale”
(AFS). The specification is to take care of
following Risk.
(a).
(b).
(c).
(d).
Interest Rate Risk
Operational Risk
Credit Risk
None of above
Q.
“Netting” is a method of aggregating
two or more obligations to achieving a
reduced net obligation. The benefits
accrues from “Netting” is:
(a). Reduced Credit Risk
(b). Liquidity Risk
(c). Systemic Risk
(d) All of the above
Q.
How is
the
risk
of so-called
catastrophic losses dealt with?
(a). Through RAROC models.
(b). Through VaR, preferably deltagamma approach.
(c). By proper Disaster Recovery Plan &
Business Continuity Plan in place.
(d). By mitigation,
capital.
with
reserves
in
Q.
Money market funds are generally
considered to have ______ interest rate
risk,and______ default risk.
(a). low; low
(b). low; high
(c). high; low
(d). high; high
Q.
The June 1999 Basle Committee on Banking
Supervision issued proposals for reform of its 1988
Capital Accord (the Basle II Proposals). These
proposals contained MAINLY:
I. Settlement risk management
II. Capital requirements
III. Supervisory review
IV. The handling of hedge funds
V. Contingency plans
VI. Market discipline
(a). I, III and VI
(b). II, IV and V
(c). I, IV and V
(d). II, III and VI
Q.
If the default probability for an “A”rated company over a three year period
is 0.30%, then the most likely
probability of default for the same
company over a six year period is:
(a). 0.30%
(b). Between 0.30% and 0.60%
(c). 0.60%
(d). Greater than 0.60%
Q.
Which of the following procedures is
essential in validating the VaR
estimates.
(a) Back Testing
(b) Scenario Analysis
(c) Stress Testing
(d) Once approved by regulators no
further validation is required.
Q. Loans are securitized to:
(a)
(b)
(c)
(d)
Reduce credit concentrations.
Reduce regulatory capital.
Provide access to loan products for
investors.
All of the above.
THANK YOU