Risk Management and Basel II

Indian Institute of Banking and Finance

1

How do banks make money?

     By playing “term” of funds: Long v/s short.

By playing risk levels- accept lower risk and place in higher risk play safety as a market mantra Dispersed source v/s concentrated use.

Trading in the market

Essentially by taking risk

2

3

Risk Definition and features

Risk: Event likely to cause loss/variability/damage to income and reputation Features:       Fairly known Cannot be avoided.

Probabilistic and generic Ascertainable, although not always quantifiable Essential for intermediation process.

Risk and Reward go together Interrelated/ Collectively exhaustive but not mutually exclusive 4

Generic and Unique risks

      Industry Unit/firm/company related Location specific Ownership related Sector specific HRD/Structure related 5

Sources of Risk

      Decision ,Indecision Business cycles/ Seasonality Economic/Fiscal changes Policy Changes Market movements Events       Political compulsions Regulations Human resources, skill sets Competition Technology Non-availability of information 6

      

Types of Risks

Credit: Default/delay: Impacts Solvency Capacity to service obligation, Liquidity: Inability to meet committed payments, inability to exit an investment. Interest Rate: Changes in the market rate causing income variability Exchange: Fluctuation in currency rates, prices becoming adverse for the company Market: Interplay of above on trading profits Legal: Operational: Failure of Men, Machine, Monitoring, Methods 7

The global financial regulatory framework is undergoing important changes…

USA PATRIOT ACT

Basel II

FATF RECOMMENDATIONS Risk Management Anti-Money Laundering Corporate Governance

…and money laundering and corporate governance issues have become entwined with operational risk management

8

Goals of risk Management

Safety and soundness of banks.

Ensuring a level playing field. Capital Adequacy Ratio (1) own funds (i.e. available capital and reserves) (2) risk-weighted assets (i.e. the amount of money the bank has put at risk in the course of its business) A level playing field !!

Source: BIS 9

How to manage risk

   Hedging Exposure limits Reserves and Provisioning 10

Basel I

  IRAC norms- uniform across institutions, products and performance Capital adequacy- Uniform across the commercial banking- coop banking will catch up shortly 11

Lessons Of Basel I

     Better NPA Management- varieties of ways New Institutions ( ARC) Laws ( Sarfaesi) Almost all banks and RRBs in good financial health- meet CRAR nomr Explosion of new- customer centric products More employment.

12

Basel II

     Primarily for internationally active banks RBI will take view on other banks- It is safe that all banks comply CRAR @ 8%on risk weight.

But weights and loss estimates differ Basel II is capital accord. Other risk management norms will happen F.M says “ Indian Banks will need additional 60,000 Crores in the next few years”- to meet with growth needs.

13

Three Pillars of Basel II

Minimum Capital Supervisory Review Market Discipline

  Advanced capital allocation risk

The new Basel Accord is based on Three Pillars

methods for Capital charge for operational  Focus on internal capabilities  Supervisors to review banks internal assessment and strategies  Focus on disclosure 14

Basle II. Minimum Capital Requirements-Pillar 1

    Sets minimum acceptable capital Capital arrived by enhanced approach with credit ratings   External or Public rating Internal rating Explicit treatment to operational risk ALM risk not treated but included in 15

Supervisory Review _ Four Principles- Pillar 2

      Banks must attain solvency relative to their risk profile Supervisors should review each bank’s own risk assessment & capital strategies Banks should maintain excess of minimum capital Regulators would intervene at an early stage Possibility of rewarding banks with better risk management systems.

RBI has already taken steps to conduct supervisory review 16

Market Discipline- Pillar 3



Improved disclosure of



Capital structure



Risk measurement and management practices



Risk profile



Capital adequacy

17

Criteria Rating Risk weight Probability of default Credit Risk -Approaches Standard External Calibrated on ratings by Basel Committee Implicitly provided by Basel Committee I. R. B Foundation Internal Function provided by Basel Committee Provided by bank on own estimates Advanced Internal Function provided by Basel Committee Provided by bank on own estimates 18

Credit Risk Approaches Criteria Exposure at Default Loss given default Standardized S upervisory values provided by Basel Implicitly provided by Basel on external estimates I.R.B Foundation Supervisory v alues provided by Basel Implicitly provided by Basel on external estimates Advanced Provided by bank on own estimates Provided by bank own estimates 19

Credit Risk Approaches

Criteria Risk mitigation Standardize d Defined by Regulator. I.R.B Foundation in d + for goods and Services, Other physical Securities criteria All included standardize Receivables subject to Advanced All types of Collaterals if Bank can prove by internal estimation

20

Market Risk

Computation of Capital

Standardized No change over 1988 Foundation No change over 1988 in VaR Advanced No change over 1988 in VaR 21

Operational Risk

Computation of Capital

Standardized Capital change based on single risk indicator Foundation Capital based on business lines and industry standards Advanced Capital based on business lines and internally calculated standards 22

Operational Risk Approaches Approach Calculation of Capital charge Basic Indicator Standardized   Average of Gross Income for three years as indicator Capital charge equals 15% of the indicator    Gross income per regulatory line as indicator business line 12, 15 or 18 % of the indictor as capital charge Depending on Total capital charge equals sum of charge per business line Advanced Measurement  Capital charge equals internally generated measures based on, Internal loss data External loss data Scenario analysis Business environment and internal control factors  Recognition of risk mitigation (upto 20%) 23

Decision areas for Banks

         Choice of methodology and convincing the regulators IT supports needed Software requirements Staff training on compliance Consultancy requirements Risk mitigation opportunities Outsourcing possibilities New jobs creation Implementation cost and time 24

BASLE II IS ALL ABOUT A RESPONSIVE AND SOPHESTICATED RISK MANAGEMENT SYSTEM

     

R = Risk = Function of Uncertainty U U = Function of Quality Information QI QI = Function of Accuracy/ Timeliness/ Relevance/ Adequacy A, T, R, Ad A = Function of IT T = Function of IT R and Ad = Function of IT , Management Science, Modeling amenable to establish mathematical relationship

25

Risk Management – a data intensive function

Credit Risk Market Risk Operational Risk Banks Transaction Data Operational CRM Data Analytical CRM Data Risk Management Data Economy & Industry Data

         Borrower Data Guarantor Data Asset-specific Data Default Data Data on Recoveries External Default Data Data on Rating and Migration Macro & Industry Data Correlation Data      Data on Exchange Rates Data on Interest Rates Data on Security Prices Data on Correlations Data on Instruments (non-linear)        Loss Event Data Causal Data Loss Effect Key Risk Indicators (KRIs) Proxies Risk Inventories Structured Self Assessment Data 

Basle Accord and IT      Basle II promises significant business benefits to those who have systems in place to access and utilize far more detailed and precise information Integration of data on finance, operations and risk management necessary Opportunity to get out of legacy systems and procedures including IT system Fundamental rethinking on how a bank’s data and information is provided and controlled Pillars are interdependent and must be addressed to concurrently 27

Basle Accord and IT

Internal Rating based approaches revolve around Probability of default Loss given default Exposure at default Other parameters Main requirements would include Defining and capturing loss data Capturing and extracting exposure data Identifying and capturing risk mitigation data Data issues would be Sources/ Data types/ Quality requirements and Granularity (level of data) 28

Basle Accord and IT

Operational Risk Management pre-supposes  Framework and systems in data integration      Low frequency-high severity occurrences Structure for risk management and interaction amongst functionaries Potential for mitigation, outsourcing and alike issues Shared facilities feasibility More synergy and little overlap 29

30

THANK YOU

31