Capital Adequacy Mms 2011

8/2/2019 Capital Adequacy Mms 2011

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CAPITAL ADEQUACYProf. B.B.Bhattacharyya


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The Capital Accord

The objective of the Basel Committee was to

smoothen out competitive differences among

international banks which were subject to

different capital regulations by national

regulators.

In 1987, the Basel Committee issued its

consultative paper on capital adequacy ofinternationally active banks.


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Scope of Application of Accord

The Basel Accord applies to banks on aconsolidated basis including subsidiaries of thebank.

The risk covered by the accord are credit andmarket risks.

In addition to credit risk, the accord also coverscounterparty risk.

The market value of the transaction varies withtime and can be positive or negative to eithercounterparty to the transaction.


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Minimum Capital

Should be enough to absorb maximum losses

1996 amendment to include market risk


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Capital for Credit Risk

Standardised Approach

IRB Foundation Approach

IRB Advanced Approach


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Capital for Market Risk

Standardised Approach (Maturity)

Standardised Approach (Duration)

Internal Model


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Capital for Operational risk

Basic Indicator Approach

Standardised Approach

Advanced Measurement Approach


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Basel I Capital

Minimum Capital Ratio (8%) *

(Credit Risk + Market Risk)

Basel II Capital Minimum Capital Ratio (8%) *

(Credit Risk + Market Risk + Operational Risk)

IRB Approach Banks internal assessment of the risk parameters

serve as primary inputs to capital calculation.


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IRB

1) P.D. Likelihood that the borrower will

default over a given time period.

2) L.G.D. Proportion of the exposure that will

be lost, should default occurs

3) E.A.D. Amount likely to be drawn in the

event of a default

4) M Residual Maturity of the exposure


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Operational Risk BIA 15% of average gross

income over three years


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Three Pillars of Basel II

The Basel II accord rests on three pillars :

1) Pillar 1 :- Minimum Capital Requirement

2) Pillar 2 :- Supervisory Review Process3) Pillar 3 :- Market Discipline


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Pillar 1 Minimum Capital

Requirements

It prescribes a risk sensitive calculation of capitalrequirements explicitly includes operational risk inaddition to market and credit risk.

The Basel I accord provided global standards forminimum capital requirements for banks. Capitalrequirement is based on the value and nature ofassets. Limitations in the accord were noticed over aperiod of time.

The total capital ratio must not be lower than 8%.

Supplementary capital comprises subordinated debt ofmore than five years maturity, loan loss reserves etc.


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Pillar 2 Supervisory Review Process

It envisages the establishment of suitable riskmanagement systems in banks and their reviewby the supervisory authority.

Basel II document of the Basel Committee laysdown the following four principals in regard tothe Supervisory Review Process (SRP):-

Principle 1 :- Banks should have a process for

assessing their overall capital adequacy inrelation to their risk profile and a strategy formaintaining their capital levels.


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Principle 2 :- Supervisors should review and

evaluate the banks internal capital adequacy

assessments and strategies. Principle 3 :- Supervisors should expect banks

to operate above the minimum regulatory

capital ratios and should have the ability torequire the banks to hold capital in excess of

the minimum.

Principle 4 :- Supervisors should seek tointervene at an early stage to prevent capital

from falling below the minimum levels.


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Reserve Bank of India

Scheduled

Commercial Banks

Scheduled Co-

operative Banks

Foreign

Banks

SBI and its

Associates

Public

Sector

Private

Sector

Regional

Rural

Other

Nationalized

Banks

Old New

Urban Co-

operatives

State Co-

operatives

Structure of Indian Banking Sector


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PARAMETER BASEL I BASEL II

Approach to capital

adequacy

One size fits all

Standardized capitalcharge regardless of rating

Covered credit risk and

market risk

Encourages risk sensitivity

Differential capital acrossexposure classes and rating

grades

Also covers operational risk

Classification of

exposure

No distinct classification

of exposure

Exposure classification in

Credit Risk (8)- Corporate,

Retail, Sovereign, Inter-bank,

Asset Management etc

Prescription for

disclosures and

regulatory oversight

No specific recommendation Specific guidelines provided

Disclosure requirements

pertaining to risk information

made more stringent

Implementation

approach

Details of implementation

schedule left to the regulator

Overall parameters specified

Detailed implementation

schedule to be stipulated for

each bank

Rationale for Basel II over Basel I

4/1/2012 17Basel II @ Welingkar Education, Mumbai


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Basel II - The Three Pillars

Basel II

Framework

Pillar 3Market Discipline

Pillar 2-

SupervisoryReview Process

Pillar 1

Minimum CapitalRequirements

4/1/2012 18Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.


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Types of Risk and approaches

Different Risk under Basel II

Internal

Ratings

Based

Credit Risk Market Risk

Standardized

Approach

Basic

Indicator

Approach

Standardized

Specific RiskGeneral

Market RiskAdvancedFoundation

Advanced

Measurement

4/1/2012 19

Operational

Risk

Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.


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Other Risks

Business Strategy Risk

Environment Risk

Group Risk

Control Risk

Liquidity Risk

Reputation Risk



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RBI Norms for Basel II..contd

Risk weights for exposure to corporates

Risk weights for exposure to retail exposures

Secured by mortgages on residential property linked to loan to value ratio

(LTV)

LTV of less than or equal to 80% Risk weight of 75%

LTV of more than 80% - Risk weight of 100%

Other retail exposures 75%

Credit rating

by domestic

rating agencies

AAA AA A BBB and

below

Unrated

Risk weight 20% 50% 100% 150% 100%


C it l St t f S l t d I di B k


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Capital Structure of Selected Indian Banks

Particulars (in Rs Lakhs) 2007-08 2006-07

Tier 1 capital 11,062,96 6352,71

Tier 2 Capital 3,548,37 3,339,99

Total Capital 14,611,33 9,692,70

Risk weighted assets and contingents

Credit Risk 89,811,92 65,624,80

Market Risk(including specific risk) 17,636,07 8,457,12

Capital Adequacy Ratios

Tier 1 10.30% 8.57%

Tier 2 3.30% 4.51%

Total 13.60% 13.08%

ICICI Bank Annual

Report FY 2007-08

HDFC Bank

Annual Report FY

2007-08

4/1/2012 22


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Ground Realities to Basel II Challenges at home

Costly Database Creation and Maintenance Process

Paucity of Credit Rating Agencies

Additional Capital Requirement

Relative Advantage to Large Banks

Risk Sensitivity

IT infrastructure

Communication gap

Cross Border Issues for Foreign Banks



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ICAAP and SREP are the two important

components of Pillar 2.

The ICAAP comprises a banks procedure and

measures designed to ensure the following :-

(a) An appropriate identification and

measurement of risks.

(b) An appropriate level of internal capital in

relation to the banks risk profile.

(c) Application and further development of

suitable risk management systems in the

bank.


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The SREP consists of :

a review and evaluation process adopted by the

supervisor.

These include the review and evaluation of the

banks ICAAP, conducting an independent

assessment of the banks risk profile.


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INTERNAL CAPITAL ADEQUACY ASSESSMENT (ICAAP),which is a procedure that ensures that governing,bodies (Board and Senior Management)

properly identify, measure, summarise and

monitor the risks of an institution,

make sure that the institution has adequate capitalas per internal regulations to cover all material risks,

operate an adequate risk management procedureand develop it on an ongoing basis.


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Four Principles Measurement of own risk and capital adequacy of banks:

Banks should have a process for assessing their overallcapital adequacy in relation to their risk profile and a

strategy for maintaining their capital levels.

Supervisory review of internal banking procedures

Supervisors should review and evaluate bank's internal

capital adequacy assessments and strategies, as well as

their ability to monitor and ensure their compliance with

regulatory capital ratios. Supervisors should take

appropriate supervisory action if they are not satisfied

with the result of this process.


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Four Principles

. Capital above the regulatory minimum

Supervisors should expect banks to operate above theminimum regulatory capital ratios and should have theability to require banks to hold capital in excess of the

minimum

Supervisory action:

Supervisors should seek to intervene at an early stageto prevent capital from falling below the minimumlevels required to support the risk characteristics of aparticular bank and should require rapid remedialaction if capital is not maintained or restored.


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ICAAP To Be A Forward-Looking

Process

The ICAAP should be forward looking in nature.

It should take into account the expected /estimated future developments.

The banks shall have an explicit, board approvedcapital plan. The plan shall outline :

- the banks capital needs

- the banks anticipated capital utilization

- the banks desired level of capital- limits related to capital

- a general contingency plan for dealing withdivergences and unexpected events.


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ICAAP To Be A Risk-Based Process

Banks shall set their capital targets, which areconsistent with their risk profile and operatingenvironment.

A Bank shall have in place a sound ICAAP, whichshall include all material risk exposures incurredby the bank.

Banks ICAAP document shall clearly indicate for

which risks a quantitative measure is consideredwarranted and for which risks a qualitativemeasure is considered to be the correctapproach.


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Pillar 3 Market Discipline

It seeks to achieve increased transparency

through expanded disclosure requirements for

banks.

Market Discipline is to compliment the Pillar 1

and Pillar 2.

It provides disclosure requirements for banks

using Basel-II framework.


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Qualitative & Quantitative Disclosures

1. Scope of application

2. Capital structure

3. Capital adequacy

4. Credit Risk general disclosures

5. Credit Risk disclosures for portfolios, under

standardized approach6. Credit Risk disclosures for portfolios, under

IRB approaches


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Qualitative & Quantitative Disclosures

7. Credit Risk mitigation disclosures forstandardized & IRB approaches

8. Securitization disclosures for standardized &IRB approaches

9. Market Risk disclosures under standardizedapproach

10.Market Risk disclosures under internal modelsapproach

11.Operational Risk

12.Equities disclosures for banking book positions

13.Internal Rate Risk in the banking book


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Constituents Of Capital

Tier I Capital

Tier II Capital

Tier III Capital


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Tier I Capital

Consists of superior quality instruments and is

the mainstay of the capital of a bank.

Perpetual non-cumulative Preference Shares

(PNCPS)


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Tier I Capital - Constituents

Permanent shareholders equity (paid up

capital)

Statutory reserves and Disclosed free Reserves

Innovative Tier I capital ( Perpetual debt

instruments )


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Tier II Capital

Consists of revaluation reserves, general

reserves, hybrid debt capital and subordinated

term debt and investment reserve.

It can be considered for purposes of capital

adequacy only upto an amount equal to the

Tier I capital of a bank.


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Tier II Capital - Constituents

Revaluation Reserves

General Provisions / general loan-loss

Reserves

Hybrid debt capital instruments

Subordinated debt


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Tier II Capital - Constituents

Revaluation Reserves

General Provisions / general loan-loss

Reserves

Hybrid debt capital instruments

Subordinated debt


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Tier III Capital

It can be considered solely for the purpose of

supporting market risk.

It cannot be used to support credit and

counterparty risks.

Tier II and Tier III capital, either together or

individually, cannot alone support market risk.

It can include only short term subordinated

debt.


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Tier III Capital - Constituents

Tier III capital can include short-term

subordinated debt with a minimum original

term to maturity of two years.

It can be used as a cushion against market risk

only.

Trading portfolios tend to be highly volatile

and change rapidly over time.


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On-Balance Sheet Assets The Basel Accord recommends that on-

balance sheet assets of banks be weighted byrisk weights designed to reflect their level ofcredit risk.

The committee has used just five weights toquantify the credit risk level of an exposure,i.e. 0%, 10%, 20%, 50% and 100%. The riskweight assigned to an asset takes account the

following characteristics of the assets. Country type

Counterparty type

Instrument type


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Off-Balance Sheet Items

Basel Accord includes off-balance sheet items

for the purpose of risk weighted assets

calculation.

Off-balance sheet items are bifurcated into

following two categories for the purpose of

calculating capital requirements :

1) Comprises Instruments

2) Comprises Derivatives


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Treatment of Market Risks

The capital requirements for market risk aresubdivided into following two subcomponents ofmarket risk:-

Specific Risk defined as the risk of loss caused

by an adverse price movement of a security dueprincipally to factors related to the issuer of thesecurity. It includes the risk that an individualdebt or equity security moves by more or less

than the general market in day-to-day trading andevent risk. It exists for both long and shortpositions, as it is essentially price risk.


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General Market risk defined as the risk of

loss caused by an adverse market movement

unrelated to any specific security or issuer.

Both general market and specific risks causechanges in the market price of an instruments.


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BASEL III

BASEL III requirements will be phased in graduallyfrom 1 January 2013.

Liquidity Coverage Ratio (LCR) Stock of high quality liquid assets = > 100%

Net Cash Outflows over a 30-day period

Net Stable Funding Ratio (NSFR) Available amount of stable funding = > 100%

Required amount of stable funding


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BASEL III CAPITAL RATIOS

2011 2012 2013 2014 2015 2016 2017 2018 2019

SUPERVISORY

MONITORING

PARALLEL RUN PHASE (PUBLIC

DISCLOSURE AS OF Jan 2015)

EFFECTIVE JAN

2018

MIN TIER 1

CAPITAL

4.0% 4.0% 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

MIN TOTAL

CAPITAL

8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

MIN TOTAL

CAPITAL PLUS

CAPITAL

CONVERSIONBUFFER

8.0% 8.0% 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%


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BASEL - III

A set and reform measures developed by BCBS tostrengthen the regulation, supervision and riskmanagement of banking sector.

The measures focus on :

- improving ability of the Banking sector toabsorb shocks arising from financial andeconomic stress.

- improve risk management and governance

- strengthen transparency and disclosures ofbanks

-Micro prudential and macro prudentialsupervision.


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BASEL - III

Seeks to address four key aspects identified asthe main cause of global crisis.

- Quality and composition of capital

(Enhancing Tier I capital requirement andintroduction of capital buffers, strictdefinition of capital).

- Liquidity crunch due to borrowing short and

lending long (Introduction of ratios to stresstesting of a financial institutions ability towithstand liquidity pressures).


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BASEL - III

Balance sheet leveraging (Introduction of

Leverage ratios to improve balance sheet

structure).

Inconsistencies in Accounting and valuation

practices (Computation of capital charges

based on covered international accounting

standards).


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Credit Risk Management

Chance that a debtor or financial instrumentissuer will not be able to pay interest or repaythe principal in terms of the credit agreement.

- Inherent part of banking.- Can cause cash flow problems and

adversely affect banks liquidity.

- Still a major single reason of bankfailures.


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Types of Credit Risks

Personal or consumer risk;

Corporate of company risk;

Sovereign or country risk.


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Credit Risk Management

1. Credit portfolio management

2. Lending function and operations

3. Credit portfolio quality review

4. Non-performing loan portfolio

5. Credit risk management policies

6. Policies to limit or reduce credit risk

7. Asset classification

8. Loan loss provisioning policy


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1. Credit Portfolio Management

Considerations which form the basis for soundlending policies.

Limit on total loans in relation to deposits, capital orassets

Geographic limits

- Awareness about the market

Credit concentrations

- Concentration limits usually refer to themaximum permitted exposure to a single

client, connected group, and/or sector ofeconomic activity i.e. agriculture, steel ortextiles etc. A lending policy should alsorequire that all concentrations be reviewed and

reported on a frequent basis.


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Distribution by Category

- Policies related to such limitations

should allow for deviations that areapproved by the board.

Type of Loans

- A lending policy should specify thetypes of loans and other credit

instruments that the bank intends to offer

to clients and should provide guidelines forspecific loans.


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Maturities

- A lending policy should establish the

maximum maturity for each type ofcredit, and loans should be granted witha realistic repayment schedule.

Loan pricing

- Rates on various loan types must besufficient to cover the costs of funds, loan

supervision, administration (including

general overhead), and probable losses. Atthe same time, they should provide a

reasonable margin of profit.


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Lending authority

- determined by the size of a bank.

Appraisal process- A lending policy should outline where the

responsibility for appraisals lies and should

define standard appraisal procedures.

Maximum ratio of loan amount to the market value

of pledged securities

- A lending policy should set forth margin

requirements for all types of securities whichare accepted as collateral.

Impairment


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Impairment

- A bank should identify and recognize the

impairment of a loan or a collectively assessed

group of loans.

Collections

- A lending policy should define delinquent

obligations of all types and specify theappropriate reports to be submitted to the

board.

Financial information

- The safe extension of credit depends on

complete and accurate information regarding

every detail of the borrowers credit standing.


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2. Lending functions and operations

Fundamental Objectives :

a) Loans should be granted on a sound andcollectible basis;

b) Funds should be invested profitably for thebenefit of shareholders and protection ofdepositors;

c) The legitimate credit needs of economicagents and/or households should besatisfied.


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Lending process review

- The integrity and credibility of the lendingprocess depend on objective credit decisions

that ensure an acceptable risk level in relation tothe expected return.

Human resources analysis- Staff organization, skills, and qualifications

should be analyzed. Information flows

- A bank must have efficient systems formonitoring adherence to established

guidelines.


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3. Credit portfolio quality review

All loans to borrowers with aggregate exposurelarger than x% of the banks capital;

All loans to shareholders and connected parties;

All loans for which the interest or repayment termshave been rescheduled while granting of the loan.

All loans for which cash payment of interest and/orprincipal is more than x days past due.

All loans classified as substandard, doubtful or loss.

I t b k D it


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Interbank Deposits

- The most important category of assets

for which a bank carries the credit risk. Off-balance-sheet commitments

f f l


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4. Nonperforming Loan Portfolio

Nonperforming assets are those not generating income.

The analysis of a non-performing loan portfolio should cover anumber of aspects as follows :

Aging of past-due loans

Reasons for the deterioration of the loan portfolio quality

A list of nonperforming loans should be assessed on a case-by-case basis.

Provision levels should be considered.

The impact on profit and loss accounts should be considered.


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5. Credit Risk Management Policies

Specific credit risk management measures threekinds of policies.

1) Limit or reduce credit risk

2) Asset classification

3) Loss provisioning

Workout procedure

- An assessment of work-out procedures

should consider the organization of thisfunction, including departments andresponsible staff.

Public disclosure requirements


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Public-disclosure requirements

- Disclosure principles related to sound

credit risk should be mandated byregulatory authorities as recommended

by the Basel Committee on Bank

Supervision.


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6. Policies to Limit or Reduce Credit Risk

Large exposures

- Bank supervisors monitor both the

banking sector and an individual

banks credit exposure in order toprotect depositors interests and to be

able to prevent situations that may put

a banking system at risk.

Related-party lending


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Related-party lending

- Lending to connected parties is viewedadversely towards credit risk exposure.It includes banks parent, majorshareholders, subsidiaries, affiliatecompanies, directors and executive

officers. Overexposure to geographical areas or

economic sectors

- Another dimension of risk concentrationis the exposure of a bank to a singlesector of the economy or a narrowgeographical region.


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Renegotiated Debt

- This refers to loans that have been

restructured to provide a reduction of

either interest or principal payments

because of the borrowers deteriorated

financial position.


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7. Asset Classification

Asset classification is a process whereby an asset is

assigned a credit risk grade, which is determined by

the likelihood that debt obligations will be serviced

and debt liquidated according to contract terms. All

assets for which a bank is taking a risk should be

classified.

It is a key risk management tool.

Assets are classified at the time of origination andthen reviewed and reclassified as necessary

8 Loan Loss Provisioning Policy


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8. Loan Loss Provisioning Policy

Asset classification provides a basis for determining

an adequate level of provisions for possible loanlosses.

Such provisions are counted as tier 2 capital and arenot assigned to specific assets.

Policies on loan-loss provisioning range frommandated to discretionary, depending on the bankingsystem.

Two main approaches exist for dealing with loss

assets : 1) to retain loss assets on the books until allremedies for collection have been exhausted and 2)all loss assets be promptly written off against thereserve i.e. removed from the books.


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Liquidity Risk Management

Liquidity is necessary for banks to compensate for

expected and unexpected balance sheet fluctuations

and to provide funds for growth.

It lies at the heart of confidence in the bankingsystem.

It addresses market liquidity rather than statutory

liquidity. The implication of liquidity risk is that a

bank may have insufficient funds on hand to meet itsobligations.


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Liquidity Management Policies

The Liquidity management policies of a bank

normally comprise :

- a decision-making structure,

- an approach to funding and liquidity

operations,

- a set of limits to liquidity risk exposure,

- a set of procedures for liquidity planning

under alternative scenarios

Foreign currencies aspects


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Foreign currencies aspects .

- The liquidity strategy for each currency,

should be a central concern of the bank.- A bank should have a management

system for its liquidity positions in all

major currencies in which it is active.

The Structure of Funding : Deposits and


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g p

Market Borrowing

Deposits- Funding structure is a key aspect of liquidity

management.- Product range- Deposit concentration

- Deposit administration

Financial market borrowing- The marginal cost of liquidity is of paramount

importance in evaluating the sources ofliquidity.

Maturity Structure and Funding Mismatches


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Maturity Structure and Funding Mismatches

Maturity mismatches are an intrinsic feature ofbanking.

An increased mismatch could be due to problems inobtaining long-term funding for the bank.

Once the contractual mismatch has been calculated,it is important to determine the expected cash flowthat can be produced by the banks asset-liabilitymanagement.

While it is apparent that the maturity structure ofdeposits for the observed bank has changed, thereasons are not straightforward or easy todetermine.


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Deposit Concentration and Volatility of Funding

Most banks monitor their funding mix and theconcentration of depositors very closely, to preventexcessive dependence on any particular source.

The increasing volatility of funding is indicative of the

changes in the structure and sources of funding thatthe banking sector is undergoing.

To assess the general volatility of funding, a bankusually classifies its liabilities that are likely to stay

with the bank under any circumstances.


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Liquidity Risk Management Techniques

The liquidity risk management has three

aspects :

1. measuring and managing net funding

requirements,

2. market access, and

3. contingency planning

Liquidity risk management involve various


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Liquidity risk management involve various

scenarios :

- The going-concern scenario : This isordinarily applied to the management of

a banks use of deposits.

- A second scenario relates to a banksliquidity in a crisis situation when a

significant part of its liabilities can not be

rolled over or replaced.

- A third scenario refers to general

market crisis, wherein liquidity is

affected in the entire banking system.

Risks associated with market funding-based


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Risks associated with market funding based

liquidity management

Purchased funds may not always be available whenneeded.

Over-reliance on liability management may cause atendency to minimize the holding of short-term

securities. During the period of tight money, thistendency could squeeze earnings and give rise toilliquid conditions.

A bank may incur relatively high costs when

obtaining funds, due to rate competition in themoney market.

If a bank purchases liabilities to support assets that


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If a bank purchases liabilities to support assets that

are already on its books, the high cost of purchased

funds may result in a negative yield spread.

When national monetary tightness occurs, interest

rate discrimination may develop, making the cost of

purchased funds prohibitive to all but a limited

number of large banks. Preoccupation with lowest possible cost and with

insufficient regard to maturity distribution can greatly

intensify a banks exposure to the risk of interest rate

fluctuations.

M k Ri k M


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Market Risk Management

Risk that a bank may experience loss due tounfavorable movements in market prices.

Sources of market risk

- Market risk results from changes in theprices of equity instruments, commodities,money and currencies. Major components like,

equity position risk, commodities risk, interestrate risk and currency risk includes a general

market risk aspect and a specific risk aspect thatoriginates in the portfolio structure of a bank.

Volatility


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Volatility

Volatility prevails in mature markets, though it

is much higher in new or illiquid markets.

Proprietary trading versus stable liquidityinvestment portfolio management

Proprietary trading is aimed at exploitingmarket opportunities with leveraged fundingwhereas the stable liquidity investment

portfolio is held and traded as a buffer. Boththe investment portfolios are subject tomarket risk.

Value at risk (VAR)


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VAR is a modeling technique that typically measuresa banks aggregate market risk exposure. The risks

covered by the model should include all interest,currency, equity and commodity for both on-and-offbalance sheet positions. The VAR amount may becalculated by using the following methodologies:

- Historical simulation approach

- Delta-normal or variance/covariance- Monte Carlo simulation

Risk capital

The Basel Committee amended the 1988 CapitalAccord in January 1996 by adding specific capitalcharges for market risk.

P tf li Ri k M t P li i


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Portfolio Risk Management Policies

While policies related to market riskmanagement may vary among banks, thereare certain types of policies present in allbanks.

Marking to market : - It is considered prudentfor a bank to evaluate and re-price positionsrelated to its stable liquidity investment

portfolio on at least a monthly basis.

Position limits:- A market risk management


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Position limits: A market risk managementpolicy should provide for limits on positions,bearing in mind the liquidity risk that couldarise on execution of unrealized transactions.Such position limits should be related to thecapital available to cover market risk.

Stop-loss provisions:- The stop-loss exposurelimit should be determined with regard to abanks capital structure and earning trends, aswell as to its overall risk profile.


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Limits to new market presence:- Limitsrelated to a new market presence should be

frequently reviewed and adjusted. Once a

market becomes established and sufficientlyliquid, a bank should readjust the limits to

levels applicable to mature markets.

Trading Book and Management of Trading


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g g g

Activities

A banks trading book should includepositions arising from brokering or marketmaking, as well as certain instruments takento hedge the risk exposures inherent in sometrading activities. In most banks, Tradingactivities are carried out in organizationalunits that are held separate from standard

banking activities. Trading activities requirehighly skilled analytical support to gaugemarket movements and opportunities.

M k t Ri k M t


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Market Risk Management

Equity Risk

- relates to taking or holding trading book

positions in equities that display equity-

like behavior and their derivatives.

- it is calculated for the specific risk of

holding a security (beta).

Commodity risk


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Commodity risk

- refers to holding or taking positions in

exchange-traded commodities, futures,and other derivatives.

- another operational aspect of this riskrelates to delivery risk and the necessity

to close out positions before delivery.

Currency risk


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y

- refers to proprietary trading positions in

currencies and gold.

- risk is based on probabilistic events, and

is apparent that no single measurementtool can capture the multifaceted nature

of market risk.

Stress Testing


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Stress Testing The purpose of stress testing is to identify events or

influences that may result in a loss. It should be both qualitative and quantitative in

nature.

The stress test scenarios and the testing results

normally are subject to supervisory attention. The complexity of stress tests normally reflects the

complexities of a banks market risk exposures andrespective market environments.

It is virtually impossible to develop a standard stresstest scenario that has a consistent impact on allbanks.

Interest Rate Risk Management


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Interest Rate Risk Management

When interest rates fluctuate, a banksearnings and expenses change, as do the

economic value of its assets, liabilities and off-

balance-sheet positions. It comprises the various policies, actions, and

techniques that a bank can use to reduce the

risk rates.

Repricing risk


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Repricing risk

The most common type of interest rate risk

arises from timing differences in the maturityof fixed rates and the repricing of the floating

rates of bank assets, liabilities, and off-balance-

sheet positions. Yield curve risk

Yield curve risk materializes when yield curve

shifts adversely affect a banks income orunderlying economic value.

Basic risk


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- Also described as Spread risk.

- It arises when assets and liabilities are

priced off different yield curves and the

spread between these curves shifts.

- It derives from unexpected change in the

spread between the two index rates. Optionality

An important source of interest rate risk stems from

the options embedded in many bank assets andliabilities or they may be embedded within otherwise

standard instruments.


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Assessing interest rate risk exposure

Since interest rate risk can have adverse

effects on both a banks earnings and its

economic value, two separate butcomplementary approaches exist for assessing

risk exposure.

Risk Management Responsibilities


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Risk Management Responsibilities

The Banks board of directors has ultimate

responsibility for the management of interest raterisk. The board should systematically review risk, insuch a way as to fully understand the level of riskexposure and to assess the performance of

management in monitoring and controlling risks incompliance with board policies.

Senior management must ensure that the structureof a banks business and the level of interest rate risk

it assumes are effectively dealt with, that appropriatepolicies and procedures are established to controland limit risk.

A banks risk monitoring and control functions


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should be sufficiently independent from its

risk-taking functions.

Bank should have an adequate system of

internal controls to oversee the interest rate

risk management process.

The design of the system of limits should

ensure that positions which exceed assigned

limits are promptly addressed by

management.

Models for the Management of Interest


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Rate Risk

Static gap model- It was common practice for financial

institutions to analyze their exposure to

interest rate risk, using the gapapproach.

- In a gap model, the components of thebalance sheet are separated into items

that are sensitive to interest rates andthose that are not.

Repricing gap model


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p g g p

- Repricing gap is a static measure and does

not give the complete picture.

- Repricing gap models nonetheless are a

useful starting point for the assessmentof interest rate exposure.

Currency Risk Management


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Currency Risk Management

Currency risk results from changes inexchange rates between a banks domestic

currency and other currencies.

It arises from a mismatch between the valueof assets and liabilities denominated in

different currencies.

It is of a speculative nature and can result ina gain or a loss.

Currency risk comprises the following :


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- Transaction risk

- Economic or business risk- Revaluation risk or translation risk

There are other types of risks also whichaccompany currency risk are : counterparty

risk, settlement risk, liquidity risk and currency-

related interest rate risk.

Policies for Currency Risk Management


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Policies for Currency Risk Management

Policy-setting responsibilities

- The policy guidelines should be periodicallyreviewed and updated to match the banks risk

profile with risk management system and staffskills.

- It should also reflect circumstances in domesticand international currency markets & should

accommodate possible changes in the currencysystem.

- Policy should specify the frequency ofrevaluation of foreign currency positions foraccounting and risk management purposes.

Risk exposure limit


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- Banks should have written policies to

govern their activities in foreigncurrencies and to limit their exposure to

currency risk.

- Limits may be applicable in various

timeframes depending on the dynamics

of the particular activity.

The net open position limit


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- It is an aggregate limit of a banks

currency risk exposure.

- It normally represents a proxy for the

maximum loss that a bank might incur dueto currency risk.

- The prudential limit to the net openposition is frequently set at 10 15% of

a banks qualifying capital.

Currency position limits


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- It can apply to balance sheet revaluation

points, overnight positions, or intradaypositions.

- It can be adjusted on a case-by-case basisdepending on the banks expectations of shifts

in the exchange rate between the domestic

and foreign currency.

Other position limits


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- If engaged in currency dealings, a bank

should normally maintain limits on spotpositions in each currency.

- If a bank is engaged in business with

derivatives, it should establish limits on

the size of mismatches in the foreign

exchange book.

- These limits are expressed as the

maximum aggregate value of all contracts

that may be outstanding for a particular

maturity.

Stop loss provisionsOperational Risk has been defined by the Basel Committee on Banking Supervision (BCBS) as the risk of loss resulting from


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It should be determined based on a banks

overall risk profile, capital structure andearning trends. When losses reach their

respective stop-loss limits, open positions

should automatically be covered.

Concentration limit

High concentration always increases risk.

Therefore, banks should establish limits on the

maximum face value of a contract.

Settlement riskOperational Risk has been defined by the Basel Committee on Banking Supervision (BCBS) as the risk of loss resulting from


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- While settlement risk can be mitigated

by a request for collateral, a bankshould also establish specific limits on

exposure to settlement risk.

- These limits should be related to the

total outstanding amount and subject to

settlement risk on any given day.

Counterparty risk


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- All transactions involving foreign contractsor currency receivables also involve

counterparty risk.

- Such risk may be due to circumstancesin the country in which the counterparty

conducts business.- This risk is particularly pronounced in

countries that lack external convertibilityand where the government imposesrestrictions on access to the foreignexchange market.

Revaluation (or Translation)


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Revaluation is essentially the same as marking

to market, except that it pertains to changes inthe domestic currency value of assets, liabilities

and off-balance sheet instruments that are

denominated in foreign currencies. It is an

important risk management tool.


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Operational Risk - An Institutions exposure topotential losses that may impact profitability

and capital resulting from inadequate internal

processes/systems , external events,inadequate employee performance or from

breaching of or non-compliance with

statutory provisions, contracts and internal

regulations.

Liquidity risk concerns


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qu d ty s co ce s

Currency risk management should incorporate

an additional liquidity risk-related aspect.Foreign currency transactions may introduce

cash flow imbalances and may require the

management of foreign currency liquidity.

The accounting treatment


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Accounting treatment may vary among

countries, depending on the purpose ofrevaluation. An analyst should be familiar with

the rules applicable on the accounting

treatment of gains or losses arising from

currency risk. The analyst should also be

familiar with the accounting rules used by a

bank under review for risk and internal

management reporting purposes.

Currency Risk Exposure and Business Strategy


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Currency Risk Exposure and Business Strategy

Banks, those operating in countries with unstablecurrencies, are keenly aware of the risks associatedwith foreign currency business.

The degree of currency risk exposure is a matter of

business orientation and is related to a banks size. Smaller and new banks are exposed to currency risk

for very short periods of time and to a limited extent,and do not need elaborate currency risk

management.

Recognition of the increased risk and of the neededtechnical skills associated with the foreign exchange


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technical skills associated with the foreign exchangebusiness has prompted regulators in almost all

countries that do not maintain external convertibilityto introduce two types of bank licenses.

Banks averse to risk may avoid dealing in forwardcontracts altogether and instead engage in currency

swaps. A currency swap avoids a net open currencyposition but still has to be marked to market.

In a dynamic trading environment it is virtuallyimpossible for a bank active in currency markets to

maintain covered positions in all currencies at alltimes.

Currency Risk Management and Capital

Ad


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Adequacy

A key aspect of currency risk management review isthe assessment of whether or not a bank has thecapacity to adequately handle its level of operationsin foreign exchange.

Currency risk management can be based on gap ormismatch analysis using the same principles asliquidity risk and interest rate risk management.

The maturity structure of loans funded by deposits

should fully correspond to the deposit maturitystructure.

Currency risk exposure implies certain capital charges

which are added to the charge calculated for market


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which are added to the charge calculated for market

risk.

According to various countries, the net open foreigncurrency position established by bank should not

exceed 10 15% of qualifying capital and reserves.

By using shorthand method, capital adequacy iscalculated as 8% of the overall net open position.

Adequate procedures and internal controls should be

in place for all other key functions related to foreign

exchange operations.

Line management should be responsible for


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overseeing foreign currency transactions and

ensuring compliance with risk limits. A bank with a high volume of foreign

exchange operations must have proper

information support if it is to developstrategies for trading operations and executing

specific transactions.


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THANK YOU !!

Capital Adequacy Mms 2011

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Transcript of Capital Adequacy Mms 2011