Risk Management, Basel

7/30/2019 Risk Management, Basel

1/21

Risk Management inBanking

SUBMITTED BY

Manish Kumar(12PGDM087)MANAGEMENT OF BANKS

Submitted to: Prof. Deepak Tandon


2/21

International Settlements

It is an international organization with a mission of helping centralbanks across the world in pursuing monetary and financial stability

It is considered to be a bank for central banks

The mission of the Bank for International Settlements (BIS) is toserve central banks in their pursuit of monetary and financialstability

to foster international cooperation in those areas and to act as abank for central banks.


3/21

The BIS pursue its mission by

1 Promoting discussion and facilitating collaboration

among central banks

2

Supporting dialogue with other authorities that areresponsible for promoting financial stability

3

Conducting research on policy issues confronting centralbanks and financial supervisory authorities

4

Acting as a prime counterparty for central banks in theirfinancial transactions

5

Serving as an agent or trustee in connection withinternational financial operations


4/21

History of Formation of Basel Accords

1 From 1965 to 1981 there were about eight bank failures (or bankruptcies) in

the United States

2

Banks throughout the world were lending extensively, while countries' externalindebtedness was growing at an unsustainable rate

3

As a result, the potential for the bankruptcy of the major international banksbecause grew as a result of low security

4

The committee drafted a first document to set up an international 'minimum'amount of capital that banks should hold

5

This minimum is a percentage of the total capital of a bank, which is also calledthe minimum risk-based capital adequacy

6

In 1988, the Basel I Capital Accord (agreement) was created. The Basel II CapitalAccord follows as an extension of the former, and was implemented in 2007
http://www.investopedia.com/terms/b/basel_I.asphttp://www.investopedia.com/terms/b/baselii.asphttp://www.investopedia.com/terms/b/baselii.asphttp://www.investopedia.com/terms/b/baselii.asphttp://www.investopedia.com/terms/b/baselii.asphttp://www.investopedia.com/terms/b/basel_I.asp


5/21

Basel I

1 In 1988, the Basel I Capital Accord was created

2

The purpose was to strengthen the stability of internationalbanking system

3

Set up a fair and a consistent international banking system in orderto decrease competitive inequality among international banks

4

The basic achievement of Basel I have been to define bank capitaland the so-called bank capital ratio

5

This minimum is a percentage of the total capital of a bank, whichis also called the minimum risk-based capital adequacy


6/21

Two-Tiered Capital

Tier 1 (Core Capital)

Includes stock issues (or share holders equity) and declaredreserves, such as loan loss reserves set aside to cushion

future losses or for smoothing out income variations

Tier 2 (Supplementary Capital)

Tier 2 capital includes all other capital such as gains oninvestment assets, long-term debt with maturity greater

than five years and hidden reserves (i.e. excess allowancefor losses on loans and leases). However, short-termunsecured debts (or debts without guarantees), are notincluded in the definition of capital
http://www.investopedia.com/terms/l/loanlossprovision.asphttp://www.investopedia.com/terms/t/tier2capital.asphttp://www.investopedia.com/terms/t/tier2capital.asphttp://www.investopedia.com/terms/l/loanlossprovision.asp


7/21

Credit Risk

1 It is defined as the risk weighted asset (RWA) of the bank, which are

banks assets weighted in relation to their relative credit risk levels

2

According to Basel I, the total capital should represent at least 8% ofthe bank's credit risk (RWA)

CreditRisks

The on-balance

sheet risk.

The non-trading off-

balancesheet risk

Thetrading off-

balancesheet risk


8/21

Credit Risk

RiskCategories

Cash, centralbank,

Governmentdebt

Developmentbank debt, non

OECD bank debt,non OECD public

sector debt

Residentialmortgages

Private sectordebt, real estate,plant equipment

Public sectordebt


9/21

Pitfalls of Basel I

1 Static measurement of default risk at 8%

ignoring default probability of different players

2

The capital charges are set at same levels

regardless of maturity of credit exposure

3

Limited differentiation of credit risk into 5categories and 4 risk weightings

4

Capital requirements ignore currency andmacroeconomic risks


10/21

Conclusion

The Basel I Capital Accord aimed to assess capital in relation to credit risk, orthe risk that a loss will occur if a party does not fulfill its obligations

It launched the trend toward increasing risk modeling research; however, itsover-simplified calculations, and classifications have simultaneously called forits disappearance, paving the way for the Basel II Capital Accord and furtheragreements as the symbol of the continuous refinement of risk and capital

Nevertheless, Basel I, as the first international instrument assessing theimportance of risk in relation to capital, will remain a milestone in the financeand banking history.


11/21

Basel II

Basel II Is ComplicatedIts goal is to better align the required regulatory capital with actual bank risk

. It has multiple approaches for securitization and for credit risk mitigants (such as collateral)

Basel II is Three Pillars

Basel II has three pillars: minimum capital, supervisor review and market discipline

Minimum Capital is the technical, quantitative heart of the accord. Banks must hold capitalagainst 8% of their assets, after adjusting their assets for risk

Supervisor review is the process whereby national regulators ensure their home country

banks are following the rules. If minimum capital is the rulebook, the second pillar is thereferee system

Market discipline is based on enhanced disclosure of risk. This may be an important pillardue to the complexity of Basel. Under Basel II, banks may use their own internal models(and gain lower capital requirements) but the price of this is transparency


12/21

Basel IIOriginal Basel Accord RBI Guidelines

Applies to all internationally active banks and on a consolidated

basis to majority-owned or controlled banking entities,

securities entities and financial entities, not including

insurance.

Applies to all scheduled commercial banks both at solo and

consolidated level and group entities, which include a licensed

bank.

The total capital ratio must be no lower than 8%. Banks are required to maintain a minimum capital to Risk-

weighted assets ratio (CRAR) of 9% on an ongoing basis.

Banks have been permitted to adopt the Standardized method,

Internal Rating Based or Advanced Measurement Approach

Banks mandated to use Standardized Approach for credit risk

and Basic Indicator Approach for operational risk. Banks to

make a road map for migration to advanced approaches only

after obtaining specific approval of RBI.

Claims on sovereigns to be risk weighted from 0% to 150%

depending upon the credit assessments AAA to B-

Exposures to domestic sovereigns (Central & States) rated at 0%

Lending against fully secured mortgages on residential property

will be risk weighted at 35%.

Lending against fully secured mortgages if the loan to value

ratio (LTV) is not more than 75%, on residential property will be

risk weighted at 75%, except where loan value is below Rs.30

lacs which is risk weighted at 50%.

In the case of past due loans where specific provision are no

less than 50% of the outstanding amount of the loan the riskweights of 100%.

Lending for acquiring residential property, which meets the

above criteria but have LTV ratio of more than 75 percent, willattract a risk weight of 100 %.


13/21

Pitfalls of Basel II

1Basel II had created an illusion of safetyan illusion that compliance with Basel II meant that bank capital would beadequate to withstand a crisis

2

The second weakness is the negative spiral effect resulting from the interplay between asset value declines occasionedby market-to-market accounting and Basel IIs rigid capital demands

3

Basel II acceded to the credence that banks inevitably know their risk exposures and know how to manage risks betterthan their regulators

4

Banks were granted broad discretion to set their own risk preferences, with the understanding that riskier institutionswould pay higher costs for the privilege through higher mandated capital. The national regulator verified the presence ofsuch internally developed risk management systems, but did not verify their effectiveness

5

Banks and other financial actors took comfort from the generalized presence of Basel II-compliant national regulation inassessing systemic risk

6

It assuaged any of the banks or their regulators incipient concerns about counterparty and broader systemic risk duringthe credit bubble leading to the Crisis


14/21

Pitfalls of Basel II

7

The complacency engendered by Basel II resulted from two levels of trust. The first was the trust that other actors were following Basel II rulesand Basel II had been designed well enough that when financial institutions complied, a systemic meltdown was so remote as to be virtuallyimpossible

8Credit rating agencies failed to appreciate the risk of certain innovative financial assets. ratings did not reflect the heightening of correlated

defaults during periods of financial stress

9Credit enhancement was used frequently by banks and other originators of asset backed securitizations to bulk up ratings to investment grade,

permitting risk-averse institutions to hold these assets, including other banks

10The inherent conflict-of-interestfacing rating agencies contributed to the problemcredit rating agencies were hired by the very promoters who

desired to sell the rated assets

11

One of the major critiques of the Basel II design assails its pro-cyclical tendencies. In good times, when asset value increases, capital is generatedto support asset growth. In difficult times, as asset value declines, banks are constrained to raise additional capital to support the same assetportfolio they previously held. During periods of expansion, increases in asset values (when market to market) generate shadow increases inregulatory capital, which permit banks to further increase the origination and acquisition of assets, and thus increase intrinsic leverage


15/21

Corrections to Basel II

Capital adequacy may continue to be a useful tool, but it may no longer be theprimary tool. Traditional supervision has to be part of the system

New requirements involvingprocyclicality buffers, leverage limitations, and liquiditymaintenance requirements will augment capital adequacy

To counter this procyclical trend, Basel II joint note, 2010 came out with a frameworkthat would have 2 elements

Promotion of the accretion ofcountercyclical buffers at banks that could be drawn

against during periods of stress

The second element would involve the applications of braking mechanisms that wouldprevent the buildup of excessive credit growth during the expansion phase of thebusiness cycle.


16/21

Basel III

Basel III is aimed at strengthening both sides of balance sheets of banks

Enhancing the quantum of common equity

Improving the quality of capital base

Creation of capital buffers to absorb shocks

Improving liquidity of assets

Optimizing the leverage through Leverage Ratio

Creating more space for banking supervision by regulators under Pillar II

Bringing further transparency and market discipline under Pillar III


17/21

RBI on Basel III norms

The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8%(international) prescribed by the Basel Committee of Total Risk Weighted Assets (RWA).

Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has beenraised to 7% under Basel III. Of the above, Common Equity Tier 1 (CET 1) capital must be atleast 5.5% of RWAs

In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (internationalstandards require these to be only at 4.5%) banks are also required to maintain a CapitalConservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital

Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3%

under Basel III; the leverage ratio is calculated by dividing Tier 1 capital by the bank'saverage total consolidated assets)

Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to holdenough unencumbered liquid assets to cover expected net outflows during a 30-day stressperiod


18/21

Comparison of Basel II and III

Requirements Basel II Basel III

Minimum ratio of total capital to RWAs 8% 10.5% (including conservation buffer)

Minimum ratio of common equity to RWAs 2% 4.5%

Capital Conservation Buffers to RWAs - 2.5%

Leverage ratio (Tier I capital/Total exposure) - 3%

Countercyclical buffer - Upto 2.5%

Liquidity Coverage Ratio (LCR) - >= 100%

Net Stable Funding Ratio (NSFR) - >=100%


19/21

How much will Indian banks need to

comply with BASEL III guidelines?

Public sector banks Private sector banks Total

Additional equity capital requirements under Basel III

(A)

1400 -1500 200 250 1600 1750

Additional equity capital requirements under Basel II

(B)

650 700 20 -25 670 725

Net equity capital requirements under Basel III (AB) 750 800 180 225 930 1025

Additional equity capital requirements under Basel III for public sector banks

Government share (if present shareholding pattern is

maintained)

880 -910

Government share (if shareholding is brought down

to 51%)

660 690

Market share (if the Government's shareholding

pattern is maintained at present level)

520 - 590

The banks in India may require additional capital of upto Rs2.6 lakh crore by 2018 asthey migrate to the capital intensive Basel-III framework, according to a study by

Standard & Poors (S&P)


20/21

Shortcomings of Basel III

Despite the promise of higher capital levels and better quality capital, Basels new minimum leverage ratiorequirement is only 3 per cent, about the same as that of the largest US banks when the global crisis erupted

Countercyclical capital bufferswill be introduced to promote the buildup of capital in good times that canbe drawn upon in periods of stress (bad times), hence reducing the procyclicality of the banking industry

The problem is that identifying good times and bad times is subjective at worst and rather difficult at best.

There is no way of coming up with a figure for the capital buffer that will absorb losses in bad times

Allowing banks to use internal models to calculate regulatory capital, reliance on rating agencies can lead tosimilar crisis in the future

Concept ofrisk weighting involves subjectivity and it is not fool proof

The regulatory framework recommended by Basel II assumes that banks are in the best position to measuretheir own risks, and that a regulatory framework that aligns regulatory capital requirements with the riskbeing taken is to be desired


21/21

Conclusion

Basel III norms are expected to come into force by2018

However it has to be understood that Basel III normshave been designed to address shortcomings ofBasel II at the fallout of 2008 crisis

Following Basel III norms does not guarantee anyprotection against future financial crisis.

Risk Management, Basel

Documents

Transcript of Risk Management, Basel