SOSEBA BANK“A LEADER FOR A NEW WORLD”RISK MANAGEMENT REPORT

Presented By: Gavyn

Risk Management of SOSEBA bank report

Introducing SoSeBa Bank in Mauritius

Issues involved: Basel Core Principles Risks: Credit, Liquidity, Market How to measure them? How to manage them? Illustration

What’s this presentation about?

23 banks for a population of 1,295,000.2 latest additions (Warwyck Private Bank Limited and Richemont Limited) last week Wide range of banking facilities. Banks regulated by the Bank of Mauritius Adherence to Core Principles for Effective

Banking Supervision set by the Basel Committee on Banking Supervision

Banking in Mauritius

Target: working class population Our mission: To provide a diverse range of

services to the working class population of Mauritius

Our vision: To emerge as a leading bank in Mauritius in the medium term.

Our values: Integrity, reliability, efficiency

SoSeBa Bank

Relevant Laws Assets Recovery Act 2011 Banking Act 2004 Bank of Mauritius Act 2004 Borrower Protection Act 2007 Companies Act 2001 Financial Intelligence and Anti Money Laundering Act

2002 (FIAMLA) Financial Services Act 2007 Insurance Act 2005 Insolvency Act 2009

+ Bank of Mauritius Guidelines

Legal aspect of banking

Banking Regulations

Banking regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines.

Banking regulation has advanced noticeably since the 2008 financial crisis, with considerable progress achieved in 2013.

There is a need for regulations since banks like to take risks.

Banking Regulations

Bank for International Settlements

Established in 1930 in the context of Young Plan.

Main purpose is to make monetary policy more predictable.

The BIS sets "requirements on two categories of capital, tier 1 capital and total capital.

Bank for International Settlements

Tier 1 & Tier 2 Capital

Tier 1 Capital Tier 2 Capital

It is a term used to describe the capital adequacy of a bank

It refers to as the equity tier one ratio.

It consists of only one equity and retained profits.

Tier 2 Capital also known as Supplementary Capital

Include a number of important and legitimate constituents of bank’s capital base

Tier 2 capital can be said to be subordinate Capital

Introduction to Basel

The Basel Committee under the banking supervision established by the central bank governors of the group of 10 countries in 1974.

Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.

Introduction to Basel

Basel 1

Basel Capital Accord (Basel 1) was approved by the G10 governors and released to banks in July 1988.

Basel 1 helps to strengthen the stability of international banking system.

Basel 1 is a set minimum capital standards for banks.

Basel 1

Limited differentiation of credit risk. No recognition of term-structure of credit

risk. Static measure of default risk. Simplified calculation of potential future

counterparty risk. Lack of recognition of portfolio

diversification effects.

Critics of Basel 1

Basel 2

Basel II is the second of the Basel Accords. Basel II, initially published in June 2004, was

intended to create an international standard for banking regulators to control how much capital banks need to put aside to guard against the types of financial and operational risks banks (and the whole economy) face.

Basel 2

Minimum Capital

Requirements

Supervisory

Review

Market Discipl

ine

3 Pillars of Basel 2

The first pillar deals with minimum capital requirements in respect of credit, market and operational risk.

Each of which has to be calculated using an approach which is suitable and sufficient for the individual bank.

Minimum Capital Requirements

Pillar 2 requires the banks to have procedures for the evaluation and assurance of an adequate capitalisation in relation to the risk profile as well as of a strategy concerning the preservation of the level of own funds (Internal Capital Adequacy Assessment Process – ICAAP).

Supervisory Review

Pillar 3 aims to increase market transparency by providing information on the scope of application, regulatory capital, risk positions, risk measurement approaches equity, risk positions, the IRB-Approach and as a result the capital requirements of a bank.

Market Discipline

BASEL 3

Basel III (or the Third Basel Accord) is a global, voluntary regulatory standard on bank capital adequacy, stress testing and market liquidity risk.

It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11.

It was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018

Basel 3

Capital Requirements

Leverage Ratio Liquidity

Requirements

Principles of Basel 3

Capital Requirements

Basel III introduced "additional capital buffers",

(i) a "mandatory capital conservation buffer" of 2.5%

and (ii) a "discretionary counter-cyclical buffer",

which would allow national regulators to require up to

another 2.5% of capital during periods of high credit

growth.

Leverage Ratio

The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets. The banks were expected to maintain a leverage ratio in excess of 3% under Basel III

Liquidity Requirements

The "Liquidity Coverage Ratio" was supposed to require a bank to hold sufficient high-quality liquid assets to cover its total net cash outflows

over 30 days.The Net Stable Funding Ratio was to require the available amount of

stable funding to exceed the required amount of stable funding over a one-year period of extended stress.

ConclusionUnlike Basel I and Basel II which are primarily related to the required level of bank loss reserves that must be held by banks for various classes of loans and other investments and assets that they have, Basel III is primarily related to the risks for the banks of a run on the bank by requiring differing levels of reserves for different forms of bank deposits and other borrowings.

Due to inherent risks in the accepting of deposits from people with an excess of money to granting loans to those in deficit of it.

Need to manage risks : Credit/ Liquidity/ Market Risk management -a four-step process Identifying Measuring ( quantifying) Managing Monitoring and reviewing

Risks in banking

Regulatory response◦ Prudential norms◦ Stringent Provisioning norms◦ Corporate governance norms

Market response-introduce new products◦ Equity futures◦ Foreign currency futures◦ Currency swaps◦ Options

As a newly established bank, SoSeBa expects to distinguish itself by its intelligent risk management.

Typical response to Risks

SoSeBa’s Proposed Risk Management Committee

Areas covered◦ Credit Risk◦ Liquidity Risk◦ Market Risk

Credit risk is defined as “the potential that a borrower or counter-party will fail to meet its obligations in accordance with agreed terms”

It is the probability of loss from a credit transaction

SOSENA’s Risk Management Framework

Working Capital Finance◦ Extended to meet day-to-day short term

operational requirements

Loan for setting up new project, expansion and diversification of existing project etc.◦ Short term or medium term

Sources of credit risk for SoSeBa

◦ Pre-Sanction appraisal Financial data of past and projected working results Detailed credit report is compiled on the borrower / surety Market reports Final / audited accounts Income tax and other tax returns / assessments

◦ Post-Sanction control Documentation of the facility and ‘after care’ follow- up Supervision through monitoring of transactions in loan

amount Physical inspection of securities and books of accounts of the

borrower Periodical reviews

Two-pronged approach to credit risk

Use of credit rating models and credit rating analysts

Credit quality of facilities to individuals or small businesses assessed through credit scoring based on a standard formulae which incorporates relevant variables like annual income, repayment capacity, and exposure limits.

Afrasia’s banking software: CRISIL & CRESS

Credit Risk Rating Framework

Bank generally sets an exposure credit limit for each counterparty to which it has credit exposure

Prudential limits: not more than 15% of capital to individual borrower and not more than 40% of capital to a group borrower.

Threshold limits set are dependent upon :◦ Credit rating of the borrower◦ Past financial records◦ Willingness and ability to repay◦ Borrower’s future cash flow projections

Credit Risk Limits

Credit risk models used by banks: Altman’s Z Score Model 95 % accuracy of prediction of bankruptcy up to

two years prior to failure on non-manufacturing firms as well.

Credit Metrics Model Tool for assessing portfolio risk due to changes in

debt value caused by changes in obligor credit quality

Value at Risk Model Constructs a probability distribution of the

portfolio values over a given time horizon

Credit Risk Modeling

1) Screening & monitoring2) Long-term Customer Relationships3) Loan Commitments 4) Collateral5) Compensating Balances6) Credit Rationing7) On-Balance Sheet Netting

Managing Credit Risk

Despite all these measure, the banking sphere experienced crises like

Enron (2001) Washington Mutual (2008) Why?Maintained a risk management function.Lines of reporting were reasonably

independent.Few career risk managers.

Failures?

Effective management of funding liquidity, capital & balance sheet ( contingency plans).

Senior Management role in understanding and acting on existing and emerging risks is extremely important.

Afterthoughts

A positive corporate culture. Actively observed policies and procedures. Effective use of technology. Independence of risk management

professionals.

Overall risk should always be lower than overall economic capital

SoSeBa’s Winning Formula:

Minimum Capital Requirement

Three Basic Pillars

Supervisory Review ProcessSupervisory Review Process

Market Discipline Requirements

Market Discipline Requirements

The New Basel Capital Accord

Standardized approach (External Ratings)

Internal ratings-based approach Foundation approach Advanced approach

Credit risk modeling(Sophisticated banks in the future)

1. Minimum Capital Requirements- Credit Risk (Pillar One)

Minimum Capital Requirement

Since the 2008 financial crisis and its recent ramifications, liquidity risk management has become a focal point for banks and regulators. 

Liquidity risk for SOSEBA is centrally managed by a dedicated liquidity risk management team in Group Treasury.

It is this central function’s responsibility to ensure that the liquidity risk management framework is implemented appropriately.

Liquidity risk is one of the major risks faced by financial intermediaries and banks in particular.

Liquidity in banking is conventionally defined as the ability to meet its obligations as they become due.

The Bank may encounter liquidity risks – the inability to meet its liquidity needs because of bank-specific problems or because of a market liquidity shortage in times of a financial crisis.

Liquidity Risk

Funding liquidity tends to manifest as a credit risk: inability to fund liabilities produces defaults.

Market liquidity risk manifests as market risk: inability to sell an asset drives its market price down, or worse, renders the market price indecipherable. 

Market liquidity risk is a problem created by the interaction of the seller and buyers in the marketplace. If the seller's position is large relative to the market, this is called endogenous liquidity risk (a feature of the seller). If the marketplace has withdrawn buyers, this is called exogenous liquidity risk (a characteristic of the market which is a collection of buyers); a typical indicator here is an abnormally wide bid-ask spread. 

Types of liquidity risks

“Principles for Sound Liquidity Risk Management and Supervision”, by providing more guidance on the following. Liquidity risk tolerance Maintaining adequate levels of liquidity Allocating liquidity costs, benefits and risks to

business Identification and measurement of contingent

liquidity risks Design and use of severe stress test scenarios A contingency funding plan Public disclosure in promoting market discipline

Basel Committee

As per the Bank of Mauritius, the liquidity risk Guidelines are issued under the authority of Section 50 of the Bank of Mauritius Act 2004 and Section 100 of the Banking Act 2004.

As per Bank of Mauritius, SOSEBA shall manage liquidity risk in a sound manner

shall establish a robust liquidity risk management framework that ensures it maintains sufficient liquidity, including a cushion of unencumbered, high quality liquid assets, to ZSwithstand a range of stress events, including those involving the loss or impairment of both unsecured and secured funding sources.

Bank of Mauritius Guidelines

Funding Requirements Limits on the net Cumulative Funding

Mismatch Intra-group Liquidity Fund Concentration Funding Capacity Cash flows denominated in individual

currencies

Measurement of liquidity risk

Risk Management Policies

Liquidity Risk Tolerance Strategy Composition of assets and liabilities  Diversification and Stability of Liabilities Access to Inter bank and Other Wholesale

Markets Management of Liquidity in Different

Currencies Management of Intra-group Liquidity Translation of Liquidity strategy into Policies

Management of liquidity risks

  senior management has set up a structure of responsibilities and controls

for managing liquidity risk and for overseeing the liquidity positions of all legal entities, branches and subsidiaries;

senior management has a thorough understanding of the close links between funding liquidity risk and market liquidity risk

the liquidity risk strategy, key policies for implementing the strategy and liquidity management structure be communicated throughout the organization by senior management;

senior management should have an oversight process with efficient and effective internal controls to ensure the enforcement of policies and procedures

senior management implements changes in a timely manner when significant changes impact on the effectiveness of controls and revisions or enhancements to internal controls are warranted;

Role of directors

• internal audit reviews the implementation and effectiveness of the agreed framework for controlling liquidity at the periodicity as determined by it;

• senior management closely monitors current trends and potential market developments that may present significant, unprecedented and complex challenges for managing liquidity risk so that they can make appropriate and timely changes to the liquidity strategy as needed.

• senior management provides regular feedback through a formal system of reporting;

 • senior management takes appropriate remedial actions

within the least delay to address the above concerns.

“Knowledge has to be improved, challenged and increased constantly or it vanishes” Peter Drucker

It is the risk that the value of on and off-balance sheet positions of a financial institution will be adversely affected by movements in market rates or prices such as interest rates, foreign exchange rates, equity prices, credit spreads and/or commodity prices resulting in a loss to earnings and capital.

Market Risk

Market Risk

Market Risk

arising from movement in market prices

Interest Rate Risk, Exchange Rate Risk, Commodities Price risk Equity Price Risk.

MARKET RISK-CONTINUED

Basel-I focused only on credit risk excluding the market risk

Risk brought vide amendments in 1996 usually measured with a Value-at-Risk

method and on daily basis capital charge should be either the

previous day’s VaR or three times the average of the daily VaR for the preceding 60 working days.

• Convergence of Economies• Easy and faster flow of information• Skill Enhancement• Increasing Market activity

• Increased Volatility• Need for measuring and managing Market Risks• Regulatory focus• Profiting from Risk

Why the focus on Market Risk Management ?

Leading to

Time

Sophistication

Mark to Market

Duration

Value at Risk

Stress Testing

Use of Statistical analysis to determine

maximum losses

Use of ‘What if’ scenarios to

determine losses in extreme

eventsCashflow analysis to

measure the sensitivity of fixed income instruments

Revaluation of the portfolio to

measure notional P/L

TimeTime

Sophistication

Mark to Market

Duration

Value at Risk

Stress Testing

Use of statistical analysis to determine

maximum losses

Use of ‘What if’ scenarios to

determine losses in extreme

eventsCashflow analysis to

measure the sensitivity of fixed income instruments

Revaluation of the portfolio to

measure notional P/L

Market Risk – Advanced Risk Measurement Techniques enables Bank to effectively control the amount of market risk it assumes and allocate capital for the same

Measurement Techniques Marking to Market Duration, Convexity Price Value of a Basis Point VaR - Forex (Spot & Forward) Stress Testing Scenario Analysis

Duration Limits VaR Limits Stop Loss Limits Counterparty Exposure

Limits Country Exposure Limits

Standardized Model

Internal Model

‘Know’ your risksAllocate Capital

Control Measures

Value-at-Risk is a measure of Market Risk, which measures the maximum loss in the market value of a portfolio with a given confidence

VaR is denominated in units of a currency or as a percentage of portfolio holdings

It is a probability of occurrence and hence is a statistical measure of risk exposure

Measure, Monitor & Manage – Value at Risk

Value at risk (VAR) is a probabilistic method of measuring the potentional loss in portfolio value over a given time period and confidence level.

The VAR measure used by regulators for market risk is the loss on the trading book that can be expected to occur over a 10-day period 1% of the time

The value at risk is $1 million means that the bank is 99% confident that there will not be a loss greater than $1 million over the next 10 days.

Value At Risk

“ The way that risk is managed in any

particular institution reflects its position in the marketplace, the products it delivers and perhaps, above all, its culture. “

Risk Management and Image of SOSEBA BANK

Trading book Banking book

The main differences are:1. Assets that are held for trading are put in the trading book, assets that are held to maturity are held in the banking book2. Assets in the trading book are marked-to-market daily, assets in the banking book are held at historic cost3. The value-at-risk for assets in the trading book is calculated at a 99% confidence level based on a 10-day time horizon. The value-at-risk for assets in the banking book are calculated at a 99.9% confidence level on a one-year horizon.

BOOK

Effective Management of Risk benefits the bank..

Efficient allocation of capital to exploit different risk / reward pattern across business

Better Product Pricing Early warning signals on potential

events impacting business Reduced earnings Volatility Increased Shareholder Value

Conclusion

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SoSeBa Bank