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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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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
6/26/2013 16Basel 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
6/26/2013 17Presented 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
6/26/2013 18
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
6/26/2013 19Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.
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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%
6/26/2013 20Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.
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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
6/26/2013 21Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.
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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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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 adequacy4. 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.
Innovative instruments like perpetual debt can
also form a part of Tier I capital.
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Tier I Capital - Constituents
Permanent shareholders equity (paid up
capital)
Statutory reserves and Disclosed free Reserves
Innovative Tier I capital
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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 1CAPITAL
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
CAPITALPLUS
CAPITAL
CONVERSIO
N BUFFER
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 lending
process depend on objective credit decisionsthat 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 b k D i
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Interbank Deposits
- The most important category of assets
for which a bank carries the credit risk. Off-balance-sheet commitments
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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.
P bli di l i t
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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 L L P i i i P li
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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 lossassets : 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
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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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The Structure of Funding : Deposits and
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.
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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.
f l k l
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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
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Trading Book and Management of
Trading 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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Currency risk
- 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 resultsnormally are subject to supervisory attention.
The complexity of stress tests normally reflects the
complexities of a banks market risk exposures and
respective market environments. It is virtually impossible to develop a standard stress
test scenario that has a consistent impact on all
banks.
I t t R t Ri k M t
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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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g
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
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g
Interest Rate Risk
Static gap model
- It was common practice for financialinstitutions 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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Repricing gap model
- 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 provisions
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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 risk
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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 involvecounterparty 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.
Liquidity risk concerns
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Liquidity risk concerns
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
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Capital 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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