CHAPTER 12 TIME VALUE OF MONEY

BANK FINANCIAL MANAGEMENT- CAIIB

SUPERVISORY

REVIEW

BALANCE SHEET MANAGEMENT

MODULE - D

CHAPTER 25 SUPERVISORY REVIEW

2

CONTENTS

1. INTRODUCTION

2. SUPERVISORY REVIEW AND EVALUATION PROCESS (SREP) – PILLAR 2

3. GUIDELINES FOR THE SREP OF THE RBI AND THE ICAAP OF BANKS

4. USE OF CAPITAL MODELS FOR ICAAP

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SUPERVISORY

REVIEW

Banks in the modern world face an inherent

risk of insolvency. Since the banks are so

highly leveraged, there could be a run on

the bank any moment if their reserves are

considered to be inadequate by the market.

Hence, banks must maintain adequate

capital in their vaults if they want to

survive. However, what constitutes

“adequate” is subjective. This is generally

measured in the form of a “capital

adequacy ratio” and central banking

institutions all over the world prescribe the

level of capital that needs to be maintained.

The capital adequacy ratio is important

from the point of view of solvency of the

banks and their protection from untoward

events which arise as a result of liquidity

risk as well as the credit risk that banks are

exposed to in the normal course of their

business. The solvency of banks is not a

matter that can be left alone to the banking

industry. This is because banks have the

savings of the entire economy in their

accounts.

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SUPERVISORY REVIEW AND EVALUATION PROCESS (SREP) – PILLAR 2

Introduction to the SREP under Pillar 2

The New Capital Adequacy Framework (NCAF), based on the Basel II Framework evolved by the Basel

Committee on Banking Supervision, was adapted for India on April 27, 2007. As per this circular, banks

were required to have a Board-approved policy on Internal Capital Adequacy Assessment Process

(ICAAP) and to assess the capital requirement as per ICAAP. It is presumed that banks would have

formulated the policy and also undertaken the capital adequacy assessment accordingly.

The Capital Adequacy Framework rests on three components or three Pillars. Pillar 1 is the Minimum

Capital Ratio while Pillar 2 and Pillar 3 are the Supervisory Review Process (SRP) and Market

Discipline, respectively. The guidelines in regard to the SRP and the ICAAP are furnished in this

Section.

The objective of the SRP is to ensure that banks have adequate capital to support all the risks in their

business as also to encourage them to develop and use better risk management techniques for

monitoring and managing their risks. This in turn would require a well-defined internal assessment

process within banks through which they assure the RBI that adequate capital is indeed held towards

the various risks to which they are exposed. The process of assurance could also involve an active

dialogue between the bank and the RBI so that, when warranted, appropriate intervention could be

made to reduce the risk exposure of the bank or augment / restore its capital. Thus, ICAAP is an

important component of the SRP.

The main aspects to be addressed under the SRP, and therefore, under the ICAAP, would include:

the risks that are not fully captured by the minimum capital ratio prescribed under Pillar 1;

the risks that are not at all taken into account by the Pillar 1; and

the factors external to the bank.

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Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the

regulatory minimum level, addressing only the three specified risks (viz., credit, market and operational

risks), holding additional capital might be necessary for banks, on account of both – the possibility of

some under-estimation of risks under the Pillar 1 and the actual risk exposure of a bank vis-à-vis the

quality of its risk management architecture. Illustratively, some of the risks that the banks are generally

exposed to but which are not captured or not fully captured in the regulatory CRAR would include:

Interest rate risk in the banking book; (b) Credit concentration risk;

Liquidity risk;

Settlement risk;

Reputational risk;

Strategic risk;

Risk of under-estimation of credit risk under the Standardised approach;

Model risk i.e., the risk of under-estimation of credit risk under the IRB approaches;

Risk of weakness in the credit-risk mitigants;

Residual risk of securitisation, etc.

Need For Improved Risk Management

While financial institutions have faced difficulties over the years for a multitude of reasons, the major

causes of serious banking problems continue to be lax credit standards for borrowers and

counterparties, poor portfolio risk management, and a lack of attention to changes in economic or other

circumstances that can lead to a deterioration in the credit standing of a bank's counterparties. This

experience is common in both advanced and developing countries.

The financial market crisis of 2007-08 has underscored the critical importance of effective credit risk

management to the long-term success of any banking organisation and as a key component to financial

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stability. It has provided a stark reminder of the need for banks to effectively identify measure, monitor

and control credit risk, as well as to understand how credit risk interacts with other types of risk

(including market, liquidity and reputational risk). The essential elements of a comprehensive credit risk

management programme include (i) establishing an appropriate credit risk environment; (ii) operating

under a sound credit granting process; (iii) maintaining an appropriate credit administration,

measurement and monitoring process; and (iv) ensuring adequate controls over credit risk as elaborated

in our Guidance note on Credit Risk issued on October 12, 2002

The recent crisis has emphasised the importance of effective capital planning and longer-term capital

maintenance. A bank’s ability to withstand uncertain market conditions is bolstered by maintaining a

strong capital position that accounts for potential changes in the bank’s strategy and volatility in market

conditions over time. Banks should focus on effective and efficient capital planning, as well as long-term

capital maintenance. An effective capital planning process requires a bank to assess both the risks to

which it is exposed and the risk management processes in place to manage and mitigate those risks;

evaluate its capital adequacy relative to its risks; and consider the potential impact on earnings and

capital from economic downturns. A bank’s capital planning process should incorporate rigorous,

forward looking stress testing.

Rapid growth in any business activity can present banks with significant risk management challenges.

This was the case with the expanded use of the “originate-to-distribute” business model, off-balance

sheet vehicles, liquidity facilities and credit derivatives. The originate-to-distribute model and

securitisation can enhance credit intermediation and bank profitability, as well as more widely diversify

risk. Managing the associated risks, however, poses significant challenges. Indeed, these activities

create exposures within business lines, across the firm and across risk factors that can be difficult to

identify measure, manage, mitigate and control. This is especially true in an environment of declining

market liquidity, asset prices and risk appetite. The inability to properly identify and measure such risks

may lead to unintended risk exposures and concentrations, which in turn can lead to concurrent losses

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arising in several businesses and risk dimensions due to a common set of factors. Strong demand for

structured products created incentives for banks using the originate-to-distribute model to originate

loans, such as subprime mortgages, using unsound and unsafe underwriting standards. At the same

time, many investors relied solely on the ratings of the credit rating agencies (CRAs) when determining

whether to invest in structured credit products. Many investors conducted little or no independent due

diligence on the structured products they purchased. Furthermore, many banks had insufficient risk

management processes in place to address the risks associated with exposures held on their balance

sheet, as well as those associated with off-balance sheet entities, such as asset backed commercial

paper (ABCP) conduits and structured investment vehicles (SIVs).

Innovation has increased the complexity and potential illiquidity of structured credit products. This, in

turn, can make such products more difficult to value and hedge, and may lead to inadvertent increases

in overall risk. Further, the increased growth of complex investor-specific products may result in thin

markets that are illiquid, which can expose a bank to large losses in times of stress if the associated

risks are not well understood and managed in a timely and effective manner.

GUIDELINES FOR THE SREP OF THE RBI AND THE ICAAP OF BANKS

The Basel capital adequacy framework rests on the following three mutually- reinforcing pillars:

Pillar 1: Minimum Capital Requirements - which prescribes a risk-sensitive calculation of capital

requirements that, for the first time, explicitly includes operational risk in addition to market and

credit risk.

Pillar 2: Supervisory Review Process (SRP) which envisages the establishment of suitable risk

management systems in banks and their review by the supervisory authority.

Pillar 3: Market Discipline - which seeks to achieve increased transparency through expanded

disclosure requirements for banks.

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