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Basel Capital Accord &Risk Management in Banks
Presentation at Dr.D.Y.Patil Institute ofManagement & Research
On 09.02.2011
Shri. V E Dalvi
General Manager
Bank of Maharashtra
Integrated Risk Management
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What is Bank Capital A bank balance sheet gives the financial
conditions of the bank.
It consists of Assets and Liabilities
Assets such as Loans which are income producingitems.
Liabilities such as deposits which are what it owesor sources of funds for Bank
Capital:-It is defined as assets minus liabilities
Bank Balance Sheet
Assets Liabilities & Capital
Loans 1000 Deposits 900
Capital 100
Total 1000 Total 1000
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Why Bank Need Capital Bank needs capital for protection in case of losses onloans or other assets
Suppose borrower defaults on loan of Rs 50, AfterLoan loss capital falls by amount of loss
The Bank still owes depositor Rs 900
If capital falls below zero Bank's assets are no longer enough to cover what it
owes depositors. It is insolvent and must ceaseoperations Its share holders lose every thing theyhave invested.
Balance Sheet of the bankAssets Liab & Capital
Loans 950 Deposits 900
Capital 50
Total 950 950
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More leverage Means More Risk
A Bank with less capital in
relation to its assets is said to
have higher leverage
High Leverage puts a bank atgreater risk of insolvency.
The low leverage bank could
survive up to Rs. 500 loan
Losses
The Higher Leverage bank
would become insolvent after
just Rs. 100 loan losses.
Balance Sheet of a
Bank
Assets Lia & Capital
Loans 1000 Deposit 500
Capital 500
Total 1000 1000
Loans 1000 Deposit 900
Capital 100
Total 1000 1000
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But More Leverage means Higher Returns
More leverage means higher risk, but alsohigher returns for shareholders if the bank
remains solvent
Assume interest received from Loans to be 10%
and interest paid on deposits to be 8%. In first case income will be Rs 100 and Cost of
Deposit will be Rs 40 so profit will be Rs 60. so
return on capital of Rs 500 is 12%
In second case income will be Rs 100 and Cost
of Deposit will be Rs 72 so profit will be Rs 28.
so return on capital of Rs 100 is 28%
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Who Regulates Bank Capital
Bank Regulators of individual countries (RBI) donot act alone in setting rules for bank capital.
They coordinate their capital regulation through
the Basel Committee on Banking Supervision
(BCBS)
The Committee meets at the Bank for
International Settlement (BIS), an international
organization, founded in 1930, that fostersmonetary and financial cooperation and acts as
a bank for central banks
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The Basel Accords
The Basel Committee periodically issues Accords thatset out international standards for bank capital as well asother bank regulations.
The first Basel Accord, now called Basel I were issued in1988.
RBI implemented in India w.e.f. 1992 with introduction ofIRAC norms and provisions for loan losses.
Basel I Accord replaced by a new set of standards ,Basel II , in 2004.
In India, it was implemented w.e.f31.03.2008 to Foreign
Banks having branches in India and Indian Banks havingInternational Presence and w.e.f31.03.2009 for all othercommercial Banks in India.
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Basel I vis--vis Basel II
Basel I Basel II
Focus on single risk
measure
More emphasis on banks own
internal risk management
methodologies, supervision
review and market discipline.
One size fits all &
Broad Brush
Approach
More risk sensitive approach,
Flexibility, capital incentives for
better risk management.Centered around
Credit Risk & Market
Risk
Operational Risk addressed
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CRAR
Capital to Risk weighted Asset Ratio
(CRAR)
CRAR = Capital (Tier I +Tier II)
Risk Weighted Assets CR, MR OR
Minimum As per Basel II 8% As per RBI 9% Why? (as cushion)
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Elements of Capital Tier I
Paid up equity, statutory reserves Capital reserves Innovative perpetual debt instruments (IPDI) (max 15% of Tier I) Other instruments notified by RBI
Tier II Revaluation reserves General provisions and loss reserves (max 1.25% of RWA)
Hybrid debt capital instruments (Upper Tier II) Subordinated debt (Lower Tier II) Surplus innovative perpetual debt Instruments
(IPDI) in excess of 15% taken in Tier I
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Basel II Pillars
Basel II framework rests on 3 mutually reinforcingpillars which are :
Pillar I -Sets out minimum capital requirements
Pillar II -Supervisory Review of Capital Adequacy Pillar III -Market Discipline
The II & III Pillars are complementary toPillar I
Regulatory Capital Charge for risk
Credit, Market & Operational Risks
Evolutionary in Risk Sensitivity to CapitalRegime
Transparency in Public Reporting
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Pillar 1- Methods for assessment of capitaladequacy
Credit Risk Market Risk Operational
Risk
Standardized
Approach
Standardized
Approach
Basic Indicator
Approach
Foundation IRB
Approach Internal Models
Approach
Standardized
Approach
Advanced IRBApproach
AdvancedMeasurement
Approach
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BaselBasel--II FrameworkII Framework
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RW for Domestic Sovereign - Central Govt. DICGC = 0%
State Govt. and ECGC cover = 20%
RW for Claims on Corporate /PSEs
RW for Regulatory Retail 75%
RW for Banks: Linked to CRAR if or
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What is Risk Management
Basic Elements of the Risk Management
Identifying the Risk
Quantifying/Measuring the Risk Controlling the Risk &
Managing the Risk.
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Types of Risk &
Risk profile of Bank/FIVarious Types Of
Risks
Credit Risk
Market Risk
Liquidity Risk
Operational Risk
Credit RiskMkt Risk
Liq RiskOp Risk
Ot er Risks
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Objectives of Risk
Management TO optimize the Risk Adjusted Returns
and not to minimize the absolute Risk.
Taking the Risk with prudential
safeguards and not to avoid or
eliminate the Risk.
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What is Credit Risk?
Credit risk is a risk resulting from uncertainty
in a counterpartys ability or willingness to
meet its contractual obligations.
Credit risk is the probability of lossesassociated with changes in the credit quality
of borrowers or counterparties.
These losses could arise due to outright
default by counterparties or due to
deterioration in credit quality even when
default has not taken place
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Why should Banks be concerned
with Credit Risk?Nature of Loan Returns
Borrower A has been sanctioned a term loan of Rs
10 crore, for 1 year at 10% rate of interest (annual)
If A does not default
Rs 11.00 lcrore at the end of 1 year
If A does default
Rs 0 under extreme circumstances
Rs 50 lac if we can recover 50%
of the principal
Upside gain
is limited
Downside loss
is large
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Why should Banks be concerned
with Credit Risk
Skewed nature of loan returns
Loan returns are highly asymmetric since there is
limited upside
If borrowers credit quality improves - no benefit tolending bank since the borrower can refinance his
loan at a lower rate
If borrowers credit quality declines - bank is not
compensated for taking the additional risk since loan
price is not revised
If borrower defaults - accrued interest is reversed
and any new payments are towards principal
If borrower becomes NPA - minimal recovery
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Risk Identification
Elements of Credit Risk
Concentration
Risk
Intrinsic
Risk
Portfolio Risk Individual Risk
Credit Risk
Downgrade
Risk
Default
Risk
Recovery
Risk
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Why Manage Credit Risk?
Market Realities structural increase in non performing assets
higher concentrations in loan portfolios
increasing competition leading to lower spreads
Volatility in values of Collateral
growth of off-balance sheet credit products (as aconsequence of enhancing non-interest income)
Changing Regulatory environment
Basel II implementation
Risk Vision
Capital is a scarce resource need for optimalutilization
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Credit Risk Management - Tools
Credit Approving Authority
Prudential Limits
Credit Risk RatingRisk Pricing
Controlling the risk through effective
Portfolio Management Loan ReviewMechanism and.
Estimation of Expected loan losses
Estimation of Unexpected loan losses
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Prudential limitsFor individuals Borrowers including NBFC-AFC:
Excl. Infrastructure
Finance
15 % of Total of Tier I and Tier II Capital as on
31.03.2007 (Rs. 449.74 crore).
Infrastructure
finance
20% of Total of Tier I and Tier II Capital as on
31.03.2007 (Rs. 599.65 crore).
For Group Borrowers including NBFC-AFC:Excl. Infrastructure
Finance
40 % of Total of Tier I and Tier II Capital as on
31.03.2007 (Rs. 1199.31 crore).
Infrastructure
finance
50 % of Total of Tier I and Tier II Capital as on
31.03.2007 (Rs. 1499.14 crore).
INDIVIDUAL NBFCExcl. Infrastructure 10% of Total Tier I and Tier II capital as on
31.03.2007 (Rs. 299.82 crore)
For Infrastructure 15% of Total Tier I and Tier II capital as on
31.03.2007 (Rs. 449.74 crore)
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Exposure Norms
Policy on Very Large Exposure:
Entry Level sub ceiling for
Individual/ Proprietary concerns - Rs. 5.00 crore
Partnership / Private / Public Ltd. Co. - 10% of Banks networth as of 31st March 2007. (This ceiling excludesPSUs, State Govt. owned companies, State Govt. Bodies)
Entry Level exposure beyond above ceiling will betreated as very large exposure. The very large exposureshall be taken only under Consortium/ Multiple BankingArrangements, where minimum credit risk rating shall beA.
Substantial Exposure Limit:
Threshold limit - 10% of the total capital funds as on31.03.2007 Substantial exposure limit- 7.5 times of theBanks capital funds as on 31.03.2007.
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Exposure ceilings - Sectors
No Particulars Exposure not to exceed
1. Real Estate Sector- 30% of Gross Creditof which
a) Housing Loans to Individuals 12.5% of Gross Credit
b) Comm. Real Estate 7.5% of Gross Credit
c) Indirect Real Estate 10% of Gross Credit2 Shares, Debentures and Bonds 10% of Net Worth
3 Advances to Stock brokers 10% of Net Worth
4 Advances to NBFCs /NBFIs 20% of Gross Credit
of whichHousing Finance Companies 10% of Gross Credit
NBFC ND - SI 2% of Gross Credit
All Other ( NBFC- D, AFC,
Factoring and other activities)
8% of Gross Credit
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Exposure ceilings - Sectors
No Particulars Exposure not to exceed
5 Infrastructure 25% of Gross Credit
of which
a) Power Sector 10% of Gross Credit
b) Roads incl. Highways 5% of Gross Creditc) Telecommunication 3% of Gross Credit
d) Residual Infrastructure
Activities
7% of Gross Credit
6 Any other sector 10% of Gross Credit7 Non Fund Business 30% of Gross Credit
8 Unsecured Exposure
(excluding Food Credit and
Staff Schematic advances)
35% of Gross Credit
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Exposure ceilings - Industries
No Particulars Exposure not to exceed
1 Sugar Industry 2% of the Gross Credit
2 Advances to Film Industry
(Cinema Theatre etc.)
1% of the Gross credit
3 Software/ IT Industry 5% of Gross Credit4 Auto and Auto Ancillary 10% of Gross Credit
5 Any other Industry 10% of Gross Credit
Exposure ceilings:Exposure ceilings:Indian Joint ventures/wholly owned subsidiaries abroad:Indian Joint ventures/wholly owned subsidiaries abroad:
Not to exceed 20% of unimpaired capital fundsNot to exceed 20% of unimpaired capital funds
(Tier I and Tier II capital).(Tier I and Tier II capital).
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What is Credit Risk Rating
Rating is an assessment/ evaluation of a person,
property, project against a specific yardstick /
benchmark.
Objective of Credit Rating
Assess a particular credit proposition (incl.
investment) on the basis of certain parameters
Outcome of rating - Degree of reliability & risk
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Credit Risk Rating
It helps in- Evaluation of borrower on the basis of certain
parameters (Outcome: Degree of reliability & risk)
Credit selection / rejection (Entry level rating Benchmark rating)
Activity-wise/ sector-wise portfolio study keeping inview the macro-level position.
Estimating concentration risk within a portfolio
Deciding concentration limit and exposure limit
Deciding exit point of syndicated loans
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Credit Risk Rating Models
The model should provides forassessment of risks under variouscomponents: such as
Financial Risk
Account Operating risk
Management Risk
Industrial RiskBusiness Risk &
Project Risk
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Credit Risk Rating Model
Within each risk component, risk parameters
and Risk factors have to be identified
Each risk factor should be assigned weight
according to its Importance
Scoring Norms should be developed for
assigning scores to each risk factor
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CRR Model - Risk parameters
Financial Risk
Assessment of Financial Statements
Past Financial Performance
Future risk
Cash Flow adequacy (Projected)
Account Operating Risk
Security Coverage Conduct of the account
Observance of financial discipline
Maturity risk
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CRR Model - Risk parameters
Management Risk
Ownership Experience & Competence
Track record
Corporate Governance
Industry Risk
Industry Characteristics
Competitive forces within the industry
Industry financials
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CRR Model - Risk parameters
Business Risk
Market Position
Operating Efficiency
Growth
Project Risk (For Project Loan only) Timeliness in completion of the project
Cost escalation of the project
Funding arrangement for cost escalation
Achievement of production target Deficiency in management of the project
Repayment period of loan (Excluding
Moratorium Period)
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a ng gra on
During the period of 12 months
Rating AAA AA A BBB BB B C Default Total
AAA 900 50 40 10 1000
AA 200 1500 200 50 50 2000
A 300 450 1800 300 50 50 50 3000
BBB 200 200 300 700 100 50 50 100 1700
BB 50 50 100 100 200 50 100 50 700
B 20 20 40 20 50 50 80 70 350
C -- -- 25 25 25 25 300 200 600
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Probability of rating Migration
During 12 months period
Rating AAA
%
AA
%
A
%
BBB
%
BB
%
B
%
C
%
Default
%
AAA 90% 5% 4% 1%
AA 10% 75% 10% 2.5% 2.5%
A 10% 15% 60% 10% 1.6% 1.6% 1.6%
BBB 12% 12% 17% 42% 6% 3% 3% 5%
BB 7% 7% 14% 14% 28% 7% 14% 9%
B 6% 6% 12% 6% 14% 14% 22% 20%
C 4.2% 4.2% 4.3% 4.3% 50% 33%
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Measuring credit RiskFormulation of Credit risk models
Probability of default(PD)
PD is the probability of a particular credit
facility defaulting within a given time horizon
(usually 12 months)
PD is the primary output of a credit risk model
Estimation of PD is based on rating migration
in 1 year time horizon over a period of time
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Measuring credit Risk
Formulation of Credit risk models
Loss Given Default (LGD)
LGD is the percentage of exposure lost
when default occurs (1- recovery rate).
It is related risk measure to PD.
LGD data sources are: banks own
historical data by risk segment, trade
association data, published regulatoryreports and rating agency reports.
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Measuring credit Risk
Formulation of Credit risk models
Estimation of Expected Loss (EL)
EL= PD x LGD x EAD
EL is average loss expectation will vary
from year to year EL shows the amount of credit loss a bank
would expect on its credit portfolio over
the chosen time horizon.
To begin with RBI introduced IRAC Norms(Standard, Sub Standard, Doubtful and Loss
Assets and Provision of 10%, 30 to 50% and
100%).
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Measuring credit Risk
Formulation of Credit risk models
Credit exposure (Rs. in crore)
Amount
of EAD
Initial
Rating
PD (%) LGD(%) Expected
Loss
1000 AAA 0 0.5 0
1000 AA 0 0.5 0
800 A 0.06 0.5 0.24
600 BBB 0.18 0.5 0.54
400 BB 1.06 0.5 2.12
500 B 5.20 0.5 13.00
200 C 19.79 0.5 19.79
4500 Total 35.69
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Measuring credit Risk
Formulation of Credit risk models
Estimation of Unexpected Loss (UL)
UL is the amount by which actual
losses exceed the expected loss.
UL is impacted by many things,
particularly volatility.
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What is Market Risk
Market Risk is the possibility of loss tothe bank caused by changes in market
variables such as Interest Rate, FEX
Rate, Equity Price and Commodity
price
Loss arises in two ways
Loss to the earnings and
Decline in the economic value of theassets.
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Market Risk Management
Market risk involves management of
risk in following areas as under
Liquidity Risk
Interest Rate Risk
Foreign Exchange Risk
Equity Price Risk &
Commodity Price Risk
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Liquidity Risk
Liquidity means
Ability of bank to honor the
commitments as and when it fallsdue.
Banks inability to honor the
commitments to meet the liquidity iscalled Liquidity Risk
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Types of Liquidity risks
Funding Risk
Need to replace net outflows due to
unanticipated withdrawal/non-renewal of
deposits
Time Risk
Need to compensate for non-receipt of expected
inflows of funds- NPAs Call Risk
Due to crystallisation of contingent liabilities &
needs of new business
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Liquidity Risk Management
Liquidity Risk is measured throughStructural Liquidity Statement and Short
Term Dynamic Statement.
Liquidity Risk is managed through AssetLiability Management.
ALCO is the Committee who monitored
and managed liquidity by deciding on therequirement of funds by changing interest
rates on assets and liabilities.
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Interest Rate Risk
Why there is Interest Rate Risk? On account of Banks core business being
financial intermediation and asset
transformation
Due to periodical renewal of assets andliabilities
Due to mismatches between
maturity/repricing dates as well as maturity
amounts between Assets and Liabilities
Since depositors and borrowers can pre-
close their accounts
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Interest Rate Risk
Rising interest rate scenario
Deposits rates are Fixed
Interest expenses will be same Loans Rates are Floating
Interest income will increase resulting
into increase in NII
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Interest Rate Risk
Falling Interest rate scenario
Deposits Rates are fixed
Interest expenses will be same
Loans Rates are Floating
Interest income will be less
NII will reduced.
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Types of Interest Rate Risk
Gap or Mismatch Risk
Basis Risk
Embedded Option Risk Price Risk
Reinvestment Risk
Revaluation Risk/Regulatory Risk
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Interest Rate Risk
Gap/Mismatch Risk
It arises on account of holding rate
sensitive assets and liabilities withdifferent principal amounts,
maturity/repricing rates
Even though maturity dates are same, if
there is a mismatch between amount ofassets and liabilities it causes interest rate
risk and affects NII
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Interest Rate Risk
Gap Report
1. RSA > RSL = POSITIVE GAP
2. RSL > RSA = NEGATIVE GAP
3. RSA = RSL = NEUTRAL GAP
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Interest Rate Risk
Basis Risk
Basis risk occurs when interest rates ofdifferent assets and liabilities move in
different magnitudes
there will be interest rate risk due to
movement of interest rates in differentmagnitudes for different types ofassets and liabilities
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Interest Rate Risk
Embedded Option Risk
Pre-payment of loans in case of falling
interest rates
Premature withdrawal of deposits in
case of rising interest rates
In both the cases banks actual NII is
less than the anticipated NII
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Interest Rate Risk
Price Risk
Bond prices and interest rates areinversely related
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Interest Rate Risk
Reinvestment Risk
It is difficult to correctly predict the
interest rates at which future cash
flows will be invested. This uncertainty
causes reinvestment risk
If interest rates declines, reinvestment
will be at lower rate
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Interest Rate Risk
Revaluation Risk/Regulatory Risk
Occurs when revaluation of assets are
to be done as per regulatory
prescriptions
When regulators change the norms the
assets may have to be re-valued as per
the changed norms and this mayreduce the value of total assets
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Interest Rate Risk
Measures of IRR
Maturity Gap Analysis to measure
interest rate sensitivity of earnings or
NII
Duration Gap Analysis to measure
interest rate sensitivity of equity
Simulation
Value at Risk
IRR Management - Falling
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IRR Management - Falling
Interest Rate Scenario
Increase maturities of investmentportfolio
Increase fixed rate loans
Increase short-term deposits /
borrowings (reduce maturity of
liabilities)
Increase floating rate deposits
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IRR Management - Rising
Interest Rate Scenario
Reduce investment portfolio maturities
Increase floating rate assets
Increase short-term assets Increase long-term
deposits/borrowings
Sell fixed rate assets
O ti l Ri k
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Operational Risk
WHAT if suddenly ATMs stopped vendingcrisp notes, bank branches closed for fewdays, the data centre of major banks shutdown, busy operations in dealing rooms ofmajor banks come to a halt and banking
personnel don't reach their offices.
This is not a doomsday scenario but whatactually happened during the Mumbai floods.Uncertainty has crept into our lives. In
technical parlance, we can call the riskinvolved in running daily operations"operational risk",
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What is Operational Risk?
Basel II has defined operational risk as
the risk of loss resulting from inadequate
or failed internal processes, people and
systems or from external events. Basel IIhas clarified that OR includes legal risk
but specifically excludes strategic and
reputational risks.
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Definition of Operational Risk
The risk of loss resulting from inadequate or failedor
external eventsinternal processes,
people & systems
Potential or
Forward looking
Inadequate collateralmanagement
Unenforceable documentation
People and systems in
the regulatory definition
are captured in internal
process
External Fraud,
Fire, Flood,
Legal action,
Tax,
Regulations,
Terrorism
Causal Categories:
Employee Behaviour
Corporate BehaviourInformation
Technology
External Environment
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Scope of Operational Risks
Op-risk is as old as banking itself.
Present in virtually all bank transactions
and activities
Clear appreciation and understanding bybanks of OR is crucial to effectivemanagement and control thereof
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Basel II definition-
Analysing specific risks: People Risk Employee fraud ( collusion, embezzlement, theft,
programming fraud)
Unauthorized activity ( insider trading, misuse of
privileged information, limit breach, incorrect models-intentional, aggressive selling tactics, ignoring/shortcircuiting procedures ( deliberate)
Employment practices and workplacesafety-(employee turnover, loss of key personnel,motivation, leave /absence from work, wrongful termination,discrimination/harassment, non-adherence to employmentlaws, workforce disruption, lack of suitable personnel)
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Basel II definition-
Analysing specific risks: Process Risk Transaction risk- Payment/settlement /delivery risk- failure of
/inadequate payment/settlement processes, losses throughreconciliation failure, delivery errors
Documentation risk- document not designed properly,
inadequate clauses/contract terms, inappropriate contractterms, failure of due diligence;
valuation/pricing ( model risk);
Internal/external reporting ( inadequate financial reporting,inadequate regulatory reporting, inadequate stock exchangereporting), compliance ( failure of internal/external complianceprocedures);
Selling risks ( product complexity, poor advice)
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Basel II definition-Analysing specific
risks: Systems Risk
Technology risk
# System failure
# Security breaches#Communications failure
# Backup & disaster recovery
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Basel II definition-Analysing specific risks:
Risk from External Events Legal liability- breach of law, misrepresentation,
etc.
Criminal activities- external frauds, robberies,money laundering, physical damage to property
caused by vandalism, arson Outsourcing risk- inadequate contract, delivery
failure( ontime, quality service), inadequate mgt ofservice providers, bankruptcy of supplier, misuse ofconfidential data, etc.
Disasters - earthquakes, floods, fire, transportfailure, energy failure, external telecommunicationfailure, etc.
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ORM framework under Basel II
All the three pillars of the New Capital Accord play an
important role in OR capital framework
3 methods of calculation of OR in a continuum of increasing
sophistication and risk sensitivity:
1) Basic Indicator Approach
2) Standardized Approach
3) Advanced Measurement Approach
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Basic Indicator Approach (the alpha)
Capital = E*gross income (E =15%)
Standardised Approach (the betas)
Capital = F*gross income, by business lines(F 12%, 15% or18% depending on business line)
Advanced Measurement Approach (AMA)
Capital = firm specific calculation
Basel II - 3 methodologies for estimation of
Minimum Capital Requirement
From 31.03. 2009 BIA has been adopted by all banks in India
C t ti f C it l Ch f
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Computation of Capital Charge for
OP Risk as per BIA
Capital Charge = 15% of Avg Gross Income forLast 3 years.
Gross Income = Net Profit
+ Provisions & Contingencies+ Operating Expenses
- Profit on sale of HTM Investment
-One time Income (Insurance Income)
-Profit on sale of Immovable/Movable
assets.
If there is Loss in any year, it should be excluded.
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Operational Risk capital:
Standardised ApproachBusiness Lines Beta Factors
1.Corporate finance 18%
2.Trading and sales 18%
3.Retail banking 12%
4.Commercial banking 15%
5.Payment and settlement 18%6.Agency services 15%
7.Asset management 12%
8. Retail brokerage 12%