Risk Management

CAPITAL MANAGEMENT AND PROFIT PLANNING

1) One of the important parameters of financial strength is Capital or Net worth.

2) The correlation between business level & capital position is called Capital Adequacy.

3) The incentive for doing business hails from profitability.

UNIT 17: CAPITAL ADEQUACY THE BASEL II OVERVIEW

1) The Central bank Governors of 10 countries formed a committee on Banking Supervisory

Authorities in 1975.

2) The Banking Supervisory Authority Committee usually meets at the Bank of International
Settlements (BIS) at Basel, in Switzerland.

3) The Basel Committee provided the framework for Capital Adequacy in 1988 is known as the
Basel I accord.

4) The Basel norms for Risk weights were more of a straightjacket nature.

5) As per Basel I all exposures to sovereign were given 0% risk weight and all bank exposures
were given 20% Risk weight.

6) Assigning Risk Weightage to assets without considering the strengths and weaknesses of
individual entities was the main shortcoming of Basel I.

7) The Basel I defined components of Capital and allotted the Risk weights to different
categories of assets.

8) Basel I stipulated minimum ratio of Capital to Risk weighted Assets.

9) The first round of proposal for changes in the Basel I accord came up for deliberations and
consultative process in June 1999.

10) The Report of Basel II Committee is titled as International Convergence of Capital

Measurement and Capital Standards a Revised frame work.

11) The Committee intends that the revised framework would be implemented by the end of year
2006.

12) The fundamental of Basel II was to revise 1988 accord and to strengthen the soundness and
stability of banking system.

13) Basel II demands Capital allocation for operational risk for the first time.

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14) The Basel II accord rests on Three Pillars.

15) First Pillar of Basel II is Minimum Capital requirement.

16) The Second Pillar of Basel II is Supervisory Review process.

17) The Third Pillar of Basel II is Market Discipline.

18) As per Second Pillar Supervisors have to ensure adequate capital for Risk management
through robust internal processes .
19) The Third Pillar puts in place disclosure norms about Risk Management practices and
allocation of regulatory Capital.

20) As per First Pillar minimum capital is required for Credit Risk, Market Risks and Operational
Risk.

21) The Capital for credit risk can be calculated in two methodologies, they are

Standardized Approach and Internal Rating Based (IRB) Approach.

22) Under IRB Approach two options are available they are Foundation Approach and Advanced
Approach.

23) The Capital for Market Risk is calculated in two methods, they are Standardized Method and
Internal Model Method.

24) The Standardized Method for Market Risk is of two types i.e. Maturity & Duration methods.

25) Capital for Operational Risk is calculated in 3 methods. They are Basic Indicator Approach,
Standard Approach and Advanced Management Approach.

26) Pillar II Supervisory Review consists of A) Evaluate Risk Assessment

B) Ensure Soundness and Integrity of Banks internal process to assess the Capital Adequacy C)
Ensure maintenance of minimum capital with PCA for shortfall D) Prescribe differential Capital,
where necessary i.e. where the internal process are slack.

27) Pillar III Market Discipline consists of A) Enhance disclosures B) Core disclosures and
Supplementary disclosures C) Timely at least semi annual disclosures.

28) The Basel II accord is more risk sensitive.

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29) There are incentives for banks with better risk management capabilities.

30) Tier I Capital is Core Capital & Tier II Capital is Supplementary Capital

31) The Capital ratio is calculated by using the Regulatory Capital & RW Assets.

32) The term Capital includes Tier I capital, Tier II capital & Tier III Capital.

33) The total Capital Adequacy Ratio must not be less than 8%.

34) Core Capital consists of Paid up capital, free reserves and unallocated surpluses less specified
deductions.

35) Subordinated debts of more than 5 years maturity, loan loss reserves, revaluation reserves,
investment fluctuation reserves and limited life preferential shares are Supplementary capital.

36) Tier III Capital consists of short term subordinated debts for the sole purpose of meeting a
portion of the capital requirement for Market Risk.

37) Tier II Capital is restricted to 100% of Core Capital and long term-subordinated debts may
not exceed 50% of Tier I Capital.

38) Tier III Capital will be limited to 250% of Tier I Capital required to support Market Risk.
39) 28.5% of Market Risk needs to be supported by Tier I Capital.

40) Revision exercise of Basel I was began in June 1999.

41) Basel II accord rests on Three Pillars viz. A) Minimum Capital requirement B) Supervisory
review process C) Market discipline.

42) Basel II provides various options to work out the minimum Capital requirement for Credit
Risk, Market Risk and Operational Risks.

43) Capital Adequacy Ratio = Regulatory Capital / Total Risk Weighted Assets.

44) Total Risk Weighted Assets = Risk Weighted Assets for Credit Risk + 12.5 * Capital for
Market Risk + 12.5 * Capital for Operational Risk.

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UNIT 18: PILLAR I CAPITAL CHARGE FOR CREDIT RISK

1. Higher the risk, higher would be the capital requirement.

2. The asset with high credit rating has lower risk and requires lower Capital.
3. The Basel II accord suggests two options for rating. They are rating by external agency and
Rating based on internal assessment.

4. Credit Risk is defined as the possibility of loss associated with the reduction of credit quality
of borrowers or counter parties.

5. In Banks losses arise from outright default due to inability or unwillingness of customers to
pay.

6. Under Basel I assets were assigned uniform Risk Weights based on their category.

7. Under Basel I exposure to sovereign were assigned a Risk Weight of 0%, claims against
Banks 20% and advances to corporates, individuals and firms were assigned 100% risk weights.

8. Under revised accord along with category of a customer his credit rating is given the due
regard for assigning the Risk Weights.

9. Under Basel II banks were given choice between two methodologies for calculating capital
requirement for credit risk.

10. Internal Rating Based (IRB) Approach has further two options Foundation Approach and
Advanced IRB Approach.

11. Standardized Approach allows banks to measure Credit Risk in a Standardized manner based
on External Credit Assessment.

12. The Risk Weights are inversely related to the rating of the counter party.
13. The criteria required for Credit Assessment by External Credit Assessment Institutions
(ECAI) are A) Objectivity B) Independence C) International Access D) Transparency E)
Disclosure F) Resources G) Credibility.

14) For the purpose of Credit Rating of Sovereigns, the Country scores of Export Credit Agency
(ECA) may be recognized.

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15) All Commercial Banks in a given country will be assigned a risk weightage either one touch
below the risk weight assigned to that sovereign or based on the external credit assessment of the
Bank itself.

16) Under Standard Approach retail and SME exposures attract a uniform Risk weightage of
75%.

17) Bonds and Securities are excluded from Retail Category.

18) No aggregate exposure to one counter party can exceed 0.2% of the overall retail portfolio.

19) Lending fully secured by mortgage on residential property will have a Risk Weightage of
35%.

20) The Loans secured by commercial property will have 100% Risk Weightage.

21) A Bank is allowed netting of the security from the outstanding provided it has the right to
liquidate the security promptly in the event of default.
22) Liquid Securities would be available for netting to the extent of realizable value provided the
securities can be promptly liquidated.

23) If the claim amount were guaranteed by another party or agency, which has a better rating,
risk weight would reduce accordingly.

24) In IRB Approach the banks internal assessment of key risk parameters serves as a primary
input to capital computation.

26) Capital charge computation under IRB Approach is dependent on four parameters. They are
PD Probability of default B) LGD Loss Given at Default

C) EAD Exposure at Default D) M Effective Maturity

27) IRB Approach computes the capital requirement of each exposure directly.

28) Under IRB Approach Banks need to categories as:

A) Corporates B) Sovereigns C) Banks D) Retail E) Equity.

29) Risk Weighted Assets are derived from capital charge computation.

30) Foundation Approach and Advanced Approach differ primarily in terms of inputs that are
provided by the Banks on its own estimates and those that are specified by the supervisor.

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31) Under Foundation Approach Banks provide their own estimates of PD and rely on
supervisory estimates for other risk components.
32) Under Advance Approach banks provide more of their own estimates of PD, LGD, EAD and
Effective Maturity.

33) Banks adopting IRB Approach are expected to continue to use the same.

34) The regulator has to select on external credit assessment institution based on seven Criteria.

35) IRB Approaches depend upon four parameters viz, PD, LGD, EAD and effective
management

UNIT19: PILLAR I CAPITAL CHARGE FOR MARKET & OPERATIONAL

RISK

1. Value of financial instruments may fall due to changes in market parameters. This Risk is
called Market Risk.

2. Banks face the Operational Risk in addition to Credit Risk and Market Risks.

3. Market Risk is defined as Risk of losses in On-Balance Sheet and Off-Balance Sheet positions
arising from movements in Market Prices.

4. The Market Risk positions that require Capital Charge are A) Interest rate related Instruments
in Trading Book B) Equities in Trading Book C) Foreign Exchange open positions through out
the Bank.

5. A Trading Book consists of financial instruments and commodities held either with trading
intent or in order to hedge other elements in Trading Book.
6. In Indian scenario the Trading Book comprises A) Securities held for trading B) Securities
available for sale C) Open Forex positions D) Open Gold positions E) Trading positions in
Derivatives F) Derivatives for hedging Trading Positions.

7) Banks are required to calculate counter party credit risk charge for OTC Derivatives.

8) The minimum capital requirement for Market Risk comprises two components i.e. Specific
charge for each security & General Market Risk charge towards interest rate risk in the portfolio.

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9) The Capital charge for specific risk is designed to protect against the adverse movement in the
price of individual security owing to factors related to individual security

10) Capital requirements for general market risk are designed to capture the risk of loss arising
from changes in the market interest rates.

11) Basel Committee has suggested Two Methods for computation of Capital Charge for Market
Risk. One is Standardized Method and another is Banks Internal Risk Management Method.

12) Under Standardized method there are two options A) Maturity method and B) Duration
method.

13) RBI prescribed Duration method to arrive at capital charge for Market Risk.

14) In Basel I, Capital for Operational Risk was not envisaged.

15) Operational Risk would vary with volume and nature of business.

16) Operational Risk is defined as the risk of loss resulting from inadequate or failed internal
process, people and system or from external events.

17) Basel II provides three methods for calculating Operational Risk Capital Charge. They are
A) The Basic Indicator Approach (BIA) B) The Standardized Approach and C) Advanced
Management Approach (AMA).

18) The Banks are expected to move from BIA to AMA & not allowed to revert .

19) Under BIA a Bank must hold capital for OR equal to 15% of average positive annual gross
income of previous 3years. If annual income is negative or zero it should be excluded while
calculating the average.

20) Gross Income = Operating profit + Operating expenses extraordinary items Residual
profits from sale of investments in banking book.

21) Under Standardized Approach Banks activities are divided into eight business lines. They
are 1) Corporate Finance 2) Trading & Sales 3) Payments & settlements 4) Commercial Banking
5) Agency services 6) Retail banking 7) Retail Brokerage and 8) Assessment Management.

22) Under Standardized method within each business line gross income is broad indicator for
Operational Risk exposure.

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23) The capital charge for each business line is calculated by multiplying gross income by a
factor assigned to that business line.
24) Under Advance Management Approach banks internal operational risk measurement is
used, which is required to be vetted by the superior.

25) Basic Indicator Approach (BIA) provides thumb rule prescription for minimum capital
requirement as 15% of Operating Income.

26) The capital charge required in Market Risk in case of investment in mortgage based
securities of all maturities is 4.5%

27) First Pillar of Basel II covers Capital Charge for CR, Mkt. risk & OR

28) Credit concentration risk was not fully captured under Pillar I

29) Strategic Risk and Interest rate Risk are not addressed in Pillar I

30) Business cycle effects are external factors to the bank.

UNIT20: PILLARS 2 & 3 SUPERVISORY REVIEW AND MARKET DISCIPLINE

1. The process of assessing capital adequacy needs to be reviewed and monitored by the super
visors.

2. Basel II considers transparency and objectivity as important parameters in review exercise.

8. The emphasis of the supervisory review should be on the quality of the Banks Risk
management and Control.

9. The periodic review would involve A) On site examination or Inspections B) Off site review
C) Discussions with banks management D) Review of work done by auditors E) Periodic
reporting.
10. Supervisors will require banks to operate with a buffer over and above the Pillar I standard.

11. If a Bank is not meeting the requirements in four principles, the supervisor should consider a
range of options like extensive monitoring, restricting dividend payments, requiring banks to raise
capital etc.

12. The important issue that require focused attention of supervisory review and which are not
directly addressed under Pillar I are A) Interest Rate Risk in Banking Book B) Operational risk
and C) Credit Risk.

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13. Credit Risk includes A) Stress tests under IRB Approach B) Definition of default C) Residual
Risk D) Credit concentration Risk.

14. Disclosures allow market participants to assess key information and thereby make informed
decision about a Bank.

15. The disclosures under Pillar III should be made at least on semi annual basis subject to
some exceptions.

16. Qualitative disclosures such as policies, systems definitions may be made on annual basis.

17. Critical information such as Tier I capital, capital ratios and other components may be
published on a quarterly basis.

18. Banks should have a formal disclosure policy approved by Board of Directors.
19. Pillar III prescribes qualitative and quantitative disclosure under 13 areas.

UNIT 21: ASSET CLASSIFICATION AND PROVISIONING NORMS

1. In August 1991 a high level committee headed by Mr. M.M. Narsimham was appointed to
execute various aspects of our financial system.

2. One of the important recommendations of Narsimham Committee was that Balance Sheet of
the Banks should be transparent and comply with international standards.

3. Following the Narsimham Committee recommendations the RBI issued guidelines /

instructions to banks in Apr 1992 for classification of assets.

4. From March 2004 an asset becomes NPA, if interest / installment remains unpaid for 90 days.

5. In case of agricultural advances, interest or installments remains unpaid for two crop seasons
incase of short term crops and one crop season incase of long duration crops then the account
becomes NPA.

6. Long duration crop is one incase of which crop season is more than one year

7. An NPA remains for a period of 12 months in the category of SS & D1and 24 months as D2
thereafter migrates to D3.

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8. The RBI introduced asset classification and provisioning in line with international practices
for the first time in 1993.

9. With passage of time, probability of recovery diminishes and hence requirement of provision
goes up.

10. Unsecured assets are those, where the realizable value of security is not more than 10% of the
outstanding dues.

11. The provision is made based on category, sub-category of the asset and value of realizable
security.

12. Once the account becomes NPA, it goes through a process of ageing where asset
classification shall progressively deteriorate.

UNIT 22: PROFIT PLANNING

1. Traditional Approach is reduce expenditure & increase fee based income.

2. Profit planning in a bank involves Balance Sheet Management.

3. Banks income arises from three sources viz Interest, fee based & treasury.

4. The interest income on highly rated corporates is much lower as compared to the income on
lower rated corporates.

5. The investment in Government securities practically risk free but the yield on such
investments is lower.
6. Banks are required to have proper blending of investment in Govt. securities and credit
profiles to maximize the profits for a given level of risk appetite.

7. Banks need to optimize the investment and lending portfolio to earn the best possible returns
for a given capital level.

8. The second major source of income is derived from fee based activities.

9. Banks have ventured into cross selling of other financial products such as insurance policies &
mutual funds etc.

10. The treasury income is derived by trading in Securities, Foreign Exchange, Equities, Bullion,
Commodities and Derivatives.

11. Treasury business is largely a speculative activity.

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12. Treasury business is to be undertaken by banks with stringent internal controls and checks.

13. Interest rates for Term Deposits in India are deregulated but Savings Bank Interest rates are
regulated by RBI.

15. Caps on open position, Mark to market variations capital provisioning based on value of
risks are risk management measure.

16. In 1990s Barings Bank, a very old British bank, collapsed due to very large losses on the
Exchange.

17.Income maximization & expenditure minimization are required to maximize profitability.

18. Due to modern technology, new products and aggressive marketing public sector banks and
old private sector banks had to change their ways.