Risk Management and Basel II

Indian Institute of Banking

and Finance

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 How do banks make money?
 By playing “term” of funds: Long v/s
short.
 By playing risk levels- accept lower risk
and place in higher risk- play safety as a
market mantra
 Dispersed source v/s concentrated use.
 Trading in the market
 Essentially by taking risk
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 Risk Definition and features
Risk:
Event likely to cause loss/variability/damage to income
and reputation
Features:
 Fairly known- Cannot be avoided.
avoided
 Probabilistic and generic

 Ascertainable, although not always quantifiable

 Essential for intermediation process.

 Risk and Reward go together

 Interrelated/ Collectively exhaustive but not

mutually exclusive

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Generic and Unique risks
 Industry
 Unit/firm/company related
 Location specific
 Ownership related
 Sector specific
 HRD/Structure related

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 Sources of Risk

 Decision ,Indecision  Political compulsions

 Business cycles/  Regulations
Seasonality  Human resources,
 Economic/Fiscal skill sets
changes  Competition
 Policy Changes  Technology
 Market movements  Non-availability of
 Events information

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 Types of Risks
 Credit: Default/delay: Impacts Solvency-Capacity to
service obligation,
 Liquidity: Inability to meet committed payments,
inability to exit an investment.
 Interest Rate: Changes in the market rate causing
income variability
 Exchange: Fluctuation in currency rates, prices
becoming adverse for the company
 Market: Interplay of above on trading profits
 Legal:
 Operational: Failure of Men, Machine, Monitoring,
Methods

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 The global financial regulatory framework is
undergoing important changes…

Market Risk
USA PATRIOT
Credit Risk ACT

Operational
Risk

FATF
Basel II RECOMMENDATIONS

Risk
RiskManagement
Management Anti-Money
Anti-MoneyLaundering
Laundering Corporate
CorporateGovernance
Governance

…and money laundering and corporate governance issues have

become entwined with operational risk management
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 Goals of risk Management
Safety and soundness of
banks.
Ensuring a level playing
field.

Capital Adequacy Ratio

(1) own funds (i.e.
available capital and
reserves)
(2) risk-weighted assets
(i.e. the amount of
money the bank has
put at risk in the
course of its business)

A level playing
Source: BIS
field !! 9
How to manage risk
 Hedging
 Exposure limits
 Reserves and Provisioning

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Basel I
 IRAC norms- uniform across
institutions, products and performance
 Capital adequacy- Uniform across the
commercial banking- coop banking will
catch up shortly

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Lessons Of Basel I
 Better NPA Management- varieties of
ways
 New Institutions ( ARC) Laws ( Sarfaesi)
 Almost all banks and RRBs in good
financial health- meet CRAR nomr
 Explosion of new- customer centric
products
 More employment.
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Basel II
 Primarily for internationally active banks
 RBI will take view on other banks- It is safe
that all banks comply
 CRAR @ 8%on risk weight. But weights
and loss estimates differ-
 Basel II is capital accord. Other risk
management norms will happen
 F.M says “ Indian Banks will need
additional 60,000 Crores in the next few
years”- to meet with growth needs.

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 Three Pillars of Basel II

Supervisory
Minimum Capital Review Market Discipline
The new Basel Accord is based on Three Pillars

Advanced Focus on
methods for internal
capital capabilities
allocation Supervisors to Focus on
review banks disclosure
Capital charge
for operational internal
risk assessment
and strategies

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 Basle II. Minimum Capital
Requirements-Pillar 1
 Sets minimum acceptable capital
 Capital arrived by enhanced approach with
credit ratings
 External or Public rating
 Internal rating
 Explicit treatment to operational risk
 ALM risk not treated but included in

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 Supervisory Review _ Four
Principles- Pillar 2
 Banks must attain solvency relative to their risk
profile
 Supervisors should review each bank’s own risk
assessment & capital strategies
 Banks should maintain excess of minimum
capital
 Regulators would intervene at an early stage
 Possibility of rewarding banks with better risk
management systems.
 RBI has already taken steps to conduct
supervisory review

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Market Discipline- Pillar 3
 Improved disclosure of
 Capital structure

 Risk measurement and management

practices
 Risk profile

 Capital adequacy

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 Credit Risk -Approaches
Criteria Standard I. R. B
Foundation Advanced

Rating External Internal Internal

Risk weight Calibrated Function Function

on ratings provided by provided by
by Basel Basel Basel
Committee Committee Committee

Probability Implicitly Provided by Provided by

of default provided by bank on own bank on own
Basel estimates estimates
Committee 18
 Credit Risk Approaches

Criteria Standardized I.R.B

Foundation Advanced

Exposure Supervisory Supervisory Provided by

at Default values values bank on
provided by provided by own
Basel Basel estimates
Loss given Implicitly Implicitly Provided by
default provided by provided by bank own
Basel on Basel on estimates
external external
estimates estimates

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 Credit Risk Approaches

Criteria Standardize I.R.B

d Foundation Advanced
All included All types of
Risk in Collaterals
mitigation Defined by standardize if
Regulator. d + Bank can
Receivables prove by
for goods internal
and estimation
Services,
Other
physical
Securities
subject to
criteria

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 Computation of Capital
Standardized
No change over 1988

Foundation
No change over 1988
Market Risk
in VaR

Advanced
No change over 1988
in VaR

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 Computation of Capital
Standardized
Capital change based on
single risk indicator

Foundation
Operational Capital based on business
Risk lines and industry standards

Advanced
Capital based on business
lines and internally
calculated standards

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 Operational Risk Approaches

Approach Basic Indicator Standardized Advanced

Measurement

Calculation of  Average of  Gross income  Capital charge

Capital charge Gross Income per regulatory equals internally
for three years line as indicator generated
as indicator  Depending on measures based
 Capital business line 12, on,
charge equals 15 or 18 % of the Internal loss data
15% of the indictor as External loss data
indicator capital charge Scenario analysis
 Total capital Business
charge equals environment and
sum of charge internal control
per business line factors
 Recognition of
risk mitigation
(upto 20%)

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 Decision areas for Banks
 Choice of methodology and convincing the
regulators
 IT supports needed
 Software requirements
 Staff training on compliance
 Consultancy requirements
 Risk mitigation opportunities
 Outsourcing possibilities
 New jobs creation
 Implementation cost and time
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BASLE II IS ALL ABOUT A RESPONSIVE AND
SOPHESTICATED RISK MANAGEMENT SYSTEM

 R = Risk = Function of Uncertainty U

 U = Function of Quality Information QI
 QI = Function of Accuracy/ Timeliness/
Relevance/ Adequacy A, T, R, Ad
 A = Function of IT
 T = Function of IT
 R and Ad = Function of IT, Management
Science, Modeling amenable to
establish mathematical relationship

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 Risk Management – a data intensive function

Credit
Credit Risk Market
Market Risk
Risk Operational Risk
Banks

 Borrower Data  Data on  Loss Event Data

 Guarantor Data Exchange  Causal Data
 Asset-specific Data Rates  Loss Effect
Transaction Data  Default Data  Data on  Key Risk
 Data on Interest Rates Indicators
Data on (KRIs)
Operational CRM Data Recoveries 

Security Prices  Proxies

 External Default
Data  Data on
 Risk Inventories
Analytical CRM Data
 Data on Rating Correlations  Structured Self
and Migration Assessment
 Data on
Risk Management Data Data
 Macro & Industry Instruments
Data (non-linear)
 External Data
Economy & Industry Data  Correlation Data

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 Basle Accord and IT

 Basle II promises significant business

benefits to those who have systems in place
to access and utilize far more detailed and
precise information
 Integration of data on finance, operations and
risk management necessary
 Opportunity to get out of legacy systems and
procedures including IT system
 Fundamental rethinking on how a bank’s data
and information is provided and controlled
 Pillars are interdependent and must be
addressed to concurrently

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 Basle Accord and IT
Internal Rating based approaches revolve around
Probability of default
Loss given default
Exposure at default
Other parameters
Main requirements would include
Defining and capturing loss data
Capturing and extracting exposure data
Identifying and capturing risk mitigation data
Data issues would be
Sources/ Data types/ Quality requirements and
Granularity (level of data)

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 Basle Accord and IT
Operational Risk Management pre-supposes
 Framework and systems in data integration

 Low frequency-high severity occurrences

 Structure for risk management and

interaction amongst functionaries

 Potential for mitigation, outsourcing and

alike issues
 Shared facilities feasibility

 More synergy and little overlap

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THANK YOU

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