BASEL II: Impact & Implications

Roadmap
BASEL II Overview Credit Risk Market Risk Operational Risk

BASEL II - Overview

Banking on Risk
Banking is an art & science of measuring & managing the risks in lending and investment activities for commensurate profits based on the risk perceptions.

Simple Bank of India

Liabilities Amt Capital & reserves 9 Deposits 130 Total 139 Assets CRR/SLR Loans Total Amt 39 100 139

Assumption CRR +SLR = 30%

What is BASEL II?

New standard for measurement of risks in banks and for providing enough capital to cover those risks. Needed for strong, sound and stable international banking systems. Will Change:
How banks measure risks. How banks allocate capital for unexpected losses. Information published by Banks Regulatory environment.

Implementation
Approved by the Basel Committee on Banking Supervision of Bank for International Settlements in June 2004. Foreign banks in India and Indian banks operating abroad are to meet norms by March 31, 2008. Other scheduled commercial banks will have to adhere to the guidelines by March 31, 2009.

Three Pillars

 Deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: faces:
Credit Risk Operational Risk Market Risk

Capital Adequacy
Minimum Regulatory capital
Capital >= 9% Credit RWA + Operational RWA+ Market RWA

 Spells out the capital requirement of a bank in relation to the credit risk in its portfolio. Sets out the allocation of capital for operational risk and market risk in the trading books of banks.

 Provides a tool to supervisors to:

keep checks on adequacy of capitalization levels of banks. link capital to the risk profile of a bank. take appropriate remedial measures, if required. ask banks to maintain capital at a level higher than the regulatory minimum.

 Provides framework for dealing with other risks (residual risks) like systematic risk, liquidity risk, legal risk, etc.

 Provides a framework for improvement of banks disclosure standards for financial reporting, risk management, asset quality, regulatory sanctions, etc. Indicates remedial measures to keep a check on erring banks. Allows banks to maintain confidentiality over certain information, disclosure of which could impact competitiveness or breach legal contracts.

From Basel I to Basel II

BASEL I Less risk sensitivity BASEL II More risk sensitivity by structuring business class and asset class. risk Focus on operational components of a bank as well as market risk. Flexibility, menu of approaches, capital incentives for better risk management.

Focus on measure.

single

One size fits all.

Credit Risk

Credit risk has been traditionally defined as default risk, i.e. the risk of loss from a borrower / counterpartys failure to repay the amount owed (principal or interest) to the bank on a timely manner based on a previously agreed payment schedule.

STANDARDISED APPROACH

INTERNAL RATINGS BASED APPROACH FOUNDATION

INTERNAL RATINGS BASED APPROACH ADVANCED

CREDIT RISK SENSTIVITY INCREASES

Standardized Approach
Recognizing that different counterparties within the same loan category present far different risks to the financial institution lender allocates a risk-weight to each of its assets and off-balance sheet positions. It calculates a sum of risk-weighted asset values. The capital charge is equal to 8% of the asset value

Key Definitions
Probability of default or PD - The likelihood that default will take place over a specified time horizon Exposure at default or EAD - The amount owned by the counterparty at the moment of default Loss given default or LGD - The fraction of the exposure, net of any recoveries, which will be lost following a default event

Internal ratings-based approach

Banks use their internal evaluation systems to assess a borrowers credit risk Foundation
Banks can estimate the risk of default or the Probability of Default (PD) associated with each borrower. Additional risk factors such as Loss Given Default (LGD) and Exposure at Default (EAD) are standardized by supervisory rules that are laid down and monitored by regulating authorities.

 Advanced
Allows banks with sufficient internal capital to assess additional risk factors. These factors include Exposure at Default (EAD), Loss Given Default (LGD) and Maturity (M).

Comparison of Capital Requirements

Credit Risk Mitigation

Collateral - Simple approach
The bank may adjust the risk weight for its exposure by using the appropriate risk weight for the supporting collateral instrument. The collateral must be marked-to-market and revalued at least every six months. A risk weight floor of 20 percent will also apply, unless the collateral is cash, certain Government securities, or certain repo instruments. Eligible collateral includes corporate debt instruments rated BBB- or higher, equity securities traded on a main index, and Government instruments.

 Comprehensive approach
The value of the exposure is reduced by a discounted value of the collateral. The amount of the discount varies with the credit rating of the collateral. The Standardized Approach provides for the amount of the discount. For example, collateral consisting of A+ rated debt with a remaining maturity of five years or less, would be discounted by 6 percent. Alternatively, the regulatory agencies may permit the banks to calculate their own discounts based on internal models that take into account market volatility, historical performance, and foreign exchange rate movement.

 Netting
Banks have legally enforceable netting arrangements they may calculate capital on the basis of the net credit exposure

Guarantees and Credit Derivatives

Provide equivalent protection are recognized subject to certain conditions (e.g. the guarantee must be direct, explicit, unconditional and irrevocable). The risk weight of the guarantor is substituted for the risk weight of actual counterparty. Guarantors and credit protection sellers must have a credit rating of at least A-.

Market Risk
Probability of loss to a bank caused by changes in market variables
Market level of interest rates Prices of securities Forex and equities

Market risk includes liquidity risk

It is the banks ability to meet obligations as and when they fall due

Liquidity Risk
Arises when banks are unable to generate cash to cope up with the decline in deposits/ or increase in assets Originates from mismatches in the maturity patterns of assets and liabilities Analysis of Liquidity Risk:
Measurement of liquidity position of the bank on an ongoing basis Examining how funding requirement are likely to be affected under crisis scenario Net funding requirements: determined by analysing the banks future cash flows

Interest Rate Risk

It is the risk to earnings or capital arising from movement of interest rates. It arises from
Repricing Risk: differences between the timing of rate changes and the timing of cash flows Basis Risk: from changing rate relationships among yield curves that affect bank activities Yield Curve Risk: from changing rate relationships across the spectrum of maturities

Interest Rate Movements

Affects a banks reported earnings by changing:
Net interest income, The market value of trading accounts (and other instruments accounted for by market value) Other interest sensitive income and expenses, such as mortgage servicing fees.

Minimum Capital requirement

Specific Risk
Capital charge for specific risk is designed to protect against an adverse movement in price of an individual security due to factors related to individual issuer. (similar to credit risk) The specific risk charges are divided into various categories such as:
Investments in Govt securities Claims on Banks Investments in mortgage backed securities securitized papers

Minimum Capital Requirement

General Risk:
Capital charge for general market risk is designed to capture the risk of loss arising from changes in market interest rates.

Risk Management
Banks position their balance sheet into:
Trading Book Banking Book

Trading Book
It includes:
Securities included under the Held for Trading Category Securities included under the Available for Sale category Open Gold positions Trading position in derivatives

Held Primarily for generating profit on short term differences in prices/yields Valued on a daily basis on mark to market basis

Portfolio of Investments
3 categories:
Held to Maturity
should not exceed 25% of the total investments Not Marked to Market

Available for Sale (MTM) Held for Trading (MTM)

Banking Book
It includes assets and liabilities which are contracted for steady income and statutory obligation and are generally held till maturity. It mainly accounts for Earning and Economic value changes.

 Earnings perspective:
This is with respect to net interest income. NII has impact on overall earnings of the bank Fee based income & non interest income These activities also sensitive to market interest rate.

Economic value Perspective:

Variation in market interest rates affect the economic value of the banks assets and liabilities
(economic value: assessment of present value of expected net cash flows, discounted at market rates)

Market Risk

Standardized Approach

Internal Model Based approach

Value at Risk (VaR)

VaR is the worst case scenario
Theoretically the entire portfolio is at risk, because markets have no guarantees. However this doesnt mean that portfolio can vanish anytime

Consider a trading portfolio. Its market value Today known Tomorrow not known

The bank holding that portfolio might report that it has a 1 day VaR of $4mn at the 95% confidence level. It implies that
With a probability of 95%, a change in the portfolio would not result in a decrease of more than $4mn during 1 day With a probability of 5%, the value of its portfolio will decrease by more than $4mn during a day

Capital Charge
Market risk for entire portfolio : 2.5% Equities:
Specific risk : 9% of the Banks gross equity position. General Market risk charge: 9%.

Thus the bank will have to maintain capital equal to 18% of investment in equities (twice the present minimum requirement).
(internationally banks use VaR models for the management of Equity position risk)

Capital Charge
Foreign Exchange Risk
Risk weight at 100% Charge : 9%

Operational Risk Management

Risk Management
I. II. III. IV. V. Risk Definition Identification of Sources of Risk Risk Measurement Create Risk Management Policy Implementation

Operational Risk
The Basel Committee on Banking Supervision defined Operational Risk as,

the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

Major Exclusions
The definition does not include:
Strategic risk: The risk of a loss arising from a poor strategic business decision. Reputational risk: The damage to an organisation through loss of its reputation or standing.

Major Sources of Operational Risk

BUSINESS PROCESSES

BUSINESS ENVIRONMENT

PEOPLE

BUSINESS STRATEGY

OPERATIONAL RISK

CONSTANT CHANGE

IT SYSTEMS

CONTROL SYSTEMS

Risk Measurement Methods

Basic Indicator Approach

KBIA = [ (GI1n x )] n Where, GI=net interest income + net non-interest income. This measure should: (i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers; (iii) exclude realised profits/losses from the sale of securities in the banking book; and (iv) exclude extraordinary or irregular items as well as income derived from insurance.

Standardized Approach
Banks activities are divided into eight business lines:
corporate finance, trading & sales, retail banking, commercial banking, payment & settlement, agency services, asset management, and retail brokerage.

Standardized Approach (contd.)

K TSA= { years Where,
1-3

max[ (GI1-8 x 3

1-8),0]}

Advanced Measurement Approach

Under this Approach, banks will be permitted to use their own internal model to calculate required capital. However three forms of models for estimating operational risk have been identified:
Internal Modeling Approach, Loss Distribution Approach, Score Card Approach.

Operational Risk Policy

Analysis of banks operational risk profile. Risks that it is willing to accept and the risks that it is not prepared to accept. How it intends to identify, assess, monitor and control its operational risks. An overview of the people, processes and systems being used. Assessment of banks risk exposure for allocating capital.

Risk Monitoring
The top management should call for an appropriate report at regular intervals on the operational exposures, loss experience and deviations from the banks operational risk policy. They should also ensure to maintain the records of :
Results of risk identification, measurements and monitoring activities. Action taken to control identified risks. Assessment of the effectiveness of the risk control tools that are used. Actual exposures against stated risk tolerance as defined by the assigned capital.

Risk Mitigation
Insurance
Personnel: adverse impact of These facilities are not yet improper personnel policies, available fraud, etc., internal in India. Technology: risk to put an of loss resulting Yet, banks have from systems unavailability, efficient system in force to poor data quality, system errors, avail the existing insurance or software problems; coverage for all the risks that can be transferred to the Physical assets: risk of damage insurers of physical assets that well in time and or loss for their timely monitor negatively renewals. impact operations; Relationships: risk of loss resulting from relationship issues such as sales practices, etc.; External: risk of loss from external fraud, and offering structured coverage.