Risk Management in Banking

SUBMITTED BY Manish Kumar(12PGDM087) MANAGEMENT OF BANKS Submitted to: Prof. Deepak Tandon

International Settlements
It is an international organization with a mission of helping central banks across the world in pursuing monetary and financial stability

It is considered to be a bank for central banks

The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability

to foster international cooperation in those areas and to act as a bank for central banks.

The BIS pursue its mission by

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Promoting discussion and facilitating collaboration among central banks

Supporting dialogue with other authorities that are responsible for promoting financial stability Conducting research on policy issues confronting central banks and financial supervisory authorities Acting as a prime counterparty for central banks in their financial transactions Serving as an agent or trustee in connection with international financial operations

History of Formation of Basel Accords

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From 1965 to 1981 there were about eight bank failures (or bankruptcies) in the United States Banks throughout the world were lending extensively, while countries' external indebtedness was growing at an unsustainable rate As a result, the potential for the bankruptcy of the major international banks because grew as a result of low security

The committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold
This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy In 1988, the Basel I Capital Accord (agreement) was created. The Basel II Capital Accord follows as an extension of the former, and was implemented in 2007

Basel I
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In 1988, the Basel I Capital Accord was created The purpose was to strengthen the stability of international banking system Set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks

The basic achievement of Basel I have been to define bank capital and the so-called bank capital ratio
This minimum is a percentage of the total capital of a bank, which is also called the minimum risk-based capital adequacy

Two-Tiered Capital
Tier 1 (Core Capital)
Includes stock issues (or share holders equity) and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations

Tier 2 (Supplementary Capital)

Tier 2 capital includes all other capital such as gains on investment assets, long-term debt with maturity greater than five years and hidden reserves (i.e. excess allowance for losses on loans and leases). However, short-term unsecured debts (or debts without guarantees), are not included in the definition of capital

Credit Risk
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It is defined as the risk weighted asset (RWA) of the bank, which are banks assets weighted in relation to their relative credit risk levels According to Basel I, the total capital should represent at least 8% of the bank's credit risk (RWA)

The onbalance sheet risk.

Credit Risks
The trading offbalance sheet risk The nontrading offbalance sheet risk

Credit Risk
Cash, central bank, Government debt

Public sector debt

Risk Categories

Development bank debt, non OECD bank debt, non OECD public sector debt

Private sector debt, real estate, plant equipment

Residential mortgages

Pitfalls of Basel I
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Static measurement of default risk at 8% ignoring default probability of different players The capital charges are set at same levels regardless of maturity of credit exposure Limited differentiation of credit risk into 5 categories and 4 risk weightings Capital requirements ignore currency and macroeconomic risks

Conclusion
The Basel I Capital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations

It launched the trend toward increasing risk modeling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord and further agreements as the symbol of the continuous refinement of risk and capital

Nevertheless, Basel I, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.

Basel II
Basel II Is Complicated Its goal is to better align the required regulatory capital with actual bank risk . It has multiple approaches for securitization and for credit risk mitigants (such as collateral)

Basel II is Three Pillars Basel II has three pillars: minimum capital, supervisor review and market discipline

Minimum Capital is the technical, quantitative heart of the accord. Banks must hold capital against 8% of their assets, after adjusting their assets for risk

Supervisor review is the process whereby national regulators ensure their home country banks are following the rules. If minimum capital is the rulebook, the second pillar is the referee system Market discipline is based on enhanced disclosure of risk. This may be an important pillar due to the complexity of Basel. Under Basel II, banks may use their own internal models (and gain lower capital requirements) but the price of this is transparency

Basel II
Original Basel Accord Applies to all internationally active banks and on a consolidated basis to majority-owned or controlled banking entities, securities entities and financial entities, not including insurance. The total capital ratio must be no lower than 8%. RBI Guidelines Applies to all scheduled commercial banks both at solo and consolidated level and group entities, which include a licensed bank. Banks are required to maintain a minimum capital to Riskweighted assets ratio (CRAR) of 9% on an ongoing basis.

Banks have been permitted to adopt the Standardized method, Banks mandated to use Standardized Approach for credit risk Internal Rating Based or Advanced Measurement Approach and Basic Indicator Approach for operational risk. Banks to make a road map for migration to advanced approaches only after obtaining specific approval of RBI. Claims on sovereigns to be risk weighted from 0% to 150% Exposures to domestic sovereigns (Central & States) rated at 0% depending upon the credit assessments AAA to BLending against fully secured mortgages on residential property Lending against fully secured mortgages if the loan to value will be risk weighted at 35%. ratio (LTV) is not more than 75%, on residential property will be risk weighted at 75%, except where loan value is below Rs.30 lacs which is risk weighted at 50%. In the case of past due loans where specific provision are no Lending for acquiring residential property, which meets the less than 50% of the outstanding amount of the loan the risk above criteria but have LTV ratio of more than 75 percent, will weights of 100%. attract a risk weight of 100 %.

Pitfalls of Basel II
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Basel II had created an illusion of safetyan illusion that compliance with Basel II meant that bank capital would be adequate to withstand a crisis The second weakness is the negative spiral effect resulting from the interplay between asset value declines occasioned by market-to-market accounting and Basel IIs rigid capital demands

Basel II acceded to the credence that banks inevitably know their risk exposures and know how to manage risks better than their regulators

Banks were granted broad discretion to set their own risk preferences, with the understanding that riskier institutions would pay higher costs for the privilege through higher mandated capital. The national regulator verified the presence of such internally developed risk management systems, but did not verify their effectiveness

Banks and other financial actors took comfort from the generalized presence of Basel II-compliant national regulation in assessing systemic risk

It assuaged any of the banks or their regulators incipient concerns about counterparty and broader systemic risk during the credit bubble leading to the Crisis

Pitfalls of Basel II
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The complacency engendered by Basel II resulted from two levels of trust. The first was the trust that other actors were following Basel II rules and Basel II had been designed well enough that when financial institutions complied, a systemic meltdown was so remote as to be virtually impossible

Credit rating agencies failed to appreciate the risk of certain innovative financial assets. ratings did not reflect the heightening of correlated defaults during periods of financial stress

Credit enhancement was used frequently by banks and other originators of asset backed securitizations to bulk up ratings to investment grade, permitting risk-averse institutions to hold these assets, including other banks

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The inherent conflict-of-interest facing rating agencies contributed to the problemcredit rating agencies were hired by the very promoters who desired to sell the rated assets

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One of the major critiques of the Basel II design assails its pro-cyclical tendencies. In good times, when asset value increases, capital is generated to support asset growth. In difficult times, as asset value declines, banks are constrained to raise additional capital to support the same asset portfolio they previously held. During periods of expansion, increases in asset values (when market to market) generate shadow increases in regulatory capital, which permit banks to further increase the origination and acquisition of assets, and thus increase intrinsic leverage

Corrections to Basel II
Capital adequacy may continue to be a useful tool, but it may no longer be the primary tool. Traditional supervision has to be part of the system

New requirements involving procyclicality buffers, leverage limitations, and liquidity maintenance requirements will augment capital adequacy

To counter this procyclical trend, Basel II joint note, 2010 came out with a framework that would have 2 elements

Promotion of the accretion of countercyclical buffers at banks that could be drawn against during periods of stress

The second element would involve the applications of braking mechanisms that would prevent the buildup of excessive credit growth during the expansion phase of the business cycle.

Basel III
Basel III is aimed at strengthening both sides of balance sheets of banks Enhancing the quantum of common equity Improving the quality of capital base

Creation of capital buffers to absorb shocks

Improving liquidity of assets Optimizing the leverage through Leverage Ratio Creating more space for banking supervision by regulators under Pillar II Bringing further transparency and market discipline under Pillar III

RBI on Basel III norms

The guidelines require banks to maintain a Minimum Total Capital (MTC) of 9% against 8% (international) prescribed by the Basel Committee of Total Risk Weighted Assets (RWA). Indian banks under Basel II are required to maintain Tier 1 capital of 6%, which has been raised to 7% under Basel III. Of the above, Common Equity Tier 1 (CET 1) capital must be at least 5.5% of RWAs In addition to the Minimum Common Equity Tier 1 capital of 5.5% of RWAs, (international standards require these to be only at 4.5%) banks are also required to maintain a Capital Conservation Buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital Leverage Ratio: Under the new set of guidelines, RBI has set the leverage ratio at 4.5% (3% under Basel III; the leverage ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets) Liquidity norms: The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold enough unencumbered liquid assets to cover expected net outflows during a 30-day stress period

Comparison of Basel II and III

Requirements Basel II Basel III Minimum ratio of total capital to RWAs 8% 10.5% (including conservation buffer)

Minimum ratio of common equity to RWAs

2%

4.5%

Capital Conservation Buffers to RWAs

2.5%

Leverage ratio (Tier I capital/Total exposure)

3%

Countercyclical buffer

Upto 2.5%

Liquidity Coverage Ratio (LCR)

>= 100%

Net Stable Funding Ratio (NSFR)

>=100%

How much will Indian banks need to comply with BASEL III guidelines?
The banks in India may require additional capital of upto Rs2.6 lakh crore by 2018 as they migrate to the capital intensive Basel-III framework, according to a study by Standard & Poors (S&P)
Public sector banks Additional equity capital requirements under Basel III 1400 -1500 (A) Additional equity capital requirements under Basel II 650 700 (B) Net equity capital requirements under Basel III (AB) 750 800 Private sector banks 200 250 Total 1600 1750

20 -25

670 725

180 225

930 1025

Additional equity capital requirements under Basel III for public sector banks Government share (if present shareholding pattern is 880 -910 maintained) Government share (if shareholding is brought down 660 690 to 51%)

Market share (if the Government's shareholding 520 - 590 pattern is maintained at present level)

Shortcomings of Basel III

Despite the promise of higher capital levels and better quality capital, Basels new minimum leverage ratio requirement is only 3 per cent, about the same as that of the largest US banks when the global crisis erupted Countercyclical capital buffers will be introduced to promote the buildup of capital in good times that can be drawn upon in periods of stress (bad times), hence reducing the procyclicality of the banking industry

The problem is that identifying good times and bad times is subjective at worst and rather difficult at best. There is no way of coming up with a figure for the capital buffer that will absorb losses in bad times

Allowing banks to use internal models to calculate regulatory capital, reliance on rating agencies can lead to similar crisis in the future

Concept of risk weighting involves subjectivity and it is not fool proof

The regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired

Conclusion
Basel III norms are expected to come into force by 2018

However it has to be understood that Basel III norms have been designed to address shortcomings of Basel II at the fallout of 2008 crisis

Following Basel III norms does not guarantee any protection against future financial crisis.