Derivative market Essay
The Indian Financial System is tasting success of a decade of financial sector reforms. The economy is surging and has gathered the critical mass to convert it into a force to reckon with. The regulatory framework in India has sparked growth and key structural reforms have improved the asset quality and profitability of banks. Growing integration of economies and the markets around the world is making global banking a reality. Widespread use of internet banking has widened frontiers of global banking, and it is now possible to market financial products and services on a global basis. In the coming years globalization would spread further on account of the likely opening up of financial services under WTO. India is one of the 104 signatories of Financial Services Agreement (FSA) of 1997.
Thereby giving India’s financial sector including banks an opportunity to expand their business on a quid pro quo basis. As in different sectors, competition is driving growth in the banking sector also.
The RBI requires all banks to comply with the standardized approach of the BASEL II accord by 31st March, 2007. The quantification and accounting of various risks would result in a more robust risk management system in the industry. This paper attempts to project the implications of this transition and its effects on the internal operations of a bank followed by its effects on the banking industry and the economy. The Basel Accord or Basle Accord refers to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking Supervision(BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee normally meets there.
OBJECTIVES OF RISK MANAGEMENT
To get knowledge of the risk management in the banking Industry What are the different types of risk in the Banking Industry? How are they complying with the requirements of Basel accord? To understand the measures adopted by each bank in different sectors for risk i.e. public, private and foreign. What are the problems faced by the banking industry in fulfilling the requirements of Basel? Suggestions and recommendations to improve risk
The Bank for International Settlements (or BIS) is an international organization of central banks which “fosters international monetary and financial cooperation and serves as a bank for central banks.” The BIS carries out its work through subcommittees, the secretariats it hosts, and through its annual General Meeting of all members. It also provides banking services, but only to central banks, or to international organizations like itself. Based in Basel, Switzerland the BIS was established by the Hague agreements of 1930. BIS therefore has two specific goals: to regulate capital adequacy and make reserverequirements transparent. Regulates capital adequacy
Capital adequacy policy applies to equity and capital assets. These can be overvalued in many circumstances. Accordingly the BIS requires bank capital/asset ratio to be above a prescribed minimum international standard, for the protection of all central banks involved. The BIS’ main role is in setting capital adequacy requirements. From an international point of view, ensuring capital adequacy is the most important problem between central banks, as speculative lending based on inadequate underlying capital and widely varying liability rules causes economic crises as “bad money drives out good” (Gresham’s Law). Specific policies are explained below. Encourages reserve transparency
Reserve policy is also important, especially to consumers and the domestic economy. To insure liquidity and limit liability to the larger economy, banks cannot create money in specific industries or regions without limit. To make bank depositing and borrowing safer for customers and reduce risk of bank runs, banks are required to set aside or “reserve”. Reserve policy is harder to standardize as it depends on local conditions and is often fine-tuned to make industry-specific or region-specific changes, especially within large developing nations.
For instance, the People’s Bank of China requires urban banks to hold 7% reserves while letting rural banks continue to hold only 6%, and simultaneously telling all banks that reserve requirements on certain overheated industries would rise sharply or penalties would be laid if investments in them did not stop completely. The PBoC is thus unusual in acting as a national bank, focused on the country not on the currency, but its desire to control asset inflation is increasingly shared among BIS members who fear “bubbles”, and among exporting countries that find it difficult to manage the diverse requirements of the domestic economy, especially rural agriculture, and an export economy, especially in manufactured goods.
Effectively, the PBoC sets different reserve levels for domestic and export styles of development. Historically, the US also did this, by dividing federal monetary management into nine regions, in which the less-developed Western US had looser policies. For various reasons it has become quite difficult to accurately assess reserves on more than simple loan instruments, and this plus the regional differences has tended to discourage standardizing any reserve rules at the global BIS scale. Historically, the BIS did set some standards which favoured lending money to private landowners (at about 5 to 1) and for-profit corporations (at about 2 to 1) over loans to individuals. These distinctions reflecting classical economics were superseded by policies relying on undifferentiated market values – more in line with neoclassical economics. The BIS sets “requirements on two categories of capital, Tier 1 capital and Total capital. Tier 1 capital is the book value of its stock plus retained earnings. Tier 2 capital is loan-loss reserves plus subordinated debt. Total capital is the sum of Tier 1 and Tier 2 capital. Tier 1 capital must be at least 4% of total risk-weighted assets.
Total capital must be at least 8% of total risk-weighted assets. When a bank creates a deposit to fund a loan, its assets and liabilities increase equally, with no increase in equity. That causes its capital ratio to drop. Thus the capital requirement limits the total amount of credit that a bank may issue. It is important to note that the capital requirement applies to assets while the bank reserve requirement applies to liabilities.” – from an extremely detailed and robust account of the use of reserve policy and other central bank powers in China by Henry C.K. Liu. The BIS provides the Basel Committee on Banking Supervision with its twelve-member secretariat, and with it has played a central role in establishing the Basel Capital Accords of 1988 and 2004.
There remain significant differences between US, EU and UN officials regarding the degree of capital adequacy and reserve controls that global banking now requires. Put extremely simply, the US as of 2006 favoured strong strict central controls in the spirit of the original 1988 accords, the EU was more inclined to a distributed system managed collectively with a committee able to approve some exceptions. The UN agencies especially ICLEI are firmly committed to fundamental risk measures: the so-called triple bottom line and were becoming critical of central banking as an institutional structure for ignoring fundamental risks in favour of technical risk management.
Risk management is not considered in the banking industry.
As there are number of banks in the banking industry in reference to the public, private and foreign sector. In order to study the risk management , I select the sample of bank in each sector i.e. SBI in public sector, ICICI Bank in private sector and CITIBANK in foreign sector. This is based on simple random sampling method. Methodology
In the methodology, I have analyzed the requirements of the Basel accord and whether the banks comply with these provisions. Data
Data for this research is based on secondary data i.e. Descriptive research. Area Of Study The area of study includes India and foreign bank.
Banks are reluctant to share information about their finance and how to manage their risk. Tools And Techniques
FOUNDATION OF BASEL ACCORDS
The Basel Accord(s) or Basle Accord(s) refers to the banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Committee is named after the Swiss town of Basel. In early publications, the committee sometimes used the English spelling “Basle” or the French spelling “Bâle,” names that are sometimes still used in the press. More recently, the Committee has deferred to the predominantly German population of the region and used the spelling “Basel.” The Basel Committee consists of representatives from central banks and regulatory authorities of the Group of Ten (economic) countries, plus others (specifically Luxembourg and Spain).
The committee does not have the authority to enforce recommendations, although most member countries (and others) tend to implement the Committee’s policies. This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee’s recommendations – thus some time may pass between recommendations and implementation as law at the national level. Throughout history, Basel has seen the conclusion of numerous accords. In 1499 Treaty of Basel was signed, ending the Swabian War, and two years later Basel joined the Swiss Confederation. In 1795, two separate peace treaties between the revolutionary French Republic on the one hand and Prussia and Spain on the other brought about the collapse of the First Coalition and the cessation of fighting in the French Revolutionary Wars.
In more recent times, on September 3, 1897, the World Zionist Organization held its first congress in Basel under the leadership of Theodor Herzl; this Jewish umbrella organization would later play an instrumental role in the creation of the state of Israel. Because of the Balkan Wars the Second International held an extraordinary congress at Basel in 1912. In 1989, the Basel Convention was opened for signature with the aim of preventing the export of hazardous waste from wealthy to developing nations for disposal.
BASEL I AND BASEL II
Basel I is the set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Banks that operate internationally are required to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. The first accord was the Basel I. It was issued in 1988 and focused mainly on credit risk by creating a bank asset classification system. This classification system grouped a bank’s assets into five risk categories: 0% – cash, central bank and government debt and any OECD government debt 0%, 10%, 20% or 50% – public sector debt 20% – development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection 50% – residential mortgages
100% – private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks The bank must maintain capital (Tier 1 and Tier 2) equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. On the other hand, capital resources were divided in two categories: Core Capital and Supplementary Capital. The first one made up of countable capital and reserves which must constitute a minimum of 50% of the net worth requirement. The Supplementary one is satisfied by off-balance sheet items (non published reserves, general asset revaluations, provisions against losses as well as medium and long term subordinated debt). Concisely, the fundamental innovation was given by the entailment of minimum net worth with the risk inherent to the different classes of assets that each bank had in its loan and investment portfolio.
Tier 1 Capital is the core measure of a bank’s financial strength from a regulator’s point of view. It is composed of core capital, which consists primarily of equity capital and cash reserves, but may also include irredeemable non-cumulative preferred stock and retained earnings The Tier 1 capital ratio is the ratio of a bank’s core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula
determined by the Regulator (usually the country’s Central Bank). Most central banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.
A good definition of Tier I capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can’t be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are, as they are held by the bank, by their nature not an amount of money on which anybody but the bank can have an influence on. Tier 2 Capital is a measure of a bank’s financial strength with regard to the second most reliable form of financial capital, from a regulator’s point of view. The forms of banking capital were largely standardised in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord. National regulators of most countries around the world have implemented these standards in local legislation. Tier 1 capital is considered the more reliable form of capital. There are several classifications of tier 2 capital.
In the Basel I Accord, tier 2 capital is composed of supplementary capital, which is categorized as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Supplementary capital can be considered tier 2 capital up to an amount equal to that of the core capital. Undisclosed Reserves- Undisclosed reserves are not common, but are accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank. Revaluation Reserves- A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its head-offices and bought them for $100 a century ago.
A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. General Provisions- A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital. Hybrid Instruments- Hybrids are instruments that have some characteristics of both debt and shareholders’ equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the bank, they may be counted as capital. Preferred stocks are hybrid instruments. Subordinated Term Debt- Subordinated debt is debt that ranks lower than ordinary depositors of the bank.
Tier 3 Capital
Tertiary capital held by banks to meet part of their market risks, that includes a greater variety of debt than tier 1 and tier 2 capitals. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier 2 capital.
Tier 3 capital is used to support market risk, commodities risk and foreign currency risk. To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated and have a minimum maturity of two years. Capital Adequacy Ratio
A measure of a bank’s capital. It is expressed as a percentage of a bank’s risk weighted credit exposures.
Also known as “Capital to Risk Weighted Assets Ratio (CRAR).” This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors. Also known as “Capital to Risk Weighted Assets Ratio (CRAR).”
Although Basel I considered bank’s use of derivatives, the financial entities’ participation in the markets where these instruments are exchanged, the risk associated to such has grown hugely since then. In addition, financial sector’s deregulation meant that the separation between the banking sector and the securities market ceased. Banks’ investments in different securities gained more importance, leaving them even more exposed to fluctuations in the price of assets. On the other hand, financial liberalization entailed a gap in terms of institutional barriers between banking and non-banking financial institutions. Consequently, liberalization produced an increase in competition.
Basel Committee recognized that Basel I had ceased being suitable in defining capital requirements for this new scenario. In this sense, Basel II intends to adopt a system of common standards amongst countries suitable to reach greater financial stability internationally given the more and more complex financial development.
The main difference with Basel I lies in the estimation of risk exposure, which under the new Agreement, will consist on the aggregation of the bank’s credit, market and operative risks. The total risk-weighted assets is determined multiplying capital requirements by market risk and operative risk per 12,5 (the reciprocal one of the minimum capital coefficient of 8%) and then adding the result to the addition of credit risk-weighted assets.
The Basel I had a number of flaws. For instance it was risk insensitive, it did not differentiate between credit risk and other types of risk, and it can easily be circumvented by regulatory arbitrage. The “capital economizing efforts” the banks were resulted in holding the lower quality assets on their balance sheet and off-loading their high quality (less risky) assets.
On the other hand during the same period financial innovations in the form of derivatives and securitization played an important role in the decline of traditional banking. This had important implications for the future of banking industry and created new challenges for regulators. It was recognized that Basel I has outlived its usefulness for the complex financial innovations driven by new technologies.
To address these limitations, the Basel Committee on banking supervision (BCBS) formalized Basel II in June 1999, in consultative paper and put forward a three pillar approach to regulating banks. The purpose of the agreement is to improve on the earlier rules by making the risk measurement more accurate and comprehensive. Later on, two more consultation papers CP2 in January 2001 and CP3 in April 2003, were published after incorporating the comments and suggestions of end users and supervisors. The final version of New Capital Adequacy framework (Basel II) was released in June 2004.
Basel II is the second of the Basel Committee on Bank Supervision’s recommendations, and unlike the first accord, Basel I, where focus was mainly on credit risk, but the purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The final version aims at:
1. Ensuring that capital allocation is more risk sensitive; 2. Separating operational risk from credit risk, and quantifying both; 3. Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage. While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic. It has three pillars which are explained later on. THREE PILLARS OF BASEL II
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place. Basel II uses a “three pillars” concept – (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline – to promote greater stability in the financial system. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all. The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. Other risks are not considered fully quantifiable at this stage. Pillar 1 focuses on making bank regulatory capital requirements more risk sensitive. The first pillar describes the alternative approaches available for the calculation of capital requirements according to credit and operational risk. As the Basel 2 recommendations are phased in by the banking industry it will move from standardised requirements to more refined and specific requirements that have been developed for each risk category by each individual bank. The upside for banks that do develop their own bespoke risk measurement systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be closer links between the concepts of economic profit and regulatory capital. Credit Risk can be calculated by using one of three approaches 1. Standardized Approach
2. Foundation IRB (Internal Ratings Based) Approach
3. Advanced IRB Approach
The standardized approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories are used under Basel 1 and are 0% for short term government bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting on commercial loans. A new 150% rating comes in for borrowers with poor credit ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as capital) remains at 8%. For those Banks that decide to adopt the standardized ratings
approach they will be forced to rely on the ratings generated by external agencies. Certain Banks are developing the IRB approach as a result. The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved ‘tools’ over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives bank a power to review their risk management system. It proposes the review process that must be carried out by national regulators in order to assure the correct risk estimation of both risks and capital for the banks in their respective countries.
The Committee identified four core principles for this process, which complement those developed previously in the topic of supervision.
Principle 1: The principle indicates that banks will hold a process in order to evaluate if they have the appropriate capital according to their risk profile. Moreover, they will have to devise a strategy in order to maintain their capital levels. Principle 2: Establishes that the supervisors will have to examine banks’ strategies and internal evaluations. Principle 3: Sets that the supervisors must expect banks to operate over the regulatory minimum capital. Principle 4: This principle settles that they will have to mediate to prevent capital from descending below the established minimum, according to the risk profile of each bank in individual.
Additionally, this Pillar analyzes risks that have been treated only partially in Pillar I, such as credit concentration risk, those that have not received any treatment, such as the liquidity, interest and external effects risks (for example, the effect of economic cycles). It also includes other aspects such as supervision transparency, accounting, cooperation and communication through frontiers.
The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately. Pillar 3 addresses the issue of improving market discipline through effective public disclosure. Specifically, it presents a set of disclosure requirements that should improve market participants’ ability to assess banks’ capital structures, risk exposures, risk management processes, and, hence, their overall capital adequacy. The proposed disclosure requirements consist of qualitative and quantitative information in three general areas: corporate structure, capital structure and adequacy, and risk management. Corporate structure refers to how a banking group is organized; for example, what is the top corporate entity of the group and how are its subsidiaries consolidated for accounting and regulatory purposes. Capital structure corresponds to how much capital is held and in what forms, such as common stock.
The disclosure requirements for capital adequacy focus on a summary discussion of the bank’s approach to assessing its current and future capital adequacy. In the risk management area, the focus is on bank exposures to credit risk, market risk, risk from equity positions, and operational risk. For credit risk, which is defined as the potential losses arising from borrowers not repaying their debts, banks must provide a qualitative discussion of their risk management policies, the key definitions and statistical methods used in their risk analysis, and information on their supervisor’s acceptance of their approach. The quantitative disclosures include total gross credit risk exposures after accounting for offsets and without taking account of credit risk mitigation efforts. These exposures also must be reported in disaggregated form by exposure type (such as loans or off-balance-sheet exposures), by geographic region, by industry or counterparty type, and by residual contractual maturity. Impaired loans and past-due loans also must be reported by geographic region and industry type.
COMPONENTS OF PILLAR I
CREDIT RISK –
Credit risk is the risk of loss due to a debtor’s non-payment of a loan or
other line of credit (either the principal or interest (coupon) or both). The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for “Internal Rating-Based Approach”. Methods of Credit risk
STANDARDIZED APPROACH- The term standardized approach refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are required to use ratings from External Credit Rating Agencies to quantify required capital for credit risk. In many countries this is the only approach the regulators are planning to approve in the initial phase of Basel II Implementation. There are some options in weighting risks for some claims, below are the summary as it might be likely to be implemented. For some “unrated” risk weights, banks are encouraged to use their own internal-ratings system based on Foundation IRB and Advanced IRB in Internal-Ratings Based approach with a set of formulae provided by the Basel-II accord. There exist several alternative weights for some of the following claim categories published in the original Framework text. Claims on sovereigns
Claims on retail products – This includes credit card, overdraft, auto loans, personal finance and small business. Risk weight: 75% Claims secured by residential property Risk weight: 35% Claims secured by commercial real estate Risk weight: 100% Overdue loans – more than 90 days other than residential mortgage loans. Risk weight: 150% for provisions are less than 20% of the outstanding amount 100% for provisions are between 20% – 49% of the outstanding amount 100% with supervisory discretion to reduce to 50% for provisions are 50% and more of the outstanding amount Other assets
Risk weight: 100%
Risk weight: 0%
The National Supervising Authority will be the one in charge to designate each risk weighing factor available under this approach the qualification granted by some of the external credit assessment institutions (ECAI). Nevertheless, banks will have to use the ratings shaped by a single assessment institution for all of their assets. Unlike Basel I, in which a distinction was made between OECD and non-OECD, risk weighing factors are assigned on the basis of investment-grade and non investment-grade ratings. FOUNDATION INTERNAL RATINGS BASED APPROACH- The term Foundation IRB or F-IRB is an abbreviation of foundation internal ratings-based approach and it refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under this approach the banks are allowed to develop their own empirical model to estimate the PD (probability of default) for individual clients or groups of clients. Banks can use this approach only subject to approval from their local regulators.
Some credit assessments in standardised approach refer to unrated assessment. Basel II also encourages banks to initiate internal-ratings based approach for measuring credit risks. Banks are expected to be more capable of adopting more sophisticated techniques in credit risk management. Banks can determine their own estimation for some components of risk measure: the probability of default (PD), exposure at default (EAD) and effective maturity (M). The goal is to define risk weights by determining the cut-off points between and within areas of the expected loss (EL) and the unexpected loss (UL), where the regulatory capital should be held, in the probability of default.
Then, the risk weights for individual exposures are calculated based on the function provided by Basel II. Under F-IRB banks are required to use regulator’s prescribed LGD (Loss Given Default) and other parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA. Basel-II benefits customers with lower probability of default. Basel-II benefits banks to hold lower capital requirement as having corporate customers with lower probability of default Basel-II benefits SME customers to be treated differently from corporates. Basel-II benefits banks to hold lower capital requirement as having credit card product customers with lower probability of default. Methods of Foundation Internal Rating Based Approach
Probability of Default (PD) is a parameter used in the calculation of economic capital or regulatory capital under Basel II for a banking institution. This is an attribute of a bank’s client. The probability of default is the likelihood that a loan will not be repaid and will fall into default. PD is calculated for each client who has a loan (for wholesale banking) or for a portfolio of clients with similar attributes (for retail banking). The credit history of the counterparty / portfolio and nature of the investment are taken into account to calculate the PD. There are many alternatives for estimating the probability of default. Default probabilities may be estimated from a historical data base of actual defaults using modern techniques like logistic regression. Default probabilities may also be estimated from the observable prices of credit default swaps, bonds, and options on common stock.
The simplest approach, taken by many banks, is to use external ratings agencies such as Egan Jones, Fitch, Moody’s Investors Service, or Standard and Poors for estimating PDs from historical default experience. For small business default probability estimation, logistic regression is again the most common technique for estimating the drivers of default for a small business based on a historical data base of defaults. These models are both developed internally and supplied by third parties. A similar approach is taken to retail default, using the term “credit score” as an euphemism for the default probability which is the true focus of the lender.
Calculation of probability of default The following steps are commonly used Analyse the credit risk aspects of the counterparty / portfolio; Map the counterparty to an internal risk grade which has an associated PD: and Determine the facility specific PD. This last step will give a weighted Probability of Default for facilities that are subject to a guarantee or protected by a credit derivative.
The weighting takes account of the PD of the guarantor or seller of the credit derivative. Once the probability of default has been estimated, the related credit spread and valuation of the loan or bond is the next step. A popular approach to this critical element of credit risk analysis is the “reduced form” modeling approach of the Jarrow-Turnbull model. Through-the-Cycle (TTC) PD’s are long-run probabilities of default which take into consideration upturns and downturns in the economy. Conceptually, it is the simple average, median or equilibrium of Point-In-Time (PIT) PD’s (PD’s which are calculated for very short horizons) over a long period of time where several economic cycles have played out. Usually, the simple regulatory formula is to take the long-term average of PIT PD’s.
This is, however, impractical as long-term data is often limited for any obligor/portfolio making calculations cumbersome. Furthermore, it is theoretically incorrect as obligor/portfolio characteristics tend to metamorphisize over time making one estimation of PD at one point-in-time incomparable with another estimate at another point-in-time. Loss Given Default- LGD is the fraction of EAD that will not be recovered following default. Loss Given Default is facility-specific because such losses are generally understood to be influenced by key transaction characteristics such as the presence of collateral and the degree of subordination. Theoretically, LGD is calculated in different ways, but the most popular is ‘Gross’ LGD, where total losses are divided by EAD.
Another method is to divide Losses by the unsecured portion of a credit line (where security covers a portion of EAD – Exposure at Default). This is known as ‘Blanco’ LGD. If collateral value is zero in the last case then Blanco LGD is equivalent to Gross LGD. Different types of statistical methods can be used to do this. Gross LGD is most popular amongst academics because of its simplicity and because academics only have access to bond market data, where collateral values often are unknown, uncalculated or irrelevant. Blanco LGD is popular amongst some practitioners (banks) because banks often have many secured facilities, and banks would like to decompose their losses between losses on unsecured portions and losses on secured portions due to depreciation of collateral quality.
The latter calculation is also a subtle requirement of Basel II, but most banks are not sophisticated enough at this time to make those types of calculations. Under Basel II to calculate the risk-weighted asset, which goes into the determination of the required capital for a bank or financial institution, the institution has to use an estimate of the LGD for each corporate, sovereign and bank exposure. There are two approaches for deriving this estimate: a foundation approach and an advanced approach. LGD warrants more attention than what has been given to it in the past decade, where credit risk models often assumed that LGD was time-invariant.
Movements in LGD result in often proportional movements in required economic capital. According to BIS (2006) institutions implementing Advanced-IRB instead of Foundation-IRB will experience larger decreases in Tier 1 capital, and the internal calculation of LGD is a factor separating the two Methods. Under Basel II, banks and other financial institutions are recommended to calculate ‘Downturn LGD’ (Downturn Loss Given Default), which reflects the losses occurring during a ‘Downturn’ in a business cycle for regulatory purposes. Downturn LGD is interpreted in many ways, and most financial institutions that are applying for IRB approval under BIS II often have differing definitions of what Downturn conditions are. One definition is at least two consecutive quarters of negative growth in real GDP. Often, negative growth is also accompanied by a negative output gap in an economy (where potential production exceeds actual demand).
The calculation of LGD (or Downturn LGD) poses significant challenges to modelers and practitioners. Final resolutions of defaults can take many years and final losses, and hence final LGD, cannot be calculated until all of this information is ripe. Furthermore, practitioners are of want of data since BIS II implementation is rather new and financial institutions may have only just started collecting the information necessary for calculating the individual elements that LGD is composed of: EAD, direct and indirect Losses, security values and potential, expected future recoveries. Another challenge, and maybe the most significant, is the fact that the default definitions between institutions vary. This often results in a so-called differing cure-rates or percentage of defaults without losses. Calculation of LGD (average) is often composed of defaults with losses and defaults without. Naturally, when more defaults without losses are added to a sample pool of observations LGD becomes lower.
This is often the case when default definitions become more ‘sensitive’ to credit deterioration or ‘early’ signs of defaults. When institutions use different definitions, LGD parameters therefore become non-comparable. Many institutions are scrambling to produce estimates of Downturn LGD, but often resort to ‘mapping’ since Downturn data is often lacking. Mapping is the process of guesstimating losses under a downturn by taking existing LGD and adding a supplement or buffer, which is supposed to represent a potential increase in LGD when Downturn occurs. LGD often decreases for some segments during Downturn since there is a relatively larger increase of defaults that result in higher cure-rates, often the result of temporary credit deterioration that disappears after the Downturn Period is over. Furthermore, LGD values decrease for defaulting financial institutions under economic Downturns because governments and central banks often rescue these institutions in order to maintain financial stability.
Exposure at Default- In general EAD can be seen as an estimation of the extent to which a bank may be exposed to a counter party in the event of, and at the time of, that counterparty’s default. It is a measure of potential exposure (in currency) as calculated by a Basel Credit Risk Model for the period of 1 year or until maturity whichever is sooner. Based on Basel Guidelines Exposure at Default (EAD) for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs. Under Basel II a bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as Exposure at Default (EAD), in banks’ internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure. EAD is mainly used in banking businesses. Calculation of EAD is different under foundation and advanced approach. While under foundation approach (F-IRB) calculation of EAD is guided by the regulators, Under F-IRB EAD is calculated taking account of the underlying asset, forward valuation, facility type and commitment details.
This value does not take account of guarantees, collateral or security (i.e. ignores Credit Risk Mitigation Techniques with the exception of on-balance sheet netting where the effect of netting is included in Exposure At Default). For on-balance sheet transactions, EAD is identical to the nominal amount of exposure. On-balance sheet netting of loans and deposits of a bank to a corporate counterparty is permitted to reduce the estimate of EAD under certain conditions. For off-balance sheet items, there are two broad types which the IRB approach needs to address: transactions with uncertain future drawdown, such as commitments and revolving credits, and OTC foreign exchange, interest rate and equity derivative contracts Under the advanced approach (A-IRB) banks enjoy greater flexibility on how they would like to calculate EAD. Under A-IRB, the bank itself determines the appropriate EAD to be applied to each exposure.
A bank using internal EAD estimates for capital purposes might be able to differentiate EAD values on the basis of a wider set of transaction characteristics (e.g. product type) as well as borrower characteristics. These values would be expected to represent a conservative view of long-run averages, although banks would be free to use more conservative estimates. A bank wishing to use its own estimates of EAD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates.
All estimates of EAD should be calculated net of any specific provisions a bank may have raised against an exposure. In terms of assigning estimates of EAD to broad EAD classifications, banks may use either internal or external data sources. Given the perceived current data limitations in respect of EAD (in particular external sources) a minimum data requirement of 7 years has been set. For a risk weight derived from the IRB framework to be transformed into a risk weighted asset, it needs to be attached to an exposure amount. Any error in EAD calculation will directly affect the risk weighted asset and thereby affect the capital requirement.
An operational risk is a risk arising from execution of a company’s business functions. As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or environmental risks, etc. More specifically, Basel II defines operational risk as the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
Although the risks apply to any organization in business, this particular way of framing risk management is of particular relevance to the banking regime where regulators are responsible for establishing safeguards to protect against systemic failure of the banking system and the economy. Some examples include:- Internal Fraud – misappropriation of assets, tax evasion, intentional mismarking of positions, [bribery] External Fraud- theft of information, hacking damage, third-party theft and forgery Employment Practices and Workplace Safety – discrimination, workers compensation, employee health and safety Clients, Products, & Business Practice- market manipulation, antitrust, improper trade, product defects, fiduciary breaches, account churning Damage to Physical Assets – natural disasters, terrorism, vandalism Business Disruption & Systems Failures – utility disruptions, software failures, hardware failures Execution, Delivery, & Process Management – data entry errors, accounting errors, failed mandatory reporting, negligent loss of client assets It is relatively straightforward for an organization to set and observe specific, measurable levels of market risk and credit risk.
By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organizations have accepted operational risk as an unavoidable cost of doing business. The Basel II definition of operational risk excludes, for example, strategic risk – the risk of a loss arising from a poor strategic business decision. Other risk terms are seen as potential consequences of operational risk events. For example, reputational risk (damage to an organisation through loss of its reputation or standing) can arise as a consequence (or impact) of operational failures – as well as from other events. It is relatively straightforward for an organisation to set and observe specific, measurable levels of market risk and credit risk. By contrast it is relatively difficult to identify or assess levels of operational risk and its many sources. Historically organisations have accepted operational risk as an unavoidable cost of doing business. Methods of operational risk management
Basel II and various Supervisory bodies of the countries have prescribed various soundness standards for Operational Risk Management for Banks and similar Financial Institutions. To complement these standards, Basel II has given guidance to 3 broad methods of Capital calculation for Operational Risk BASIC INDICATOR APPROACH – The patrimonial requirement by operative risk will be equal to 15% of the annual average gross income (positive) of the bank during the past three years. It is based on annual revenue of the Financial Institution. Based on the original Basel Accord, banks using the basic indicator approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.
The fixed percentage ‘alpha’ is typically 15 percent of annual gross income. STANDARDISED APPROACH – based on annual revenue of each of the broad business lines of the Financial Institution. Basel II requires all banking institutions to set aside capital for operational risk. Standardized approach falls between basic indicator approach and advanced measurement approach in terms of degree of complexity. Based on the original Basel Accord, under the Standardised 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. Within each business line, gross income is a broad indicator that serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor (denoted beta) assigned to that business line.
Beta serves as a proxy for the industry-wide relationship between the operational risk loss experience for a given business line and the aggregate level of gross income for that business line. The total capital charge is calculated as the three-year average of the simple summation of the regulatory capital charges across each of the business lines in each year. In any given year, negative capital charges (resulting from negative gross income) in any business line may offset positive capital charges in other business lines without limit. In order to qualify for use of the standardised approach, a bank must satisfy its regulator that, at a minimum: Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
ADVANCED MEASUREMENT APPROACH- In order to use this advanced approach, banks will have to fulfill certain requirements as: the establishment of a responsible independent unit to measure operative risk (subject to the approval of the supervisor), design and implement internal controls. It is based on the internally developed risk measurement framework of the bank adhering to the standards prescribed (methods include IMA, LDA,
Scenario-based, Scorecard etc.). Under this approach the banks are allowed to develop their own empirical model to quantify required capital for operational risk. Banks can use this approach only subject to approval from their local regulators. Also, according to section 664 of original Basel Accord, In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum: Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework; It has an operational risk management system that is conceptually sound and is implemented with integrity; and It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
Market risk is the risk that the value of an investment will decrease due to moves in market factors. The five standard market risk factors are: Equity risk, the risk that stock prices will change.
Interest rate risk, the risk that interest rates will change. Currency risk, the risk that foreign exchange rates will change. Commodity risk, the risk that commodity prices (e.g. grains, metals) will change. As with other forms of risk, market risk may be measured in a number of ways. Traditionally, this is done using a Value at Risk methodology. Value at risk is well established as a risk management technique, but it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the single period of the model.
For short time horizons, this limiting
assumption is often regarded as acceptable. For longer time horizons, many of the transactions in the portfolio may mature during the modeling period. Intervening cash flow, embedded options, changes in floating rate interest rates, and so on are ignored in this single period modeling technique. Value at risk is well established as a risk management technique, but it contains a number of limiting assumptions that constrain its accuracy. The first assumption is that the composition of the portfolio measured remains unchanged over the single period of the model.
For short time horizons, this limiting assumption is often regarded as acceptable. For longer time horizons, many of the transactions in the portfolio may mature during the modeling period. Intervening cash flow, embedded options, changes in floating rate interest rates, and so on are ignored in this single period modeling technique. VALUE AT RISK (VaR) is an easy-to-understand measure of the risk of a specific portfolio of financial assets, at a specified probability and over a specified time horizon.
The probability that the mark-to-market loss on the portfolio over the time horizon is greater than VaR, assuming normal markets and no trading, is the specified probability level. For example, if a portfolio of stocks has a one-day 5% VaR of $1 million, there is a 5% probability that the portfolio will decline in value by more than $1 million over the next day, assuming markets are normal and there is no trading. A large, unlikely loss such as this is termed a “VaR break.” VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital.
VaR is sometimes used in non-financial applications as well. Important related ideas are economic capital, backtesting, stress testing and expected shortfall The 10% Value at Risk of a normally distributed portfolio. VaR has five main uses in finance: risk management, risk measurement, financial control, financial reporting and computing regulatory capital. VaR is sometimes used in non-financial applications as well. Common parameters for VaR are 1% and 5% probabilities and one day and two week horizons, although other combinations are in use. The reason for assuming normal markets and no trading, and to restricting loss to things measured in daily accounts, is to make the loss observable. In some extreme financial events it can be impossible to determine losses, either because market prices are unavailable or because the loss-bearing institution breaks up.
Some longer-term consequences of disasters, such as lawsuits, loss of market confidence and employee morale and impairment of brand names can take a long time to play out, and may be hard to allocate among specific prior decisions.
VaR marks the boundary between normal days and extreme events. Institutions can lose far more than the VaR amount; the only thing we can say is they won’t do so very often. The probability level is about equally often specified as one minus the probability of a VaR break, so that the VaR in the example above would be called a one-day 95% VaR instead of one-day 5% VaR. This generally does not lead to confusion because the probability of VaR breaks is almost always small, certainly less than 0.5. Although it virtually always represents a loss, VaR is conventionally reported as a positive number. A negative VaR would imply the portfolio has a high probability of making a profit, for example a one-day 5% VaR of negative $1 million implies the portfolio has a 95% chance of making $1 million or more over the next day. Varieties of VaR
The definition of VaR is nonconstructive, it specifies a property VaR must have, but not how to compute VaR. Moreover, there is wide scope for interpretation in the definition.This has led to two broad types of VaR, one used primarily in risk management and the other primarily for risk measurement. The distinction is not sharp, however and hybrid versions are typically used in financial control, financial reporting and computing regulatory capital. To a risk manager, VaR is a system, not a number.
The system is run periodically (usually daily) and the published number is compared to the computed price movement in opening positions over the time horizon. There is never any subsequent adjustment to the published VaR, and there is no distinction between VaR breaks caused by input errors (including Information Technology breakdowns, fraud and rogue trading), computation errors (including failure to produce a VaR on time) and market movements. A frequentist claim is made, that the long-term frequency of VaR breaks will equal the specified probability, within the limits of sampling error, and that the VaR breaks will be independent in time and independent of the level of VaR.
This claim is validated by a backtest, a comparison of published VaRs to actual price movements. In this interpretation, many different systems could produce VaRs with equally good backtests, but wide disagreements on daily VaR values. For risk measurement a number is needed, not a system. A Bayesian probability claim is made, that given the information and beliefs at the time, the subjective probability of a VaR break was the specified level. VaR is adjusted after the fact to correct errors in inputs and computation, but not to incorporate information unavailable at the time of computation.
In this context, “backtest” has a different meaning. Rather than comparing published VaRs to actual market movements over the period of time the system has been in operation, VaR is retroactively computed on scrubbed data over as long a period as data are available and deemed relevant. The same position data and pricing models are used for computing the VaR as determining the price movements. Although some of the sources listed here treat only one kind of VaR as legitimate, most of the recent ones seem to agree that risk management VaR is superior for making short-term and tactical decisions today, while risk measurement VaR should be used for understanding the past, and making medium term and strategic decisions for the future. When VaR is used for financial control or financial reporting is should incorporate elements of both. For example, if a trading desk is held to a VaR limit, that is both a risk-management rule for deciding what risks to allow today, and an input into the risk measurement computation of the desk’s risk-adjusted return at the end of the reporting period.
Risk measure and risk metric
The term “VaR” is used both for a risk measure and a risk metric. This sometimes leads to confusion. Sources earlier than 1995 usually emphasize the risk measure, later sources are more likely to emphasize the metric. The VaR risk measure defines risk as mark-to-market loss on a fixed portfolio over a fixed time horizon, assuming normal markets. There are many alternative risk measures in finance. Instead of mark-to-market, which uses market prices to define loss, loss is often defined as change in fundamental value. For example, if an institution holds a loan that declines in market price because interest rates go up, but has no change in cash flows or credit quality, some systems do not recognize a loss. Or we could try to incorporate the economic cost of things not measured in daily financial statements, such as loss of market confidence or employee morale, impairment of brand names or lawsuits.
Rather than assuming a fixed portfolio over a fixed time horizon, some risk measures incorporate the effect of expected trading (such as a stop loss order) and consider the expected holding period of positions. Finally, some risk measures adjust for the possible effects of abnormal markets, rather than excluding them from the computation. The VaR risk metric summarizes the distribution of possible losses by a quantile, a point with a specified probability of greater losses. Common alternative metrics are standard deviation, mean absolute deviation, expected shortfall and downside risk. VaR risk management
Supporters of VaR-based risk management claim the first and possibly greatest benefit of VaR is the improvement in systems and modeling it forces on an institution. In 1997, Philippe Jorion wrote: The greatest benefit of VAR lies in the imposition of a structured methodology for critically thinking about risk. Institutions that go through the process of computing their VAR are forced to confront their exposure to financial risks and to set up a proper risk management function. Thus the process of getting to VAR may be as important as the number itself.
Publishing a daily number, on-time and with specified statistical properties holds every part of a trading organization to a high objective standard. Robust backup systems and default assumptions must be implemented. Positions that are reported, modeled or priced incorrectly stand out, as do data feeds that are inaccurate or late and systems that are too-frequently down. Anything that affects profit and loss that is left out of other reports will show up either in inflated VaR or excessive VaR breaks. “A risk-taking institution that does not compute VaR might escape disaster, but an institution that cannot compute VaR will not.” The second claimed benefit of VaR is that it separates risk into two regimes. Inside the VaR limit, conventional statistical methods are reliable.
Relatively short-term and specific data can be used for analysis. Probability estimates are meaningful, because there are enough data to test them. In a sense, there is no true risk because you have a sum many independent observations with a left bound on the outcome. A casino doesn’t worry about whether red or black will come up on the next roulette spin. Risk managers encourage productive risk-taking in this regime, because there is little true cost. People tend to worry too much about these risks, because they happen frequently, and not enough about what might happen on the worst days. Outside the VaR limit, all bets are off. Risk should be analyzed with stress testing based on long-term and broad market data. Probability statements are no longer meaningful. Knowing the distribution of losses beyond the VaR point is both impossible and useless. The risk manager should concentrate instead on making sure good plans are in place to limit the loss if possible, and to survive the loss if not. One specific system uses three regimes.
1. Out to three times VaR are normal occurrences. You expect periodic VaR breaks. The loss distribution typically has fat tails, and you might get more than one break in a short period of time. Moreover, markets may be abnormal and trading may exacerbate losses, and you may take losses not measured in daily marks such as lawsuits, loss of employee morale and market confidence and impairment of brand names. So an institution that can’t deal with three times VaR losses as routine events probably won’t survive long enough to put a VaR system in place. 2. Three to ten times VaR is the range for stress testing. Institutions should be confident they have examined all the foreseeable events that will cause losses in this range, and are prepared to survive them. These events are too rare to estimate probabilities reliably, so risk/return calculations are useless
3. Foreseeable events should not cause losses beyond ten times VaR. If they do they should be hedged or insured, or the business plan should be changed to avoid them, or VaR should be increased. It’s hard to run a business if foreseeable losses are orders of magnitude larger than very large everyday losses. It’s hard to plan for these events, because they are out of scale with daily experience. Of course there will be unforeseeable losses more than ten times VaR, but it’s pointless to anticipate them, you can’t know much about them and it results in needless worrying. Better to hope that the discipline of preparing for all foreseeable three-to-ten times VaR losses will improve chances for surviving the unforeseen and larger losses that inevitably occur. “A risk manager has two jobs: make people take more risk the 99% of the time it is safe to do so, and survive the other 1% of the time. VaR is the border.”
VaR risk measurement
The VaR risk measure is a popular way to aggregate risk across an institution. Individual business units have risk measures such as duration for a fixed income portfolio or beta for an equity business. These cannot be combined in a meaningful way. It is also difficult to aggregate results available at different times, such as positions marked in different time zones, or a high frequency trading desk with a business holding relatively illiquid positions. But since every business contributes to profit and loss in an additive fashion, and many financial businesses mark-to-market daily, it is natural to define firm-wide risk using the distribution of possible losses at a fixed point in the future.
In risk measurement, VaR is usually reported alongside other risk metrics such as standard deviation, expected shortfall and “greeks” (partial derivatives of portfolio value with respect to market factors). VaR is a distribution-free metric, that is it does not depend on assumptions about the probability distribution of future gains and losses. The probability level is chosen deep enough in the left tail of the loss distribution to be relevant for risk decisions, but not so deep as to be difficult to estimate with accuracy. Risk measurement VaR is sometimes called parametric VaR. This usage can be confusing, however, because it can be estimated either parametrically (for examples, variance-covariance VaR or delta-gamma VaR) or nonparametrically (for examples, historical simulation VaR or resampled VaR). The inverse usage makes more logical sense, because risk management VaR is fundamentally nonparametric, but it is seldom referred to as nonparametric VaR. COMPONENTS OF PILLAR II
LIQUIDITY RISK – Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity. Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited
ability to liquidate that position at short notice will compound its market risk.
Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.
Measures of Liquidity Risk
Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm’s liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values. As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm’s marginal funding cost. LIQUIDITY RISK ELASTICITY
Culp denotes the change of net of assets over funded liabilities that occur when the liquidity premium on the bank’s marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over libor, for non financials the LRE would be measured as a spread over commercial paper rates. Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads. LEGAL RISK
Legal and regulatory risk: Sometimes governments change the law in a way that adversely affects a bank’s position. The Risk Principle is an area of law
closely tied to legal causation in negligence. It provides limits on negligence for harm caused unforeseeably. It is a mistake to see the management of legal risk as simply something that must be left to well-managed firms to deal with on their own. Legal risk can arise at many levels and there will be situations where the best kind of legal risk management involves some kind of collective action either through trade associations or at a market-wide level. As we continue on the globalization odyssey such management methods will become more important.
It is not possible to explore further the many interesting possibilities in this area in this article. It is an important field of activity, however, and it would be a mistake to see it as limited to what is usually described as “financial regulation” – important though that is. The field of play is much bigger than regulation. It covers all aspects of law that are material to financial transactions and markets. It is tempting to say that globalization is here to stay; but, at the level of legal implementation, it has still not arrived. As it approaches, we should welcome it but recognize that it will bring risks with it. Lawyers, economists and politicians have some interesting challenges ahead as a result. They need to keep the channels of communication open and each hear what the others are saying if we are to respond effectively
COMPONENT OF PILLAR III
Disclosure means the giving out of information, either voluntarily or to be in compliance with legal regulations or workplace rules. In Computer security, full disclosure means disclosing full information about vulnerabilities. Journalism, full disclosure refers to disclosing the interests of the writer which may bear on the subject being written about. In real property transactions, disclosure refers to providing to a buyer information known to the seller or broker/agent concerning the condition or other aspects of real property that would affect the property’s value or desirability. These rules regarding what information must be disclosed, and whether the information must be disclosed even if a buyer does not ask, vary from one jurisdiction to the next. To individuals with disabilities, disclosure refers to informing others as to one’s disability.
This is typically done in a school or work environment and is needed to request accommodations. The public disclosure requirements in Basel II are far-reaching and are intended to improve market discipline and its usefulness to bank supervisors. Yet, how well the requirements might work in practice depends on how they are implemented. For example, the disclosures must not be overly burdensome on the reporting banks, but they must be accurate. The BCBS has made an effort to see that the relatively narrow focus of Pillar 3 on bank capital adequacy does not conflict with broader accounting requirements. The BCBS intends to maintain an ongoing relationship with international accounting authorities and to promote consistency among disclosure frameworks. Note that Pillar 3 disclosures need not be audited by an external auditor, unless otherwise required by accounting standard setters, securities regulators, or other authorities, but management should ensure that the information is appropriately verified.
Qualitative disclosures of summaries of bank risk management policies are to be reported annually, and that should be sufficient since they are not likely to change often. However, many variables, such as regulatory capital ratios, are to be reported quarterly. More frequent disclosures have not been proposed and could be overly burdensome for some institutions at this point, but given the nature of certain bank business lines, such disclosures may become commonplace in the future. Another important implementation issue is determining whether a specific piece of information is proprietary.
The BCBS has determined that specific items that may prejudice a bank’s proprietary or confidential information need not be disclosed. However, the bank must disclose more general information about the subject matter, together with an explanation of why those specific items were not disclosed. Along the same lines, determining whether specific disclosure items are material is another challenge. Under the current guidelines, banks should decide which disclosures are material based on commonly accepted principles; that is, information is material if its omission might change or influence the assessment or decision of a user relying on that information. This definition is consistent with International Accounting Standards and with many national accounting frameworks. In summary, many implementation details are addressed within the Pillar 3 disclosure requirements, but many specific questions and additional issues will arise during the actual implementation
process. However, it is reasonable to assume that as these issues are worked out, the improved disclosure by banks should facilitate market discipline, contribute to supervisory monitoring efforts, and enhance the stability of the national and international banking systems. Area
Banks should adopt a disclosure policy. The policy should state the frequency of disclosure and how compliance with the disclosure policy will be monitored. The information should be disclosed at least once a year.
As far as possible, the information should be disclosed in one publication and through one channel. The information should be broken down by asset class.
The goals and policies for the bank’s risk management should be described. Capital
Information about shareholders’ equity, its composition and deductions to it (e.g. goodwill). Statement of Risk Weighted Assets (RWA), solvency and minimum capital requirement. Description of the models used for estimating credit risk, market risk and operational risk. Credit Risk
Definition of default.
Description of methods used for value adjustments and provisioning. Credit exposure broken down by geography, industry, time to maturity and counterparty. Market Risk
Information about the characteristics of the internal model used. Description of the approach used for stress testing and back testing of the internal model. Reporting of aggregate Value-at-Risk (Var), high, mean and low VaR, over the reporting period. Operational Risk
Approaches for the assessment of shareholders’ equity.
The Standardised Approach is used for calculating the required capital. The Group’s Risk Management department is responsible for the process of gathering internal loss data, and reporting to business management and relevant Risk Committees.
STATE BANK OF INDIA (SBI)
SBI provides a range of banking products through its vast network in India and overseas, including products aimed at NRIs. With an asset base of $126 billion and its reach, it is a regional banking behemoth. SBI has laid emphasis on reducing the huge manpower through Golden handshake schemes and computerizing its operations.
The State Bank Group, with over 16000 branches, has the largest branch network in India. It has a market share among Indian commercial banks of about 20% in deposits and advances, and SBI accounts for almost one-fifth of the nation’s loans. After a 20 year hiatus the Bank will be recruiting 20000 clerks and 3500 officers So far, more than 2.4 million have applied There are six associate banks that fall under SBI, and together these seven banks constitute the State Bank Group. All use the same logo of a blue keyhole and all the associates use the “State Bank of” name followed by the regional headquarters’ name. Originally, the then seven banks that became the associate banks belonged to princely states until the government nationalized them in 1959. In tune with the first Five Year Plan, emphasizing the development of rural India, the government integrated these banks into State Bank of India to expand its rural outreach. There has been a proposal to merge all the associate banks into SBI to create a “mega bank” and streamline operations.
The first step along these lines occurred in September 2008 when State Bank of Saurashtra merged with State Bank of India. State Bank of Indore, State Bank of Bikaner & Jaipur, State Bank of Hyderabad, State Bank of Mysore, State Bank of Patiala, State Bank of Travancore Sate Bank of India has often acted as guarantor to the Indian Government, most notably during Chandra Shekhar’s tenure as Prime Minister of India. With more than 11,111 branches and a further 6500+ associate bank branches, the SBI has extensive coverage. State Bank of India has electronically networked all of its branches under Core Banking System (CBS). The bank has one of the largest ATM networks in the region. More than 8500 ATMs across India. The State Bank of India has had steady growth over its history, though it was marred by the Harshad Mehta scam in 1992. In recent years, the bank has sought to expand its overseas operations by buying foreign banks. It is the only Indian bank to feature in the top 100 world banks in the Fortune Global 500 rating and various other rankings BASEL REQUIREMENTS
It has observed the rules and regulations of BASEL II with respect to Pillar III of market disclosures in context of capital adequacy framework, capital structure, credit risk, securitization, market risk, operational risk, Interest rate risk. The quantitative disclosures are as under:
TABLE DF-2 : CAPITAL STRUCTURE:
Type of Capital
Equity (Tier –I)
State Bank of India has raised Equity by way of Rights Issue during March 2008 aggregating Rs.16,722 crs (including Premium). Domestic Banking Subsidiaries have raised equity through Equity Instruments. The majority shareholder is SBI while some of them like SBBJ, SBIr, SBM and SBT have public shareholding as well. Domestic Non-Banking Subsidiaries have raised equity through Equity Instruments. The majority shareholder in these Non-Banking Subsidiaries is SBI and the others are ADB (SBICAP-13.84%), SGAM (SBI FUNDS-37%), GE Capital (SBI CARDS-40%), SIDBI (SBI FACTORS-20%) etc. Innovative
SBI has raised IPDI’s in the International Market during FY: 06-07 and 07-08. Some of the Banking Subsidiaries like State Bank of Indore and State Bank of Travancore have also raised capital through Perpetual Debt Instruments. Foreign Subsidiary Banks have not raised Tier I Capital by way of IPDIs as of date. Tier-II
SBI and its Subsidiaries have raised Upper as well as Lower Tier II Capital.
In case of Domestic Subsidiaries, Tier-II capital has been raised by way of Upper Tier-2 and Tier-2 bonds (except SBICI Bank Ltd). The instruments used are generally unsecured, redeemable, non-convertible bonds. They are plain vanilla bonds with no embedded put option, or call option without RBI’s prior approval. Tier II capital of Foreign Subsidiaries comprises of subordinated term debt (SBIML, CBIL and IOIB), General provisions and Property revaluation reserves.
Paid up share capital
Innovative Instruments (only total)
Other capital instruments (only total)
Amt deducted from Tier-1 cap(if any total):
Other amounts deducted from Tier-1 capital, including goodwill and Investments 3419.65
Total Eligible Tier-2 capital (net of deductions)
Total Tier-3 capital
Debt capital instruments eligible for inclusion in upper Tier-2 capital
Total amount outstanding
Of which raised during current year
Amount eligible to be reckoned as capital
Subordinated Debt eligible for inclusion in lower Tier-2 capital
Total amount outstanding
of which raised during the current year
Amount eligible to be reckoned capital
Other deductions from capital if any
Total eligible capital (net of deductions from tier-I and tier II capital) 96044.55
In Basel I scenario, the Bank was deducting, equity investment made in Subsidiaries (where our holding is higher than 50%), from Tier I capital.
Under Basel II scenario, the Bank has to deduct 50% from Tier I Capital and 50% from Tier II Capital, of the equity investment made in the financial entities, where investment is more than 30%.
TABLE DF – 3 : CAPITAL STRUCTURE :
Qualitative Disclosures (a) A summary discussion of the Bank’s approach to assessing the adequacy of its Capital to support current and future activities. • Sensitivity Analysis is conducted annually or more frequently as required, on the movement of Capital Adequacy Ratio (CAR) in the medium horizon of 3 years, considering the projected growth in Advances, investment in Subsidiaries/Joint Ventures and the impact of Basel II Framework etc. • CAR of the Bank is estimated to be well above the Regulatory CAR of 9% in the medium horizon of 3 years. However, to maintain adequate capital, the Bank has ample options to augment its capital resources by raising Subordinated Debt and Hybrid Instruments, besides Equity as and when required.
• During FY: 2006-07, the State Bank of India has raised Upper Tier II Subordinated Debt of Rs. 7,942.90 crs in 8 tranches, Lower Tier II Subordinated Debt of Rs. 1,500 crs (both reckoned as Tier II Capital) and Innovative Perpetual Debt (IPDI Hybrid Debt), reckoned as Tier I Capital of US $ 400 mio (around Rs. 1,739 crs) in Overseas Market. Further, during FY: 2007-08, the Bank has raised Upper Tier II Subordinated Debt of Rs. 6,023.50 crs (reckoned as Tier II Capital) in 2 tranches and IPDIs (reckoned as Tier I Capital) of US $ 225 mio (around Rs. 916 crs) in the Overseas Market. • The Bank has also raised equity through Rights Issue during the FY: 2007-08 and has added an additional Capital Funds (Tier I) of about Rs.16,722 crs to ensure a minimum Tier I capital of 8%. • The Bank has put in place the ICAAP Policy and the same is being reviewed on a yearly basis which would enable us to maintain Economic Capital, thereby reducing substantial Capital Risk Quantitative Disclosures
(b) Capital requirements
for credit risk
• Portfolios subject to
• Securitization exposures
Total Rs.59241.33 crs @ 9.00% CAR
(c) Capital requirements
for market risk
* Standardized duration
• Interest Rate Risk
• Foreign Exchange Risk
• Equity Risk
Rs. 2270.46 crs
Rs. 83.30 crs
Rs. 1906.82 crs
……………………………………………………………….. Rs. 4260.58 crs @ 9.00% CAR
(d) Capital requirements for operational risk:
• Basic indicator approach
Rs. 4531.79 crs
……………………………………………………………….. Rs. 4531.79 crs @ 9.00% CAR
TABLE DF-4 : CREDIT RISK:
Definitions of past due and impaired assets (for accounting purposes) Non-performing assets
An asset becomes non-performing when it ceases to generate income for the Bank. As from 31st March 2006, a non-performing Asset. (NPA) is an advance where:
(i) Interest and/or instalment of principal remain ‘overdue’ for a period of more than 90 days in respect of a Term Loan, (ii) The account remains ‘out of order’ for a period of more than 90 days, in respect of an Overdraft/Cash Credit (OD/CC), (iii) The bill remains ‘overdue’ for a period of more than 90 days in the case of bills purchased and discounted, (iv) Any amount to be received remains ‘overdue’ for a period of more than 90 days in respect of other accounts. (v)
A loan granted for short duration crops is treated as NPA, if the instalment of principal or interest thereon remains overdue for two crop seasons and a loan granted for long duration crops is treated as NPA, if instalment of principal or interest thereon remains overdue for one crop season. vi) An account would be classified as NPA only if the interest charged during any quarter is not serviced fully within 90 days from the end of the quarter.
‘Out of Order’ status
An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of Bank’s Balance Sheet, or where credits are not enough to cover the interest debited during the same period, such accounts are treated as ‘out of order’. ‘Overdue’- Any amount due to the Bank under any credit facility is ‘overdue’ if it is not paid on the due date fixed by the Bank.
Discussion of the Bank’s Credit Risk Management Policy
The Bank has in place a Credit Risk Management Policy, as a part of its Loan Policy, which is reviewed from time to time. Over the years, the policy & procedures in this regard have been refined as a result of evolving concepts and actual experience. The policy and procedures have been aligned to the approach laid down in Basel-II Guidelines.
The Policy aims at ensuring that there is no undue deterioration in quality of individual assets within the portfolio. Simultaneously, it also aims at continued improvement of the overall quality of assets at the portfolio level, by establishing a commonality of approach regarding credit basics,
appraisal skills, documentation standards and awareness of institutional concerns and strategies, while leaving enough room for flexibility and innovation.
Credit Risk Management encompasses identification, assessment, measurement, monitoring and control of the credit exposures. In the processes of identification and assessment of Credit Risk, the following functions are undertaken :
(i) Developing and refining the Credit Risk Assessment (CRA) Models to assess the Counterparty Risk, by taking into account the various risks categorized broadly into Financial, Business, Industrial and Management Risks, each of which is scored separately.
(ii) Conducting industry research to give specific policy prescriptions and setting quantitative exposure parameters for handling portfolio in large / important industries, by issuing advisories on the general outlook for the Industries / Sectors, from time to time. The measurement of Credit Risk includes setting up exposure limits to achieve a well-diversified portfolio across dimensions such as companies, group companies, industries, collateral type, and geography. For better risk management and avoidance of concentration of Credit Risks, internal guidelines on prudential exposure norms in respect of individual companies, group companies, Banks, individual borrowers, non-corporate entities, sensitive sectors such as capital market, real estate, sensitive commodities, etc., are in place.
The Bank has processes and controls in place in regard to various aspects of Credit Risk Management such as appraisal, pricing, credit approval authority, documentation, reporting and monitoring, review and renewal of credit facilities, managing of problem loans, credit monitoring, etc.
Credit Risk-Quantitative Disclosures
g) NPA Ratios
Gross NPAs to gross advances
h) Net NPAs to net advances
Amount of Non-Performing
i) Amount of provisions held for
j) Movement of provisions for
depreciation on investments
TABLE DF-6 : CREDIT RISK MITIGATION:
(a) Qualitative Disclosures :
Policies and Processes for Collateral Valuation and Management A Credit Risk Mitigation and Collateral Management Policy, addressing the Bank’s approach towards the credit risk mitigants used for capital calculation is in place.
The objective of this Policy is to enable classification and valuation of credit risk mitigates in a manner that allows regulatory capital adjustment to reflect them. The Policy adopts the Comprehensive Approach, which allows full offset of collateral (after appropriate haircuts) against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral. The following issues are addressed in the Policy:
(i) Classification of credit risk mitigants
(ii) Acceptable credit risk mitigants
(iii) Documentation and legal process requirements for credit risk mitigants (iv) Valuation of collateral
(v) Custody of collateral
(vii) Monitoring of credit risk mitigants
Description of the main types of Collateral taken by the Bank The following Collaterals are usually recognised as Credit Risk Mitigants under the Standardised Approach : • Cash or Cash equivalent (Bank Deposits/NSCs/KVP/LIC Policy, etc.) • Gold
• Securities issued by Central / State Governments
• Debt Securities rated BBB- or better/ PR3/P3/F3/A3 for Short-Term Debt Instruments
Main types of Guarantor Counterparty and their creditworthiness
The Bank accepts the following entities as eligible guarantors, in line with RBI Guidelines :
• Sovereign, Sovereign entities (including BIS, IMF, European Central Bank and European Community as well as Multilateral Development Banks, ECGC and CGTSME, PSEs, Banks and Primary Dealers with a lower risk weight than the Counterparty.
• Other guarantors having an external rating of AA or better. In case the guarantor is a parent company, affiliate or subsidiary, they should enjoy a risk weight lower than the obligor for the guarantee to be recognised by the Bank. The rating of the guarantor should be an entity rating which has factored in all the liabilities and commitments (including guarantees) of the entity.
Information about (Market or Credit) risk concentrations within the mitigation taken:
The Bank has a well-dispersed portfolio of assets which are secured by various types of collaterals, such as:-
• Eligible financial collaterals listed above
• Guarantees by sovereigns and well-rated corporates,
• Fixed assets and current assets of the counterparty.
(b) For disclosed Credit Risk Portfolio under Standardised Approach, the total exposure that is covered by eligible financial collateral; after the application of haircuts: Rs.482169.13.
TABLE DF-7 SECURITISATION
• Bank’s objective in relation to Securitisation activity is to achieve improvement in leverage ratios, asset performance & quality and to achieve desirable investment & maturity characteristics. • Loss on sale on transfer of assets to Special Purpose Vehicle (SPV) shall be recognised upfront. • Profit on sale of the securitised assets shall be amortised over the life of the Pass Through Certificates (PTCs) assets issued or to be issued by SPV. Quantitative Disclosures
The Group does not have any securitization exposures.
TABLE DF-8: MARKET RISK IN TRADING BOOK
1) The following portfolios are covered by the Standardised Duration approach for calculation of Market Risk: • Securities held under the Held for Trading (HFT) and Available for Sale (AFS) categories. • Derivatives entered into for hedging HFT&AFS securities and Derivatives entered into for Trading.
2) Market Risk Management Departments (MRMD)/Mid-Office have been put in place based on the approval accorded by the respective Boards of Banks and other subsidiaries for their Risk Management Structure. Market risk units are responsible for identification, assessment, monitoring and reporting of Market Risk in Treasury Operations.
3) Board approved Trading Policies and Investment Policies with defined Market Risk Management parameters for each asset class are in place. Risk monitoring is an ongoing process with the position reported to the Top
Management and the Risk Management Committee of the Board at stipulated intervals.
4) Risk Management and reporting is based on parameters such as a Modified Duration, Price Value of Basis Point (PVBP), Maximum permissible Exposures, Net Open Position limits, Gap limits, Value at Risk (VaR) etc, in line with the global best practices.
5) Respective Foreign Offices are responsible for risk monitoring of their investment portfolio as per the local regulatory requirements. Stop loss limit for individual investments and exposure limits for certain portfolios have been prescribed.
Minimum Regulatory Capital requirements for market risk as on 31.03.2008 is as under: (Rs in crores) • Interest rate risk : 2270.46
• Equity position risk : 1906.82
• Foreign exchange risk : 83.30
Total : 4260.58
TABLE DF-9 : OPERATIONAL RISK:
Operational Risk Management
Operational risk is the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. Operational risk includes legal risk but excludes strategic and reputational risks.
The Operational Risk Management Policy of the Bank establishes a consistent framework for systematic and proactive identification, assessment, measurement, monitoring and mitigation of operational risk. The policy applies to all business and functional areas within the Bank. The Operational Risk Management Policy is supplemented by operational systems,
procedures and guidelines which are periodically updated.
The objective of the Bank’s Operational Risk Management Policy is to continuously review systems and control mechanisms, proper alignment of risk management activities with business strategy and between the risk and finance functions, create awareness of operational risk throughout the Bank, assign risk ownership, compliance with regulations and improve quality of products and services and mitigate operational risks.
The Operational Risk Management Department is functioning in SBI as well as each of the Banking Subsidiaries as part of the Integrated Risk Governance Structure under the control of their respective Chief Risk Officers.
The Bank has put in place the following measures to control and mitigate operational risks:
The Bank has issued a “Book of Instructions”, which contains detailed procedural guidelines for processing various banking transactions. Amendments and modifications to these guidelines are implemented through circulars sent to all offices. Guidelines and instructions are also disseminated through job cards, e-circulars, training programs, etc. The Bank has issued necessary instructions to all offices regarding delegation of financial powers, which detail sanctioning powers of various levels of officials for different types of financial transactions
About 90% of the branches (covering 98% of the business) of State Bank of India have been brought under Core Banking System (CBS). The remaining branches are also being brought under CBS in a time bound manner. All branches of the Banking Subsidiaries are already under CBS.
Training of staff – Inputs on Operational Risk are included as part of Risk Management modules in the training programs conducted for various categories of staff at Bank’s apex training institutes and learning centres.
Insurance – The Bank has obtained Insurance cover for potential operational
A system of prompt submission of reports on frauds is in place in the Bank. A comprehensive system of preventive vigilance has been established in all business units of the Group.
The Bank’s Inspection & Management Audit Department periodically conducts risk based audits and evaluates adequacy and effectiveness of the control systems and the functioning of various control procedures. It also conducts review of the systems established to ensure compliance with legal and regulatory requirements, codes of conduct and the implementation of policies and procedures.
Risk and Control Self Assessment (RCSA) process is being rolled out in both domestic as well as international offices for identification, assessment, control and mitigation of operational risks in the Bank. The process of building a comprehensive database of losses due to Operational Risks has been initiated with a view to graduate to Advanced Measurement Approaches for Operational Risk Management.
TABLE DF-10 :
INTEREST RATE RISK IN THE BANKING BOOK (IRRBB)
1. Qualitative Disclosures
Interest rate risk refers to fluctuations in Bank’s Net Interest Income and the value of its Assets and Liabilities arising from internal and external factors. Internal factors include the composition of the Bank’s assets and liabilities, quality, maturity, interest rate and re-pricing period of deposits, borrowings, loans and investments. External factors cover general economic conditions. Rising or falling interest rates impact the Bank depending on Balance Sheet positioning. Interest rate risk is prevalent on both the asset as well as the liability sides of the Bank’s Balance Sheet.
The Asset – Liability Management Committee (ALCO) which is responsible for
evolving appropriate systems and procedures for ongoing identification and analysis of Balance Sheet risks and laying down parameters for efficient management of these risks through Asset Liability Management Policy of the Bank. ALCO, therefore, periodically monitors and controls the risks and returns, funding and deployment, setting Bank’s lending and deposit rates, and directing the investment activities of the Bank. ALCO also develops the market risk strategy by clearly articulating the acceptable levels of exposure to specific risk types (i.e. interest rate, liquidity etc). The Risk Management Committee of the Board of Directors (RMCB) oversees the implementation of the system for ALM and review its functioning periodically and provide direction. It reviews various decisions taken by the Asset – Liability Management Committee (ALCO) for managing market risk.
1.1 Interest rate risk exposure is measured with Interest Rate Gap analysis, Simulation, Duration and Value-at-Risk (VaR). RBI has stipulated monitoring of interest rate risk at monthly intervals through a Statement of Interest Rate Sensitivity (Repricing Gaps) to be prepared as the last Reporting Friday of each month. Accordingly, ALCO reviews Interest Rate Sensitivity statement on monthly basis.
1.2 Interest rate risk in the Fixed Income portfolio of Bank’s investments is managed through Duration analysis. Bank also carries out Duration Gap analysis (on quarterly basis) to estimate the impact of change in interest rates on economic value of Bank’s assets and liabilities and thus arrive at changes in Market Value of Equity (MVE).
1.3 The following prudential limits have been fixed for monitoring of various interest risks:
Changes on account of Maximum Impact
Interest rate volatility (as % of capital and reserve)
Changes in Net Interest Income
(with 1% change in interest rates
for both assets and liabilities) 5%
Change in Market value of Equity
(with 1% change in interest rates
for assets and liabilities) 20%
1.4 The prudential limit aims to restrict the overall adverse impact on account of market risk to the extent of 20% of capital and reserves, while part of the remaining capital and reserves serves as cushion for credit and operational risk.
Duration Gap: The impact of interest rate changes on the Market Value of Equity is monitored through Duration Gap analysis by recognising the changes in the value of assets and liabilities by a given change in the market interest rate. The change in value of equity (including reserves) with 1% parallel shift in interest rates for both assets and liabilities needs to be estimated. Maximum limit up to which the value of the equity (including reserves) will get affected with 1% change in interest rates to be restricted to 20% of capital and reserves.
2. Quantitative Disclosures
Earnings at Risk (EaR)
Assets Liabilities Impact on NII
Lending rate / yield Term Deposit / 1953.49
on investment Borrowing Cost
increase by 100 bps. increases by 100 bps.
Market Value of Equity (MVE) As at March 2008
Impact on Market Value of Equity (MVE) 2367.96
Minimum Regulatory Capital requirements for market risk as on 31.03.2008 is as under: (Rs in crores)
• Interest rate risk : 2270.46
• Equity position risk : 1906.82
• Foreign exchange risk : 83.30
Total : 4260.58
ICICI Bank (BSE: ICICI) (formerly Industrial Credit and Investment Corporation of India) is India’s largest private sector bank in market capitalization and second largest overall in terms of assets. Bank has total assets of about USD 100 billion (at the end of March 2008), a network of over 1,399 branches, 22 regional offices and 49 regional processing centres, about 4,485 ATMs (at the end of September 2008), and 24 million customers (at the end of July 2007). ICICI Bank offers a wide range of banking products and financial services to corporate and retail customers through a variety of delivery channels and specialised subsidiaries and affiliates in the areas of investment banking, life and non-life insurance, venture capital and asset management.
(These data are dynamic.) ICICI Bank is also the largest issuer of credit cards in India. . ICICI Bank has got its equity shares listed on the stock exchanges at Kolkata and Vadodara, Mumbai and the National Stock Exchange of India Limited, and its ADRs on the New York Stock Exchange (NYSE). The Bank is expanding in overseas markets and has the largest international balance sheet among Indian banks. ICICI Bank now has wholly-owned subsidiaries, branches and representatives offices in 18 countries, including an offshore unit in Mumbai.
This includes wholly owned subsidiaries in Canada, Russia and the UK (the subsidiary through which the hisave savings brand is operated), offshore banking units in Bahrain and Singapore, an advisory branch in Dubai, branches in Belgium, Hong Kong and Sri Lanka, and representative offices in Bangladesh, China, Malaysia, Indonesia, South Africa, Thailand, the United Arab Emirates and USA. Overseas, the Bank is targeting the NRI (Non-Resident Indian) population in particular. ICICI reported a 1.15% rise in net profit to Rs. 1,014.21 crore on a 1.29% increase in total income to Rs. 9,712.31 crore in Q2 September 2008 over Q2 September 2007. The bank’s current and savings account (CASA) ratio increased to 30% in 2008 from 25% in 2007. BASEL REQUIREMENTS
Pillar 3 disclosures apply o ICICI Bank Limited and its consolidated entities, wherein ICICI Bank Limited is the controlling entity in he group. It has observed the rules and regulations of BASEL II with respect to Pillar III of market disclosures in context of capital adequacy framework, capital structure, amount of Tier- 1 capital, Tier- 2 capital, Non performing Loans, credit risk, securitization, market risk, operational risk, Interest rate risk. 1. CAPITAL STRUCTURE
a. Amount of Tier-1 capital (September 30, 2008)
Tier-1 capital elements
Paid – up share capital/common stock
Innovative Tier-1 capital instruments
Gross Tier-1 capital
Investment in instruments eligible for regulatory capital of Financial subsidiaries/associates 57.69
Intangible assets other than goodwill
Securitisation exposures including credit enhancements
Net Tier-1 capital
1. Includes preference shares permitted by RBI for inclusion in Tier-1 capital. 2. Includes statutory reserves, disclosed free reserves and capital reserves. 3. Includes losses and deferred tax assets and unamortized early retirement options.
b. Amount of Tier-2 capital (September 30, 2008)
Tier-2 capital elements
General provisions & loss reserves
Upper Tier-2 instruments
Lower Tier-2 instruments
Gross Tier-2 capital
Investment in instruments eligible for regulatory capital of Financial subsidiaries/associates 57.69
Securitisation exposures including credit enhancements
Net Tier-2 capital
Pursuant to clarification received from RBI, Upper Tier II capital bonds of US$ 750 mn issued in January 2007 are included in Tier-II capital
c. Debt capital instruments eligible for inclusion in Tier-1 and Tier-2 capital
Tier – 1 capital
Total amount outstanding at september30,2008
Amount raised for the period
Amount eligible to be reckoned as capital funds
Amount (in billions)
Eligible Tier-1 capital
Eligible Tier-2 capital
Total Eligible capital
2. CAPITAL ADEQUACY
a. Capital requirements for various risk areas (September 30, 2008) Risk area
-Portfolio subject to standardized approach
-for interest rate risk
-For foreign exchange risk(including gold)
-For equity position risk
Total capital requirements at 9%
Total capital funds of the bank
Tosl risk weighted assets
Capital adequacy raio
3. CREDIT RISK
Fund based facilities
Non-Fund based facilities
Credit exposure includes exposure towards term loans, working capital facilities (i.e. funded facilities like cash credit, demand loan, temporary limits and non-funded facilities like letter of credit, acceptances, financial guarantee, performance guarantee etc.), sell-down, derivatives, credit derivatives and investments that are held-to-maturity. Claims on sovereign (to the extent of Rs. 539.61 billion) and investments covered under specific market risk have been excluded.
4. CREDIT RISK: PORTFOLIOS SUBJECT TO THE TANDARDIZED APPROACH
a. Credit exposures by risk weights
The table below discloses the amount of credit exposures in three major risk buckets Exposure category
Less than 100% risk weight
100% risk weight
More than 100% risk weight
Deducted from capital
Includes credit exposures and excludes claims on sovereign and investments covered under specific market Risk.
5. CREDIT RISK MITIGATION
a. Portfolio covered by eligible financial collateral. The table below details the total exposure that is covered by eligible financial collateral as at September 30, 2008.
Exposures covered by financial collateral
Exposure before use of credit risk mitigation techniques
Exposure after use of credit risk mitigation techniques
Break-up of total outstanding exposures securitized by exposure type (September 30, 2008). Exposure type
Amount (in billions)
Home & home equity loans
a. Deals originated in the period where the Bank does not have any retained exposure 4,750.0
b. Deals originated in the period where the Bank has retained exposure and deals originated prior to current year 9,850.8
1. The amounts represent the outstanding principal as on September 30, 2008 for securitization deals. 2. The figures exclude direct assignments.
7. MARKET RISK IN TRADING BOOK
a. Capital requirements for market risk (September 30, 2008) Risk category
– for interest rate risk
– for foreign exchange (including gold) risk
– for equity position risk
8. INTEREST RATE RISK IN THE BANKING BOOK (IRRBB)
a. Level of interest rate risk
The following table sets forth, using the balance sheet as at September 30, 2008 as the base, one possible prediction of the impact of changes in
interest rates on net interest income for the period ending September 30, 2009, assuming a parallel shift in the yield curve:
Citibank is a major international bank, founded in 1812 as the City Bank of New York, later First National City Bank of New York. Citibank is now the consumer banking arm of financial services giant Citigroup, one of the largest companies in the world. As of March 2007, it is the largest bank in the United States by holdings. Citibank has operations in more than 100 countries and territories around the world. More than half of its 1,400 offices are in the United States, mostly in the New York City, Chicago, Miami, and Washington, D.C. metropolitan areas, as well as in California.
In addition to the standard banking transactions, Citibank offers insurance, credit card and investment products. Their online services division is among the most successful in the field, claiming about 15 million users. As a result of the global financial crisis and huge losses in the value of its subprime mortgage assets, Citibank was rescued by the U.S. government under plans agreed for Citigroup. On November 23, 2008, in addition to initial aid of $25 billion, a further $25 billion was invested in the corporation together with guarantees for risky assets amounting to $306 billion.
Following its merger with the First National Bank, the bank changed its name to The First National City Bank of New York in 1935, then shortened it to First National City Bank in 1952. The company organically entered the leasing and credit card sectors, and its introduction of USD certificates of deposit in London marked the first new negotiable instrument in market since 1888. Later to become part of MasterCard, the bank introduced its First National City Charge Service credit card – popularly known as the “Everything Card” – in 1967. During the mid-1970s, under the leadership of CEO Walter Wriston, First National City Bank (and its holding company First National City Corporation) was renamed as Citibank, N.A. (and Citicorp, respectively). By that time, the bank had created its own “one-bank holding company” and had become a wholly owned subsidiary of that company, Citicorp (all shareholders of the bank had become shareholders of the new corporation, which became the bank’s sole owner).
The name change also helped to avoid confusion in Ohio with Cleveland-based National City Bank, though the two would never have any significant overlapping areas except for Citi credit cards being issued in the latter National City territory. (In addition, at the time of the name change to Citicorp, National City of Ohio was mostly a Cleveland-area bank and had not gone on its acquisition spree that it would later go on in the 1990s and 2000’s.) Any possible name confusion had Citi not changed its name from National City eventually became completely moot when PNC Financial Services acquired the National City of Ohio in 2008 as a result of the subprime mortgage crisis.
Citibank, N.A. (National Association) – The “original” Citibank, primarily doing business in New York State and the tri-state New York City metropolitan area. Also the parent company of the other subsidiaries. Citibank Canada.
Citibank Texas, N.A. – The former First American bank.
Citibank (West), F.S.B. – The former Citicorp Savings (a savings and loan operating in California), as well as the former California Federal Bank and Golden State Bank. Citibank, F.S.B. – The primary Citibank subsidiary serving all other states, based in Chicago. Citibank Banamex USA – Formally
California Commerce Bank, Banamex’s U.S. banking division. Citibank (South Dakota), N.A. – A credit card and lending-only bank based in Sioux Falls, South Dakota, including the former Associates National Bank. Universal Financial Corp. – A credit card bank, purchased in 1997, that manages the AT&T Universal Card. BASEL REQUIREMENTS
Pillar 3 disclosures apply CITI Bank Limited and its consolidated entities. It has observed the rules and regulations of BASEL II with respect to Pillar III of market disclosures in context of capital adequacy framework, capital structure, amount of Tier- 1 capital, Tier- 2 capital, Capital Adequacy, credit risk, securitization, market risk, operational risk, Interest rate risk.
1. CAPITAL STRUCTURE
Tier-1 capital elements
Interest-free Funds from Head office
Operating Surplus in Current year
Debit balance in Head office account
Deferred Tax asset
Credit enhancement on securitization (50%)
Tier I capital
Property Revaluation Reserves
General Loss Provision on standard assets
Sub-ordinated term debt
Credit Enhancement on securitizaion (50%)
Tier II capital
Total capital funds
CAPITAL REQUIREMENTS FOR CREDIT RISK
Generally includes exposures to banks, Financial institutions and corporate. 540,601
Generally include exposures o individuals and households small businesses of
a retail nature 246,635
Includes exposure in the nature of direct investment in securitized paper and includes credit enhancement which is reduced from capital funds 200
CAPITAL REQUIREMENTS FOR OPERATIONAL RISK
Per the basic indicator approach for operational risk the bank is required to maintain capital at the rate of 15% of average gross income of previous three years. The risk weighted assets for operational risk are calculated by dividing the operational risk capital charge by 9%. The capital requirement for operational risk is Rs. 6,607 millions.
2. CAPITAL ADEQUACY RATIO
Total capital ratio
Tier 1 capital ratio
3. CREDIT RISK
Amount of NPAs (Gross)
Rs. In millions
The reason of not following of all the rules and regulations are as follows: Basel II displays a confusing or at least insufficient treatment in the matter of provisions; it does not particularly consider liquidity or interest rate risks; nor it contemplates to attenuation of credit risks by means of portfolio diversification; nor does it set down a specific treatment for exchange rate risks.
Since the size plays a crucial role here, in the absorption of high implementation costs required for the advanced approaches (systems development, hardware update, hiring and skilling of proficient staff, etc.).
It is indeed credit institutions with greater spread who can end up being beneficiaries of the implementation of these approaches, which are able to generate a reduction in capital integration requirements.
LDC do not posses developed credit informative systems, or at least have relative trustworthiness, which is why it will require a certain amount of time to develop consistent databases that allow for the estimation of parameters to be applied in the new adequacy standard.
Correspondingly, it turns banking supervision more complex and more expensive. In addition, it is hindered by the given shortage of highly skilled human resources, especially in LDC. For example, in Latin America, a
few years ago it was considered that 60% of controlling agents required that they be especially skilled.
It must be recognized that Basel Regulation Committee responded the different critics formulated and introduced more flexibility in the scheme by allowing the adoption of different approaches, even, the combination of such (i.e. IRB approach for internationally active banks and the simplified standard approach for the rest of the financial system).
Additional difficulties of enforcement appear in these economies, especially given the little diffusion in terms of external rating systems and the lack of reliable statistical records, necessary for the construction of risk models.
SUGESSTIONS & RECOMMENDATIONS
First of all, the success of Basel II requires strong and developed financial system. The views of the International Monetary Fund clearly indicates that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources from the more urgent priorities, ultimately widening rather than strengthening supervision. Such Premature adoption of Basel II by the world economies poses many problems. There are the risks associated with the “too quickly and too ambitious” approach of moving towards Basel II. What is important in going forward is to be able to strengthen there financial system and focus on achieving greater level of compliance with the Basel Core Principles.
Second, the success of Basel II depends exclusively on the availability of the reliable, accurate and the timely reporting of data. For this data intensive Capital Accord, the non availability of the good quality data is a challenge to effective Basel II implementation. The uncalculated, overestimated / underestimated risks can nullify the whole efforts in this context. It has to be acknowledged that the existing data is not fully comprehensive to serve the purpose.
Moreover, the human minds are needed to interpret the data for decision-making. Just as bias can affect the collection of data, it can also effect its interpretation. Those who are skilled at decision-making will give better results than those whose judgments are poor. The human resources are the “tools” for the gradual implementation of Basel II. Courses should be offered by the business schools, education institutions and banks training institutions to make the human resources more skillful in qualitative studies and quantitative techniques.
In addition to the credit rating institutions, the developing countries need to exploit more effectively the role of the auditors of the borrowing entity
The third important issue is the asymmetry in regulatory regime amongst the different segments of the financial sector viz, banking, securities firms and insurance sector. In many developing countries only the banks are required to comply with Basel II, and not the other financial services providers. Such a discriminatory treatment may jeopardize whole developmental efforts, as all these financial institutions together determine the financial stability in the economy.
One of the most difficult aspects of implementation is the cross-border challenges. With the openness of the economies, capital flows freely among the world economies. The conclusion derived from empirical evidence is that there will be a decline in credit flows from banks of developed countries to the developing countries because of the higher risk perception of their financial system, and lack of appropriate rating and risk-management systems. There is dire need to find a robust and a workable solution to this potential threat to the world economies.
As seen above, I concluded that risk management is considered in the banking sector in India. According to the three banks taken, the observation states that the Banks take the appropriate measures to mitigate the risk like credit risk, market risk, operational risk and various other risks, but the methods which are recommended under the Basel Accords are not fully confirmed as this research is purely based upon he secondary data received.
In other words, There are other methods also, which are undertaken to mitigate the risk in the banking Industry such as hedging, Insurance etc, or by changing its strategies of doing business like capital structure, asset allocation ,hiring, training, service mix, pricing, securitisation, incentive programs, products, technology, internal control, market strategy, distribution, sound internal audit system, appropriate management information system etc which have not been covered in this research but generally are undertaken by every bank.
In wrapping up, I would emphasize that implementation of Basel II should help supervisors and market participants better detect increases in risk in individual institutions and across the financial system through a more risk Sensitive capital measure. Basel II also promises to reinforce and accelerate improvements in bank risk management globally, as well as promote future innovations through its reliance on banks’ internal methodologies. How well these improvements unfold will depend critically on the actions of supervisors in integrating the new regulatory capital requirements with their overall supervisory and regulatory approach. While conducting the research, certain inherent problems arises which includes:
Chances of error might rise, as the data used in the research is in secondary form. Time factor is the major factor to create limitation
Information based on websites of banks are very difficult to analyze.
Future of Risk Management in Indian Banking Industry- By Aashika Agarwal & Sudhir Sirohy NEWSPAPERS
The Economic Times
The Times of India