Presentation by S P Dhal, Faculty Member, SPBT College

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Risk Management in Banks
Module B
Live Interactive Learning Session

• Presentation by S P Dhal, Faculty Member, SPBT
  College

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(No Transcript)
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What is Risk?

• Risk is the probability that the realised return
  would be different from the anticipated/expected
  return on investment.
• Risk is a measure of likelihood of a bad
  financial outcome.
• All other things being equal risk will be
  avoided.
• All other things are however not equal and that a
  reduction in risk is accompanied by a reduction
  in expected return.

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What is Risk?

• The uncertainties associated with risk elements
  impact the net cash flow of any business or
  investment. Under the impact of uncertainties,
  variations in net cash flow take place. This
  could be favourable or un-favourable. The
  un-favaourable impact is RISK of the business.

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Anatomy of Bank Risk
Financial Risk
Non-Financial Risk
Business Risk
Strategic Risk
Delivery (of Financial Services) Risk
Balance Sheet Risk
Operational Risk
Legal Risk
Reputational Risk
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Balance Sheet Risk
Credit Risk
Market Risk
Concentration Risk
Intrinsic Risk
Commodity Risk
Interest Rate Risk
Liquidity Risk
Currency Risk
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Interest Rate Risk
Price Risk
Reinvestment Risk
Yield Curve Risk
Basis Risk
Gap Risk
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Risk in Traditional Sense

• Systematic Risks
• Affects all Industry/ All securities
• Non-controllable
• Non-diversifiable
• Unsystematic Risks
• Affects specific Industry/ Specific Securities
• Controllable
• Diversifiable

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Risk in Banking Business

• Banking business is broadly grouped under
  following major heads from Risk Management point
  of view
• The Banking Book
• The Trading Book
• Off-Balance-sheet Exposures

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The Banking Book

• All assets liabilities in banking book have
  following characteristics
• 1. They are normally held until maturity
• 2. Accrual system of accounting is applied
• Since assets liabilities are held till
  maturity, their mismatch may land the bank in
  either excess cash in-flow or shortage of cash on
  a particular time. This commonly known as
  Liquidity Risk.

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The Banking Book

• Due to change in interest rates, assets and
  liabilities are subjected to interest rate risk
  on their maturities/re-pricing.
• Further, the assets side of the banking book
  generates credit risk arising from defaults in
  payment of interest and or installments by the
  borrowers.
• In addition to all these risk, banking book also
  suffers from Operational Risk.

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The Trading Book

• The trading book includes all the assets that
  are held with intention of trading that are
  marketable. They are normally held for a short
  duration and positions are liquidated in the
  market. Trading Book assets include investment
  held under Held for Trading category.
• They are subjected to Market Risk and are marked
  to market.

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Off-Balance-Sheet Exposure

• Off-balance sheet exposure is contingent in
  nature- Guarantees, LCs, Committed or back up
  credit lines etc.
• A contingent exposure may become a fund-based
  exposure in Banking book or trading book.
• Therefore, Off-balance sheet exposures may have
  liquidity risk, interest rate risk, market risk,
  credit or default risk and operational risk

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RISKS IN BANKING

• Risk is inherent in Banking
• Banking is not avoiding risks but managing it
• Risks in banking can be of Broadly 3 types
• Credit Risk
• Market Risk
• Operational Risk
• ALM addresses to Market Risks

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Risk Management in Banks Basel Accord I, 1988

• In 1988, Basel Committee on Banking Supervision,
  published a framework for a minimal capital
  requirement for credit exposure. The bank books
  were classified into 5 buckets i.e. grouped under
  5 categories according to credit risk weights of
  zero, ten, twenty, fifty and one hundred percent.
• Assets required to be classified into one of
  these risk buckets based on the parameter of
  counter party.
• Banks required to hold capital equal to 8 of
  the risk-weighted value of assets. In India, the
  minimum capital requirement is 9 as decided by
  RBI.

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1996 Amendment to include Market Risk

• In 1996, BCBS published an amendment to provide
  an explicit capital cushion for Market Risk to
  which banks are exposed.
• Market Risk is the risk of adverse deviations of
  the marked-to-market value of the assets due to
  market movements as a result of change in
  interest rates, market price or exchange rate.

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Basel II Accord- Need Goals

• Linking of risks with capital in terms of Basel
  Accord I needed a revision for the following
  reasons
• - Credit assessment under Basel I is not risk
  sensitive enough. One Suit fit all approach was
  applied all types of entity with 100 risk
  weightage.
• - Risk arising out of operation were ignored
  though it has potential of affecting the banks
  survival.

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Basel Accord II

• The Basel II Accord is based on three pillars
• Minimum Capital Requirement
• Supervisory review process
• Market discipline

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The New Basel Capital Accord
Three Basic Pillars
Market Discipline Requirements
Minimum Capital Requirement
Supervisory Review Process
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1. Minimum Capital Requirements- Credit Risk
   (Pillar One)

• Standardized approach (External Ratings)
• Internal ratings-based approach
• Foundation approach
• Advanced approach
• Credit risk modeling (Sophisticated banks in the
  future)

Minimum Capital Requirement
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The New Basel Capital Accord

• Standardized Approach
• Provides Greater Risk Differentiation than 1988
• Risk Weights based on external ratings
• Five categories 0, 20, 50, 100, 150
• The loans considered past due be risk weighted
  at 150 percent unless a threshold amount of
  specific provision has already been set aside by
  the bank against the loan
• Special treatment for retail SME sectors

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The New Basel Capital Accord
Capital for Credit Risk- Internal Rating Based
Approach

• Three elements
• Risk Components PD, LGD, EAD
• Risk Weight conversion function
• Minimum requirements for the management of
  policy
• and processes
• Emphasis on full compliance
• Definitions
• PD Probability of default conservative view
  of long run average (pooled) for borrowers
  assigned to a RR grade.
• LGD Loss given default
• EAD Exposure at default
• Note BIS is Proposing 75 for unused
  commitments
• EL Expected Loss

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The New Basel Capital Accord

• Market Risk
• (a) Standardised Method
• (i) Maturity Method
• (ii) Duration Method
• (b) Internal Models Method

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The New Basel Capital Accord

• Capital Charge for Operational Risk-
• As in credit, three alternate approaches are
  prescribed
• - Basic Indicator Approach
• - Standardised Approach
• - Advanced Measurement Approach

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Capital Charge for Operational Risk- Basic
Indicator Approach

• To begin with, RBI has advised bank to follow
  Basic Indicator Approach in India which is 15 of
  the average Gross Income over three year.

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• KBIA ? (GI?) / n,
• Where
• KBIA the capital charge under the Basic
  Indicator Approach.
• GI annual gross income, where positive,
  over the previous three years
• 15 set by the Committee, relating the
  industry-wide level of required capital to the
  industry-wide level of the indicator.
• 15 set by the Committee, relating the
  industry-wide level of required capital to the
  industry-wide level of the indicator.
• n number of the previous three years for which
  gross income is positive
• Gross income Net profit () Provisions
  Contingencies () operating expenses
  (Schedule 16) (-) profit on sale of HTM
  investments (-) income from insurance (-)
  extraordinary / irregular item of income () loss
  on sale of HTM investments.

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New Basel Accord II supervisory review process-

• Defines the role of supervisors with regard to
  capital adequacy

Pillar II
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New Basel Accord II Market Discipline

• Disclosure requirements that allow market
  participants to assess key information about a
  banks risk profile and level of capitalisation.

Pillar-III
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Value at Risk

• VaR is defined as the predicted worst-case loss
  at a specific confidence level over a certain
  period of time assuming normal trading
  conditions.
• That means, we can incur loss a maximum of Rs. X
  (the VaR) over the next one week (time period)
  and, may expect with 99 confidence level (i,.e.
  it would be so 99 times out of 100).

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Advantages of VaR

• It captures an important aspect of risk
• in a single number
• It is easy to understand
• It asks the simple question How bad can things
  get?

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Q. A Bank reports a one-week VaR of 1M at the
95 confidence level. Which of the following
statements is most likely to be true?
  (a) The daily return on the company
portfolio follows a normal distribution so that
a one-week VaR could be computed. (b) The
one week VaR at the 99 confidence level is
5M. (c) With probability 95, the company
will not experience a loss greater than 95M in
one week. (d) With probability 5, the
company will loose 1M or more in one week.

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Q. Risk Weight of 2.5 on Government Bonds is
introduced to address

• (a). Credit Risk
• (b). Operational Risk
• (c). Market Risk
• (d). Counter Party Risk

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Q. Reserve Bank of India has advised Banks to
build up an Investment Fluctuation Reserve (IFR)
of a minimum 5 per cent of their investments in
the categories Held for Trading (HFT) and
Available for Sale (AFS). The specification is
to take care of following Risk.

• (a). Interest Rate Risk
• (b). Operational Risk
• (c). Credit Risk
• (d). None of above

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Q. Netting is a method of aggregating two or
more obligations to achieving a reduced net
obligation. The benefits accrues from Netting
is

• (a). Reduced Credit Risk
• (b). Liquidity Risk
• (c). Systemic Risk
• (d) All of the above

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Q. How is the risk of so-called catastrophic
losses dealt with?

• (a). Through RAROC models.
• (b). Through VaR, preferably delta- gamma
  approach.
• (c). By proper Disaster Recovery Plan
  Business Continuity Plan in place.
• (d). By mitigation, with reserves in capital.

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Q. Money market funds are generally considered
to have ______ interest rate risk,and______
default risk.

• (a). low low
• (b). low high
• (c). high low
• (d). high high

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Q. The June 1999 Basle Committee on Banking
Supervision issued proposals for reform of its
1988 Capital Accord (the Basle II Proposals).
These proposals contained MAINLY

• I. Settlement risk management
• II. Capital requirements
• III. Supervisory review
• IV. The handling of hedge funds
• V. Contingency plans
• VI. Market discipline

(a). I, III and VI (b). II, IV and V (c). I, IV
and V (d). II, III and VI
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Q. If the default probability for an A-rated
company over a three year period is 0.30, then
the most likely probability of default for the
same company over a six year period is

• (a). 0.30
• (b). Between 0.30 and 0.60
• (c). 0.60
• (d). Greater than 0.60

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Q. Which of the following procedures is
essential in validating the VaR estimates.

• (a) Back Testing
• (b) Scenario Analysis
• (c) Stress Testing
• (d) Once approved by regulators no further
  validation is required.

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Q. Loans are securitized to

• (a) Reduce credit concentrations.
• (b) Reduce regulatory capital.
• (c) Provide access to loan products for
  investors.
• (d) All of the above.

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THANK YOU