Risk Management Module D Capital Management

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Risk ManagementModule DCapital
ManagementProfit planning

• By S.G.Savadatti
• savadatti_at_iibf.org.in

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Balance Sheet
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Principles

• Liabilities- Taken at book value
• Assets - The lower of book value or market
  value
• Minimum capital should be adequate to absorb the
  maximum loss that is likely to occur.
• It means, others money is treated as more
  sacrosanct.
• Thus, capital in a business is regarded as a
  surrogate for the financial strength of the
  business.
• What then is minimum capital? To know that,
  one
• needs to assess the loss that is likely to
  occur.
• This leads us to the concept of risk
  weights.

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Basel-1

• Addressed mainly credit risk and
  
  
  
• defined components of capital
• assigned risk weights to different types
• of assets
• assigned credit conversion factors to off-balance
  sheet items and
• bench marked minimum ratio of
  capital to risk
  weighted assets
• Risk weight norms under Basel 1 were of a
  straightjacket nature. The Basel- II accord
  addresses this shortcoming by emphasizing on the
  credit rating methodologies.

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The Basel - II Accord

• 1st Pillar- Minimum capital requirements
• Replaces existing one-size-fits-all frame
  work with several
• options for banks.
• 2nd Pillar- Supervisory review process
• Provides guidelines for supervisors for
  effective implementation.
• 3rd Pillar- Market discipline
• Clamps disclosure norms about risk
  management practices.
• The revised accord provides incentives to
  banks to improve
• their risk management systems.

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Components of Capital

• Regulatory capital would consist of
• Tier-I or core capital (paid up capital, free
  reserves unallocated surpluses, less specified
  deductions.)
• Tier-Il or supplemental capital (subordinated
  debt gt 5yrs., loan loss reserves, revaluation
  reserves, investment fluctuation reserves, and
  limited life preference shares ) and
• Tier- III capital (short term subordinated debt
  gt2yrs lt 5yrs solely for meeting a proportion of
  market risk.)
• Tier II capital restricted to 100 of Tier-I
  capital
• Long term subordinated debt to be lt 50 of
  tier-I capital
• Tier III to be less than 250 of Tier-I capital
  assigned to market risk,
• i.e., a minimum of 28.5 of market risk must be
  covered by tier-I
• 
  

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Pillar-1 Minimum Capital Requirements

• The total capital ratio must not be lower than 8
• The scope of risk weighted assets is expanded to
  include certain additional aspects of market risk
  and also operational risk.
• For the first time, operational risk is
  brought under the ambit of risk- weighted
  assets
• Thus, total risk-weighted assets
  Risk weighted assets for credit risk
• 
  12.5 Capital for market risk
• 
  12.5 Capital for operational risk
• Minimum capital requirement is calculated in
  three steps
• Capital for credit risk
• Capital for market risk
  and
• Capital for operational risk

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Pillar- I MCR CAPITA L FOR CREDIT RISK

• a Standard approach
• Based on ratings of External Credit
  Assessment Institutions ( ECAI ), satisfying
  seven requisite criteria and to be approved by
  national supervisors. A simplified standard
  approach (SSA) is also put in place.
• Internal rating based ( IRB) approaches
  
• Based on the banks internal assessment of key
  risk parameters such as,
• probability of default ( PD), loss given at
  default ( LGD ), exposure
  at default ( ED), and effective maturity ( M )
  etc.
• b Foundation approach and
• c Advanced approach
• Banks, however, cannot determine all the
  above four parameters. .In foundation approach,
  banks estimate PD and supervisors decide the
  other parameters.In the Advanced approach, banks
  have more say on all the parameters as well.

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Pillar- I MCR CAPITA L FOR MARKET RISK

• The risk of losses in on-balance sheet and
  off-balance sheet positions arising from
  movements in market prices.
• Following Market risk positions require capital
  charge
• Interest rate related instruments in trading
  book
• Equities in trading book and
• Forex open positions

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Pillar- I MCR CAPITA L FOR MATKET RISK

• The minimum capital required comprises two
  components
• Specific charge for each security
  and
• General market risk charge towards
• interest rate risk in the portfolio
• Capital charge for interest rate related
  instruments
• Banks have to follow specific capital charges
  prescribed by
• RBI for interest rate related instruments as
  given on page nos.315 316
• of the text book. These charges range from 0
  to 9 for different
• instruments and for different maturities.
• As regards general market risk, RBI has
  prescribed duration method
• to arrive at the capital charge for market
  risk ( modified duration ).

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Pillar- I MCR CAPITA L FOR OPERATIONAL RISK

• There is a general perception that the
  operational
• risks are on the rising path
• The downfall of Barings Bank is mainly
  attributed to operational risk. Operational risk
  would vary with the volume and nature of
  business. It may be measured
• as a proportion of gross income.
• Operational risk is the risk of loss resulting
  from inadequate or failed internal processes,
  people and systems or from external events.
• 
  Contd.

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Pillar- I MCR CAPITA L FOR OPERATIONAL RISK
(Contd.)

• Capital charges for operational risks
• Basic Indicator Approach
• Average over the three years of a fixed
  percentage (denoted v by Alfa, presently 15 ) of
  positive annual gross income.
• Standardised Approach
• Here, banks activities are divided into eight
  business lines such as corporate finance, retail
  banking, asset management etc. Each business line
  is assigned a factor say, Beta, which determines
  the capital requirement for that business line.
  Average for three years gives capital for
  operational risks.
• Advanced Management Approach
• Here, banks internal risk measurement system is
  used after due vetting by the supervisor. As a
  minimum five year observation period of internal
  loss data is required this method may evolve over
  a period of time.

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Prevention and control of operational risks

• Personnel Ensure employee integrity, domain
  knowledge and efficiency through effective
  selection, training and promotion.
• Work Culture A value based ethical business
  approach
• Organisational structure Effective chain of
  command, compliances and redressal mechanism
• Audit and Internal Control Effective audits,
  mix of continuity and surprise checks.
• System Reviews and Revision Periodical reviews
  in the
• light of changing environment, legal frame
  work, experience etc.
• are essential.

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Pillar- II Supervisory Review Process

• Transparency and objectivity Hall marks of the
  process
• Two objectives
• Ensuring adequate capital of banks
• Encouraging banks to develop and
  implement
• better risk management practices
• (ICAAP- Internal Capital Adequacy
  Assessment
• Process ).
• The supervisory duties are guided by four
  principles

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Supervisory Review Process Four Principles

• 1. Banks should have rigorous processes to ensure
  
• adequate capital
• 2 Supervisors should review and evaluate risk
  management systems and strategies and take
  appropriate action whenever warranted.
• 3 Supervisors should expect banks to operate
  above the minimum regulatory capital levels to
  cover the uncertainties related to the system and
  bank specific uncertainties.
• 4 Supervisors should intervene and take
  immediate remedial action whenever a banks
  capital is sliding below the minimum regulatory
  capital.

.
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Pillar- II Supervisory Review Process

• The supervisory review process would invariably
  involve some amount of discretionary elements.
  Supervisors, must therefore take care to carryout
  their obligations in a transparent and
  accountable manner.

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Pillar- III Market Discipline

• Disclosure norms to enable the market to assess
  a banks position
• Market discipline contributes to a safe and sound
  banking environment.
• Disclosures under pillar-III have been ensured
  not to conflict with those required under
  accounting standards
• Information given under pillar-III to be
  consistent with that given in the audited
  statements.
• Banks to give all information in one place
• Disclosures to be on a semi-annual basis.
  However, critical information needs to be
  published on a quarterly basis.
  
• 
  Contd.

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Pillar- III Market Discipline (Contd.)

• Proprietary and confidential information need
  not be disclosed
• However, the bank must draw attention to the
  information that it has not disclosed and must
  state the reasons for the non-disclosure. The
  bank must, however,
• part with more general information on that
  subject matter.
• Banks should have a formal disclosure policy
  approved by the board
• Pillar-III prescribes qualitative and
  quantitative disclosures in this regard.

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Asset Classification and Provisioning norms

• An account is considered non-performing when
  interest / instalments remain unpaid for 90 days.
• Income recognition of non-performing assets to be
  on receipt basis and not on accrual basis.
• Assets to be classified as
• - Standard assets
• -Substandard assets
• -Doubtful assets and
• -Loss assets
• First stage of NPA is sub-standard category.
  Progressive deterioration drags it through the
  next classifications.

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Provisioning Norms

• NPA causes two fold impact on profitability.
  Firstly, asset ceases to earn interest, and
  secondly, provisions are to be created against
  the NPA based upon the asset classification and
  value of security if any.
• Depending on the age of the NPA, the
  classification changes. With the passage of time,
  recovery probability diminishes and provisioning
  requirement goes up.
• A non-performing asset backed with no security
  moves from sub-standard category to loss
  category.
• Provisioning requirements for Doubtful-III
  category and for loss category are the same i.e.
  at 100.

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Profit Planning

• Profitability is a function of six variables,
  viz.
• 1 Interest income 4
  Interest expenses
• 2 Fee based income 5 Staff
  expenses
• 3 Trading income 6 Other
  operating expenses
• Maximising the first three and
  
  
  minimising the others would boost
  profitability.
• 
  Contd.

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Profit Planning (Contd.)

• Banks have to optimise the allocation of funds
  amongst
• securities
• credit portfolios
• forex / bullion positions
• to achieve best possible results in terms of
  profitability and capital adeqacy.
• Fee-based income areas may have to be reworked
  with the introduction of new products and phasing
  out of out dated ones.

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GUIDELINES FOR IMPLEMENTATION OF THE NEW
CAPITAL ADEQUACY FRAMEWORKAPRIL, 2007. BASEL
II FINAL GUIDELINES

• All commercial banks ( excluding local area banks
  and RRBs )shall adopt
• Standardised approach for
  credit risk and
  Basic Indicator Approach for operational
  risk.
• Banks shall continue to apply standardised
  duration approach for market risk.

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GUIDELINES FOR IMPLEMENTATION OF THE NEW
CAPITAL ADEQUACY FRAMEWORKAPRIL, 2007. BASEL
II FINAL GUIDELINES

• Effective dates for
  migration
• Foreign banks in India and Indian banks with
  operational presence outside India to migrate to
  above selected approaches w.e.f. 31st March,
  2008.
• All other commercial banks are encouraged to
  migrate to these approaches not later than 31st
  March, 2009.

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Useful Reference Materials

• RBI GUIDELINES FOR IMPLEMENTATION OF THE NEW
  CAPITAL ADEQUACY FRAMEWORKAPRIL, 2007. BASEL
  II FINAL GUIDELINES
• Indias Preparedness for Basel II
  Implementation
• By V.Leeladhar, Dy. Governor
• Basel II and Credit Risk Management
• By V.Leeladhar, Dy.
  Governor
• ( The above two articles appear in the RBI
  Monthly Bulletin of October, 2007 from page
  no.1669 to 1683)