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Risk Management Module D Capital Management

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Forex open positions. Pillar- I MCR : CAPITA L FOR MATKET RISK ... 3 Trading income 6 Other operating expenses ... forex / bullion positions ... – PowerPoint PPT presentation

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Title: Risk Management Module D Capital Management


1
Risk ManagementModule DCapital
ManagementProfit planning
  • By S.G.Savadatti
  • savadatti_at_iibf.org.in

2
Balance Sheet
3
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.

4
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.

5
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.

6
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


7
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

8
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.

9
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

10
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 ).

11
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.

12
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.


13
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.

14
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

15
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.

.
16
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.

17
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.

18
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.

19
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.

20
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.

21
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.

22
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.

23
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.

24
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.

25
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)
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