Risk Management System In Banks
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P.K .MIT RA Gen er al Ma na ger Punjab Nati onal Ban k He ad Office, N ew Del hi
Outline of the Presentation
Introduction to Risk Management and Overview of Basel II Approaches to measure Credit Risk Credit Risk Management in Punjab National Bank Benefits of moving to advanced approaches
punjab national bank …..the name you can BANK upon
2
Need for Risk Management
Globalization of Indian Economy Integration of global markets Competition from Foreign and Private Sector Banks
Need to shift from demand driven to supply driven limits Bank should determine appetite for borrower based on his risk assessment Risk Based Lending
Improve and monitor portfolio quality
punjab national bank …..the name you can BANK upon
3
Basel Committee on Banking SupervisionBCBS A committee of central bankers/ bank supervisors from
major industrialized countries like Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. BCBS has no formal supranational authority nor legal force However IMF , World Bank, International Rating Agencies, International Financial Institutions, etc use it as a benchmark for assessment of the banks/ banking system punjab national bank …..the name you can BANK upon
4
Basel Accord – I (1988) Portfolio Approach – It focused primarily on credit risk and assets of
the banks were categorized into risk buckets with risk weights ranging from 0% to 150%.
Particulars Risk We ight Cash in hand, Balance with banks, Investment in 0% government securities etc Money at call and short notices, Investment under government guaranteed securities, Advances to 20% staff members etc Claim guaranteed by DICGC/ECGE 50% Advance to public against Housing Finance 75% Advances to corporates, claim on PSUs, SME 100% and Retail exposure etc. Advances under consumer credit 125% Advances covered under Commercial real estate 150%
Minimum Capital Requirement – 8% of risk weighted assets only for
credit risk (9% by RBI) Based on 1988 accord, RBI initiated various actions for the banks like classification of assets, provision norms, classification of asset class etc. punjab national bank
…..the name you can BANK upon
5
Need for a new frame-work Financial innovations viz derivatives and securitisation
etc. and growing complexity of transactions Requirement of more flexible approaches as opposed to “one size fits all” Approach Requirement of Risk sensitivity as opposed to a “broad- brush Approach” In last 8-10 years banking sector worldwide has seen catastrophic losses which led to failure of some established banks like Bearing bank and Continental Illinois.
punjab national bank …..the name you can BANK upon
6
Banking Risks
Credit Risk Market Risk Liquidity Interest rate Foreign exchange Commodities and Equity Operational Risk
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Credit Risk
Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter-parties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter-party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. punjab national bank …..the name you can BANK upon
8
Market risk
Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. The Bank for International Settlements (BIS) defines market risk as “ the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity market and interest rate market, currency exchange rates and commodity prices”. punjab national bank …..the name you can BANK upon
9
Market risk
Liqu idit y risk : Liquidity risk occurs when Bank is not in a position to pay amounts due to its customers/counterparties or these are met by borrowing from the market at high cost. In ter es t Rat e Ri sk : The risk that changes in interest rates will adversely impact the revenues and balance sheet. Fo rex ri sk -Risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position. Equ ity /Commo dit y ri sk – Risk that a bank may suffer losses as a result of adverse movements in equity/commodity prices during a period in which it has an open position.
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10
Operational Risk Basel Committee on Banking Supervision defines the operational risk as “Risk
of direct or indirect loss resulting from inadequate or failed internal control processes, people, systems or from external events”
Such breakdowns can lead to financial losses through Error Fraud Failure to perform in a timely manner Cause the interest of the bank to be compromised like exceeding authority, conducting business in an unethical or risky manner punjab national bank …..the name you can BANK upon
11
Examples of Operational Risk Cause
Definition
Internal Processes
Losses from failed transactions, client settlements and every day business processes.
accounts,
People
Losses caused by an employee or involving employees (intentional or unintentional), or losses caused through the relationship or contact that a firm has with its clients, shareholders, third parties, or regulators.
Systems
Losses arising from disruption of business or system failure due to unavailability of infrastructure or IT.
External Events
Losses from the actions of 3rd parties including external fraud, or damage to property or assets, or from change in regulations that would alter the firm’s ability to continue doing business. punjab national bank …..the name you can BANK upon
12
Approaches to measure different risk under new accord
Approaches to measure Credit risk Standardized approach Internal ratings based (IRB) approach Foundation Advanced Approaches to measure Operational risk Basic Indicator Approach The Standardised Approach Advanced Measurement Approach Approaches to measure Market risk Standardised method Internal Model punjab national bank …..the name you can BANK upon
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punjab national bank …..the name you can BANK upon
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Approaches to Credit Risk Management under Basel II INCREASED SOPHISTICATION
Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.
ADVANCED INTERNAL RATING BASED APPROACH FO UND ATION INT ERN AL RA TING BA SED AP PRO AC H
Risk weights are assigned in slabs
STAN DAR DISED according to the asset class or are based APPR OACH
on assessment by external assessment institutions
credit
RED UCED CAPI TA L R EQ UIR EMENT
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Credit Risk: Standardised Approach
Risk weights are assigned in slabs of 0%, 20%, 50%, 100% & 150% on the basis of rating assigned by ECAIs. For example -- Claims on Sovereigns (or Central Bank) – 0% to 150% risk weight on the basis of country risk scores and at national discretion, a lower risk weight may be applied. Claims on Corporates – will be risk weighted in the range of 20-150% and unrated Corporates will be assigned 100% risk weight.
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Credit Risk: Standardised Approach Ratings
RW for foreign Sovereign
AAA to AA
0%
A
20%
BBB
50%
BB to B Below B
100% 150%
Unrated
100%
RW for banks Rupee Claim
Foreign Currency Claim
Scheduled Banks
20%
20% Others 100%
RW for Corporates
50%
20% AAA 50% AA 100%
50%
150%
100% 150%
150% 150%
50%
100%
RW as per RBI document. punjab national bank …..the name you can BANK upon
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Off Balance sheet items under Standardised approach
The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factor’ (CCF). This will then have to be again multiplied by the risk weights attributable to the relevant counter-party as specified in previous slide. Sr. No. 1
2
3
Instruments
Direct credit substitutes e.g. general guarantees of indebtedness (including standby L/Cs serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptance). Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and standby L/Cs related to particular transactions). Short-term self-liquidating trade-related contingencies (such as documentary credits collateralised by the underlying shipments) for both issuing bank and confirming bank.
Credit Conversion Factor (% ) 100
50
20
*** Above list is not exhaustive.
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Credit Risk Mitigants under Standardised Approach Eligible collaterals Cash or deposit with bank, Gold Securities issued by Central and State Governments Indira Vikas Patra, Kisan Vikas Patra and National Savings Life insurance policies ( up to surrender value) Debt securities rated by a recognised Credit Rating Agency having at least “BB” rating when issued by public sector entities and at least “A” rating when issued by other entities. Debt securities not rated by a recognised Credit Rating Agency where these are issued by a bank, listed on a recognised exchange and classified as senior debt Equities included in main index. Mutual funds having publicly quoted daily prices. Irrevocable, unconditional guarantees issued by entities with a lower risk weight than the counterparty. punjab national bank …..the name you can BANK upon
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Four Key Risk Elements in IRB Approach Probability of Default (PD) It mea su re s t he lik eliho od th at th e bor ro we r w ill def au lt ov er a giv en tim ehor izon.
Exp osu re at Defaul t (EAD) It me asu res the amou nt of the faci li ty t hat is like ly to be dra wn i f a defa ult occur s .
Lo ss Give n De fault (LGD) It m easu res t he prop ortio n of t he expo sure that wil l be lo st if a defau lt occurs. Maturi ty (M) It me asure s the re main in g eco no mic maturity of the exposu re .
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Probability of Default (PD)
Probability of default measures the likelihood that the borrower will default over a given time-horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as an year. For estimation of PD, PNB already has Risk Rating System in place for the last 5 years and the history of default rates is being tracked since then.
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Loss Given Default (LGD) Loss Given Default is the credit loss incurred if an obligor of the bank defaults. LGD = 1 – Recovery Rate where, Recovery = Present Value of { Cash flows received from borrower after the date of default - Costs incurred by the bank on recovery } Recovery rate = Recovery (as calculated above)/ Exposure on the date of default
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Exposure at Default (EAD)
EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK
20 65
60 40
Sanctioned limits
Loan outstanding
Utilisation of unavailed limit in event of default
Exposure at time of default (EAD)
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Maturity (M)
It measures the remaining economic maturity of the exposure. Determines framework for comparing different exposures.
Principal & outstanding balance Opening Date of Loan Contractual date of Maturity of Loan Contractual and Discount Rate of Interest Freq. of int. payment per annum Tenor/Maturity (Years) Time Period Cash Present Value of in years flow Cash Flow (A) (B) (c) 1 900 825.69 2 900 757.51 3 10900 8416.80 Total ------------------------> 10000.00 27591.11 Economic Maturity = 10000.00
10000 01/01/2003 31/12/2006 9.00% 1 3 (A) x (c) 825.69 1515.02 25250.40 27591.11 = 2.76
Internal Rating Based Approach
Under the IRB approach, a bank estimates each borrower’s creditworthiness and the results are translated into estimates of a potential future loss amount, which forms the basis of minimum capital requirement.
Under this approach, the treatment of each exposure class (i.e. corporate, bank, sovereign, retail & equity exposure) is based on three main elements namely: Risk components Risk weight functions Minimum requirements punjab national bank …..the name you can BANK upon
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Internal Rating Based Approach
The underlying concepts and approaches prescribed in IRB have been developed based on credit risk measurement techniques being used by sophisticated banks for ascertaining their capital requirements. The Capital required is derived from an estimate of potential losses for a credit portfolio over one year time horizon with 99.9% confidence level. 99.9% confidence level implies that there is only one chance in 1000 that the losses will be larger than the regulatory capital. The credit risk on an asset, reflected in UL & EL, increases as PD, LGD, EAD or M increases.
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Foundation IRB Vs Advanced IRB Approach Foundation IRB Approach
Advanced IRB Approach
Values for Loss given default (LGD) and Values for Loss given default (LGD) exposure at default (EAD) are provided by and exposure at default (EAD) are the regulatory authority. determined by each bank through internal modeling with a data of 5-7 years. Assessment of values of credit mitigants is Banks may assess the value of its credit done by the regulatory authority. mitigants. For retail exposure, there is no foundation IRB (only advanced IRB where besides PD, the bank concerned will have to estimate LGD & EAD.)
Advanced IRB is applicable to retail exposure also.
punjab national bank …..the name you can BANK upon
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Expected Loss (EL)
Expected Loss is the bank’s cost of doing business. Expected loss has to be provided for. The Expected Loss (in currency amounts) EL = PD * EAD * LGD If expressed as a percentage figure of the EAD EL = PD * LGD. The bank should also proactively incorporate an expected loss rate in the estimation of the total spread to be charged on the loan. Expected loss is not a measure of risk as it is anticipated.
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Unexpected Loss (UL)
Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.
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EL Vs UL Expected V/s Unexpected Losses 8.00%
7.53%
7.00% Loan losses
6.00%
Unexpected loss
5.00%
4.58%
4.00%
3.93%
3.52%
3.00% 2.00%
1.41%
1.21%
1.00%
3.32%
2.21%
1.96% Expected loss
0.44%
0.00% 1
2
3
2.30% 0.42%
0.27% 4
5
6
7
8
9
10
11
12
0.56%
13
14
Time (Year)
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Capital Requirement under IRB Borrower
Transaction
Internal Rating Probability of Default (PD)
Capital Requirement
=
Exposure at Default
X
Collateral
Maturity
Loss Given Default (LGD)
Maturity (M)
Risk Weight
X
9%
[LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD) punjab national bank …..the name you can BANK upon
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Risk Weight function Standard normal distribution (N) applied to threshold and conservative value of systematic factor
Inverse of the standard normal distribution (G) applied to PD to derive default threshold
Inverse of the standard normal distribution (G) applied to confidence level i.e. 99.9% to derive conservative value of systematic factor
= [LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD) Asset Expected Maturity Smoothened Loss (E.L.) Correlation (regression) Maturity adjustment punjab national bank …..the name you can BANK upon
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Minimum Criteria for IRB Adv Approach To be eligible for IRB Approach a bank must demonstrate to its supervisor that it meets certain minimum requirements at the outset and on an on going basis. These include: • A robust rating system comprising all of the methods, processes, controls and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates. • Risk rating system operations which includes Coverage of ratings, Integrity of rating process, overrides based on expert judgement, Data maintenance and use of stress tests in assessment of capital adequacy. punjab national bank …..the name you can BANK upon
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Minimum Criteria for IRB Adv Approach • Corporate Governance and overseeing of risk management by Board of Directors/Top Management • Use of Internal ratings and default and loss estimates in credit approval, risk management processes, corporate governance functions etc apart from using them in capital calculations • Risk quantification covering definition of default, requirements specific to estimations of PD, LGD and EAD • Robust internal control systems for risk management and validation of the models used, internal estimates of risk inputs viz. PD, LGD and EAD etc.
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Set Up for Management of Credit Risk SYSTEM & MODELS
Migration Implementation Periodical Conducting Analysis of Preventive portfolio various implementing and Default Monitoring review analysis credit risk System Rate models Analysis. (PMS)
INDUSTRY ANALYSIS GROUP
Preparation of Liaison with external Monitoring industry scenarios of various agencies for wise profile of the industries updating the industry bank profiles.
INDUSTRY DESK
Developing and
Approval of rating of borrowers falling under HO powers
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Implementing Standardised Approach
RBI has advised banks to start parallel run of “Standardized Approach of Credit Risk” w.e.f. 01/04/2006 This require system for categorisation of assets as per Basel II and for collating data of credit risk mitigation techniques i.e. details of primary/collateral securities. System should also be able to consolidate Risk Weighted Assets and arrive at the required capital charge for credit risk.. Bank has implemented the system and parallel run as per RBI guidelines has since been started. punjab national bank …..the name you can BANK upon
38
Implementing Foundation IRB approach
All eligible credit exposures beyond a threshold limit of above Rs 20 lacs are risk rated through internal credit risk rating models. Default Rates for last five years generated. The default rates are satisfactory and comparable with international standards. Migration of ratings analysed since last four years. In addition to Default rating, Facility-rating is being implemented. punjab national bank …..the name you can BANK upon
39
Implementing Advanced IRB approach
Data requirements as well as features of application tools for Risk Management finalized. A data warehouse is being established which will have application tools also. The gaps in the existing systems for adoption of Basel II are being identified. Goal is to adopt IRB advanced approach by March 2010, subject to RBI approval.
punjab national bank …..the name you can BANK upon
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Annual Average Default rates as at 31.03.2006 Rating
Large Mid Corporate (5 Corporate years average (3 year DR) % average DR) %
Combined*** Three year Average DR(%) for 2004-06
Small Loan A/Cs Two Yr. Average DR(%) for 200506
AAA
0.00
0.00
0.00
0.00
AA
0.00
0.00
0.00
0.00
A
0.18
0.78
0.40
0.59
BB
0.64
0.88
0.77
0.90
B
0.91
4.03
2.35
1.96
C
6.44
8.16
6.40
3.60
D
14.96
12.82
13.21
11.93
1.91
2.06
1.72
1.25
Total
***Large & Mid Corporate punjab national bank …..the name you can BANK upon
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Validation of rating models GINI Coefficient GINI- COEFFICIENT
X
% CUMULATIVE DEFAULT POPULATION
Ideal 100 90 80 70 60 50 40 30 20 10 0
AAA rating
Actual
Z
Y
B rating
C rating
BB rating A rating
D rating
0 10 GINI Coeff ici ent = 0.63
AA rating
Random
20
30
40
50
60
70
80
90
100
% CUMULATIVE POPULATION
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Probability of default of PNB Vs Crisil 32.00% 28.00% Probability of Default
24.00%
CRISIL
20.00%
Exponential fiiting
16.00% 12.00% 8.00%
PNB
4.00% 0.00%
AAA
AA
A
BB
BB
C
D
Actual
0.03%
0.09%
0.40%
0.77%
2.35%
6.40%
13.21%
Exponential
0.04%
0.10%
0.28%
0.77%
2.14%
5.94%
16.47%
CRISIL
0.00%
0.00%
1.01%
3.47%
15.85%
30.30%
28.57%
Rating Grades punjab national bank …..the name you can BANK upon
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Comparative average annual default rate (Up to 31.03.06)
PNB AAA 0.00 AA 0.00 A 0.40 BB 0.77 B 2.35 C 6.40 D 13.21
S&P AAA 0.00 AA 0.00 A 0.06 BBB 0.18 BB 1.06 B 5.20 C 19.79
Moody Aaa 0.00 Aa 0.02 A 0.00 Baa 0.15 Ba 1.29 B 6.81 C 24.06
CRISIL AAA 0.00 AA 0.00 A 1.01 BBB 3.47 BB 15.85 B 30.30 C 28.57
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Impact of Basel II on Capital Requirement Existing Particulars
Total Capital (A)
12831.85
12831.85
(@ 9%) 8001.22 1075.90 0.00 9077.12
(@ 9%) 7813.69 1075.90 855.90 9745.49
12.72
11.85
88902.46 11954.44 0.00 100856.90
86818.76 11954.44 9510.03 108283.23
Min. Capital Requirement Credit Risk Market Risk Operational Risk Total Capital Required (B) CRAR = [(A)/(B)]*0.09 Risk Weighted Assets Credit Risk Market Risk Operational Total Risk Weighted Assets
Standardised Approach Basel II
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Road Map for Basel II Implementation Approach Credit Risk Standardized IRB Foundation IRB Advanced Market Risk Standardized Internal Risk Management Model Method
RBI’s Indication 31.03.08 Not Indicated Not Indicated 31.03.06
Bank’s Preparedness Parallel run started w.e.f 1.4.06 March 2009 (Subject to RBI approval) March 2010 (Subject to RBI approval) Already implemented
Not Indicated
March 2008 (Subject to RBI approval)
31.03.08 Not Indicated Not Indicated
Simple approach can be implemented immediately (Subject to RBI approval) March 2009 (Subject to RBI approval) March 2010 (Subject to RBI approval)
Operational Risk Basic Indicator Standardized Advanced
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Benefits of moving to Advanced approaches
Relief in Capital Charge Risk based Pricing – focus on identified business areas. Competitive pricing in niche areas. Image/Prestige International recognition/benefits in dealing with Foreign banks Risk Control
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Areas requiring attention of Auditors
Banks must correctly classify the assets into Sovereign, Banks, Corporate, Retail and Equity asset classes. Banks must have used data of at least 5 to 7 years in various models for estimation of various risk components (viz., PD, LGD, EAD and M). Banks must have robust systems in place to evaluate the accuracy and consistency with regard to the system, processing and the estimation of PDs. Banks must use proper credit risk mitigants in capital calculation. Banks must have a credible track record in the use of internal ratings at least for the last 3 years. Banks must disclose in greater detail the rating process, risk factors, validation etc. of the rating system. Internal and External audit must review annually, the banks’ rating system including the quantification of internal ratings. punjab national bank …..the name you can BANK upon
48
Areas requiring attention of Auditors
Banks must use appropriate risk weights against the asset classes. Banks must update the credit risk rating at least on annual basis. Banks must have adequately qualified and trained staff for rating process. Banks must compute the default rates on regular basis and these should be validate at regular intervals. Banks must have in place sound stress testing process for the assessment of capital adequacy. Internal rating must be explicitly linked with the banks’ internal assessment of capital adequacy in line with requirements of Pillar 2.
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Thank you and Happy New Year
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Outline of the Presentation
Introduction to Risk Management and Overview of Basel II Approaches to measure Credit Risk Credit Risk Management in Punjab National Bank Benefits of moving to advanced approaches
punjab national bank …..the name you can BANK upon
2
Need for Risk Management
Globalization of Indian Economy Integration of global markets Competition from Foreign and Private Sector Banks
Need to shift from demand driven to supply driven limits Bank should determine appetite for borrower based on his risk assessment Risk Based Lending
Improve and monitor portfolio quality
punjab national bank …..the name you can BANK upon
3
Basel Committee on Banking SupervisionBCBS A committee of central bankers/ bank supervisors from
major industrialized countries like Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States. BCBS has no formal supranational authority nor legal force However IMF , World Bank, International Rating Agencies, International Financial Institutions, etc use it as a benchmark for assessment of the banks/ banking system punjab national bank …..the name you can BANK upon
4
Basel Accord – I (1988) Portfolio Approach – It focused primarily on credit risk and assets of
the banks were categorized into risk buckets with risk weights ranging from 0% to 150%.
Particulars Risk We ight Cash in hand, Balance with banks, Investment in 0% government securities etc Money at call and short notices, Investment under government guaranteed securities, Advances to 20% staff members etc Claim guaranteed by DICGC/ECGE 50% Advance to public against Housing Finance 75% Advances to corporates, claim on PSUs, SME 100% and Retail exposure etc. Advances under consumer credit 125% Advances covered under Commercial real estate 150%
Minimum Capital Requirement – 8% of risk weighted assets only for
credit risk (9% by RBI) Based on 1988 accord, RBI initiated various actions for the banks like classification of assets, provision norms, classification of asset class etc. punjab national bank
…..the name you can BANK upon
5
Need for a new frame-work Financial innovations viz derivatives and securitisation
etc. and growing complexity of transactions Requirement of more flexible approaches as opposed to “one size fits all” Approach Requirement of Risk sensitivity as opposed to a “broad- brush Approach” In last 8-10 years banking sector worldwide has seen catastrophic losses which led to failure of some established banks like Bearing bank and Continental Illinois.
punjab national bank …..the name you can BANK upon
6
Banking Risks
Credit Risk Market Risk Liquidity Interest rate Foreign exchange Commodities and Equity Operational Risk
punjab national bank …..the name you can BANK upon
7
Credit Risk
Credit risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter-parties. In a bank’s portfolio, losses stem from outright default due to inability or unwillingness of a customer or counter-party to meet commitments in relation to lending, trading, settlement and other financial transactions. Alternatively, losses result from reduction in portfolio value arising from actual or perceived deterioration in credit quality. punjab national bank …..the name you can BANK upon
8
Market risk
Market Risk is the risk to the bank’s earnings and capital due to changes in the market level of interest rates or prices of securities, foreign exchange and equities, as well as the volatilities of those changes. The Bank for International Settlements (BIS) defines market risk as “ the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity market and interest rate market, currency exchange rates and commodity prices”. punjab national bank …..the name you can BANK upon
9
Market risk
Liqu idit y risk : Liquidity risk occurs when Bank is not in a position to pay amounts due to its customers/counterparties or these are met by borrowing from the market at high cost. In ter es t Rat e Ri sk : The risk that changes in interest rates will adversely impact the revenues and balance sheet. Fo rex ri sk -Risk that a bank may suffer losses as a result of adverse exchange rate movements during a period in which it has an open position. Equ ity /Commo dit y ri sk – Risk that a bank may suffer losses as a result of adverse movements in equity/commodity prices during a period in which it has an open position.
punjab national bank …..the name you can BANK upon
10
Operational Risk Basel Committee on Banking Supervision defines the operational risk as “Risk
of direct or indirect loss resulting from inadequate or failed internal control processes, people, systems or from external events”
Such breakdowns can lead to financial losses through Error Fraud Failure to perform in a timely manner Cause the interest of the bank to be compromised like exceeding authority, conducting business in an unethical or risky manner punjab national bank …..the name you can BANK upon
11
Examples of Operational Risk Cause
Definition
Internal Processes
Losses from failed transactions, client settlements and every day business processes.
accounts,
People
Losses caused by an employee or involving employees (intentional or unintentional), or losses caused through the relationship or contact that a firm has with its clients, shareholders, third parties, or regulators.
Systems
Losses arising from disruption of business or system failure due to unavailability of infrastructure or IT.
External Events
Losses from the actions of 3rd parties including external fraud, or damage to property or assets, or from change in regulations that would alter the firm’s ability to continue doing business. punjab national bank …..the name you can BANK upon
12
Approaches to measure different risk under new accord
Approaches to measure Credit risk Standardized approach Internal ratings based (IRB) approach Foundation Advanced Approaches to measure Operational risk Basic Indicator Approach The Standardised Approach Advanced Measurement Approach Approaches to measure Market risk Standardised method Internal Model punjab national bank …..the name you can BANK upon
13
punjab national bank …..the name you can BANK upon
14
Approaches to Credit Risk Management under Basel II INCREASED SOPHISTICATION
Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized.
ADVANCED INTERNAL RATING BASED APPROACH FO UND ATION INT ERN AL RA TING BA SED AP PRO AC H
Risk weights are assigned in slabs
STAN DAR DISED according to the asset class or are based APPR OACH
on assessment by external assessment institutions
credit
RED UCED CAPI TA L R EQ UIR EMENT
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Credit Risk: Standardised Approach
Risk weights are assigned in slabs of 0%, 20%, 50%, 100% & 150% on the basis of rating assigned by ECAIs. For example -- Claims on Sovereigns (or Central Bank) – 0% to 150% risk weight on the basis of country risk scores and at national discretion, a lower risk weight may be applied. Claims on Corporates – will be risk weighted in the range of 20-150% and unrated Corporates will be assigned 100% risk weight.
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Credit Risk: Standardised Approach Ratings
RW for foreign Sovereign
AAA to AA
0%
A
20%
BBB
50%
BB to B Below B
100% 150%
Unrated
100%
RW for banks Rupee Claim
Foreign Currency Claim
Scheduled Banks
20%
20% Others 100%
RW for Corporates
50%
20% AAA 50% AA 100%
50%
150%
100% 150%
150% 150%
50%
100%
RW as per RBI document. punjab national bank …..the name you can BANK upon
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Off Balance sheet items under Standardised approach
The credit risk exposure attached to off-Balance Sheet items has to be first calculated by multiplying the face value of each of the off-Balance Sheet items by ‘credit conversion factor’ (CCF). This will then have to be again multiplied by the risk weights attributable to the relevant counter-party as specified in previous slide. Sr. No. 1
2
3
Instruments
Direct credit substitutes e.g. general guarantees of indebtedness (including standby L/Cs serving as financial guarantees for loans and securities) and acceptances (including endorsements with the character of acceptance). Certain transaction-related contingent items (e.g. performance bonds, bid bonds, warranties and standby L/Cs related to particular transactions). Short-term self-liquidating trade-related contingencies (such as documentary credits collateralised by the underlying shipments) for both issuing bank and confirming bank.
Credit Conversion Factor (% ) 100
50
20
*** Above list is not exhaustive.
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Credit Risk Mitigants under Standardised Approach Eligible collaterals Cash or deposit with bank, Gold Securities issued by Central and State Governments Indira Vikas Patra, Kisan Vikas Patra and National Savings Life insurance policies ( up to surrender value) Debt securities rated by a recognised Credit Rating Agency having at least “BB” rating when issued by public sector entities and at least “A” rating when issued by other entities. Debt securities not rated by a recognised Credit Rating Agency where these are issued by a bank, listed on a recognised exchange and classified as senior debt Equities included in main index. Mutual funds having publicly quoted daily prices. Irrevocable, unconditional guarantees issued by entities with a lower risk weight than the counterparty. punjab national bank …..the name you can BANK upon
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Four Key Risk Elements in IRB Approach Probability of Default (PD) It mea su re s t he lik eliho od th at th e bor ro we r w ill def au lt ov er a giv en tim ehor izon.
Exp osu re at Defaul t (EAD) It me asu res the amou nt of the faci li ty t hat is like ly to be dra wn i f a defa ult occur s .
Lo ss Give n De fault (LGD) It m easu res t he prop ortio n of t he expo sure that wil l be lo st if a defau lt occurs. Maturi ty (M) It me asure s the re main in g eco no mic maturity of the exposu re .
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Probability of Default (PD)
Probability of default measures the likelihood that the borrower will default over a given time-horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as an year. For estimation of PD, PNB already has Risk Rating System in place for the last 5 years and the history of default rates is being tracked since then.
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Loss Given Default (LGD) Loss Given Default is the credit loss incurred if an obligor of the bank defaults. LGD = 1 – Recovery Rate where, Recovery = Present Value of { Cash flows received from borrower after the date of default - Costs incurred by the bank on recovery } Recovery rate = Recovery (as calculated above)/ Exposure on the date of default
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Exposure at Default (EAD)
EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK
20 65
60 40
Sanctioned limits
Loan outstanding
Utilisation of unavailed limit in event of default
Exposure at time of default (EAD)
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Maturity (M)
It measures the remaining economic maturity of the exposure. Determines framework for comparing different exposures.
Principal & outstanding balance Opening Date of Loan Contractual date of Maturity of Loan Contractual and Discount Rate of Interest Freq. of int. payment per annum Tenor/Maturity (Years) Time Period Cash Present Value of in years flow Cash Flow (A) (B) (c) 1 900 825.69 2 900 757.51 3 10900 8416.80 Total ------------------------> 10000.00 27591.11 Economic Maturity = 10000.00
10000 01/01/2003 31/12/2006 9.00% 1 3 (A) x (c) 825.69 1515.02 25250.40 27591.11 = 2.76
Internal Rating Based Approach
Under the IRB approach, a bank estimates each borrower’s creditworthiness and the results are translated into estimates of a potential future loss amount, which forms the basis of minimum capital requirement.
Under this approach, the treatment of each exposure class (i.e. corporate, bank, sovereign, retail & equity exposure) is based on three main elements namely: Risk components Risk weight functions Minimum requirements punjab national bank …..the name you can BANK upon
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Internal Rating Based Approach
The underlying concepts and approaches prescribed in IRB have been developed based on credit risk measurement techniques being used by sophisticated banks for ascertaining their capital requirements. The Capital required is derived from an estimate of potential losses for a credit portfolio over one year time horizon with 99.9% confidence level. 99.9% confidence level implies that there is only one chance in 1000 that the losses will be larger than the regulatory capital. The credit risk on an asset, reflected in UL & EL, increases as PD, LGD, EAD or M increases.
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Foundation IRB Vs Advanced IRB Approach Foundation IRB Approach
Advanced IRB Approach
Values for Loss given default (LGD) and Values for Loss given default (LGD) exposure at default (EAD) are provided by and exposure at default (EAD) are the regulatory authority. determined by each bank through internal modeling with a data of 5-7 years. Assessment of values of credit mitigants is Banks may assess the value of its credit done by the regulatory authority. mitigants. For retail exposure, there is no foundation IRB (only advanced IRB where besides PD, the bank concerned will have to estimate LGD & EAD.)
Advanced IRB is applicable to retail exposure also.
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Expected Loss (EL)
Expected Loss is the bank’s cost of doing business. Expected loss has to be provided for. The Expected Loss (in currency amounts) EL = PD * EAD * LGD If expressed as a percentage figure of the EAD EL = PD * LGD. The bank should also proactively incorporate an expected loss rate in the estimation of the total spread to be charged on the loan. Expected loss is not a measure of risk as it is anticipated.
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Unexpected Loss (UL)
Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations.
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EL Vs UL Expected V/s Unexpected Losses 8.00%
7.53%
7.00% Loan losses
6.00%
Unexpected loss
5.00%
4.58%
4.00%
3.93%
3.52%
3.00% 2.00%
1.41%
1.21%
1.00%
3.32%
2.21%
1.96% Expected loss
0.44%
0.00% 1
2
3
2.30% 0.42%
0.27% 4
5
6
7
8
9
10
11
12
0.56%
13
14
Time (Year)
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Capital Requirement under IRB Borrower
Transaction
Internal Rating Probability of Default (PD)
Capital Requirement
=
Exposure at Default
X
Collateral
Maturity
Loss Given Default (LGD)
Maturity (M)
Risk Weight
X
9%
[LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD) punjab national bank …..the name you can BANK upon
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Risk Weight function Standard normal distribution (N) applied to threshold and conservative value of systematic factor
Inverse of the standard normal distribution (G) applied to PD to derive default threshold
Inverse of the standard normal distribution (G) applied to confidence level i.e. 99.9% to derive conservative value of systematic factor
= [LGD * N [(1 - R)^-0.5 * G (PD) + (R / (1 - R))^0.5 * G (0.999)] - PD * LGD] * (1 - 1.5 x b(PD))^ -1 × (1 + (M - 2.5) * b (PD) Asset Expected Maturity Smoothened Loss (E.L.) Correlation (regression) Maturity adjustment punjab national bank …..the name you can BANK upon
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Minimum Criteria for IRB Adv Approach To be eligible for IRB Approach a bank must demonstrate to its supervisor that it meets certain minimum requirements at the outset and on an on going basis. These include: • A robust rating system comprising all of the methods, processes, controls and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates. • Risk rating system operations which includes Coverage of ratings, Integrity of rating process, overrides based on expert judgement, Data maintenance and use of stress tests in assessment of capital adequacy. punjab national bank …..the name you can BANK upon
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Minimum Criteria for IRB Adv Approach • Corporate Governance and overseeing of risk management by Board of Directors/Top Management • Use of Internal ratings and default and loss estimates in credit approval, risk management processes, corporate governance functions etc apart from using them in capital calculations • Risk quantification covering definition of default, requirements specific to estimations of PD, LGD and EAD • Robust internal control systems for risk management and validation of the models used, internal estimates of risk inputs viz. PD, LGD and EAD etc.
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Set Up for Management of Credit Risk SYSTEM & MODELS
Migration Implementation Periodical Conducting Analysis of Preventive portfolio various implementing and Default Monitoring review analysis credit risk System Rate models Analysis. (PMS)
INDUSTRY ANALYSIS GROUP
Preparation of Liaison with external Monitoring industry scenarios of various agencies for wise profile of the industries updating the industry bank profiles.
INDUSTRY DESK
Developing and
Approval of rating of borrowers falling under HO powers
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Implementing Standardised Approach
RBI has advised banks to start parallel run of “Standardized Approach of Credit Risk” w.e.f. 01/04/2006 This require system for categorisation of assets as per Basel II and for collating data of credit risk mitigation techniques i.e. details of primary/collateral securities. System should also be able to consolidate Risk Weighted Assets and arrive at the required capital charge for credit risk.. Bank has implemented the system and parallel run as per RBI guidelines has since been started. punjab national bank …..the name you can BANK upon
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Implementing Foundation IRB approach
All eligible credit exposures beyond a threshold limit of above Rs 20 lacs are risk rated through internal credit risk rating models. Default Rates for last five years generated. The default rates are satisfactory and comparable with international standards. Migration of ratings analysed since last four years. In addition to Default rating, Facility-rating is being implemented. punjab national bank …..the name you can BANK upon
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Implementing Advanced IRB approach
Data requirements as well as features of application tools for Risk Management finalized. A data warehouse is being established which will have application tools also. The gaps in the existing systems for adoption of Basel II are being identified. Goal is to adopt IRB advanced approach by March 2010, subject to RBI approval.
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Annual Average Default rates as at 31.03.2006 Rating
Large Mid Corporate (5 Corporate years average (3 year DR) % average DR) %
Combined*** Three year Average DR(%) for 2004-06
Small Loan A/Cs Two Yr. Average DR(%) for 200506
AAA
0.00
0.00
0.00
0.00
AA
0.00
0.00
0.00
0.00
A
0.18
0.78
0.40
0.59
BB
0.64
0.88
0.77
0.90
B
0.91
4.03
2.35
1.96
C
6.44
8.16
6.40
3.60
D
14.96
12.82
13.21
11.93
1.91
2.06
1.72
1.25
Total
***Large & Mid Corporate punjab national bank …..the name you can BANK upon
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Validation of rating models GINI Coefficient GINI- COEFFICIENT
X
% CUMULATIVE DEFAULT POPULATION
Ideal 100 90 80 70 60 50 40 30 20 10 0
AAA rating
Actual
Z
Y
B rating
C rating
BB rating A rating
D rating
0 10 GINI Coeff ici ent = 0.63
AA rating
Random
20
30
40
50
60
70
80
90
100
% CUMULATIVE POPULATION
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Probability of default of PNB Vs Crisil 32.00% 28.00% Probability of Default
24.00%
CRISIL
20.00%
Exponential fiiting
16.00% 12.00% 8.00%
PNB
4.00% 0.00%
AAA
AA
A
BB
BB
C
D
Actual
0.03%
0.09%
0.40%
0.77%
2.35%
6.40%
13.21%
Exponential
0.04%
0.10%
0.28%
0.77%
2.14%
5.94%
16.47%
CRISIL
0.00%
0.00%
1.01%
3.47%
15.85%
30.30%
28.57%
Rating Grades punjab national bank …..the name you can BANK upon
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Comparative average annual default rate (Up to 31.03.06)
PNB AAA 0.00 AA 0.00 A 0.40 BB 0.77 B 2.35 C 6.40 D 13.21
S&P AAA 0.00 AA 0.00 A 0.06 BBB 0.18 BB 1.06 B 5.20 C 19.79
Moody Aaa 0.00 Aa 0.02 A 0.00 Baa 0.15 Ba 1.29 B 6.81 C 24.06
CRISIL AAA 0.00 AA 0.00 A 1.01 BBB 3.47 BB 15.85 B 30.30 C 28.57
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Impact of Basel II on Capital Requirement Existing Particulars
Total Capital (A)
12831.85
12831.85
(@ 9%) 8001.22 1075.90 0.00 9077.12
(@ 9%) 7813.69 1075.90 855.90 9745.49
12.72
11.85
88902.46 11954.44 0.00 100856.90
86818.76 11954.44 9510.03 108283.23
Min. Capital Requirement Credit Risk Market Risk Operational Risk Total Capital Required (B) CRAR = [(A)/(B)]*0.09 Risk Weighted Assets Credit Risk Market Risk Operational Total Risk Weighted Assets
Standardised Approach Basel II
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Road Map for Basel II Implementation Approach Credit Risk Standardized IRB Foundation IRB Advanced Market Risk Standardized Internal Risk Management Model Method
RBI’s Indication 31.03.08 Not Indicated Not Indicated 31.03.06
Bank’s Preparedness Parallel run started w.e.f 1.4.06 March 2009 (Subject to RBI approval) March 2010 (Subject to RBI approval) Already implemented
Not Indicated
March 2008 (Subject to RBI approval)
31.03.08 Not Indicated Not Indicated
Simple approach can be implemented immediately (Subject to RBI approval) March 2009 (Subject to RBI approval) March 2010 (Subject to RBI approval)
Operational Risk Basic Indicator Standardized Advanced
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Benefits of moving to Advanced approaches
Relief in Capital Charge Risk based Pricing – focus on identified business areas. Competitive pricing in niche areas. Image/Prestige International recognition/benefits in dealing with Foreign banks Risk Control
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Areas requiring attention of Auditors
Banks must correctly classify the assets into Sovereign, Banks, Corporate, Retail and Equity asset classes. Banks must have used data of at least 5 to 7 years in various models for estimation of various risk components (viz., PD, LGD, EAD and M). Banks must have robust systems in place to evaluate the accuracy and consistency with regard to the system, processing and the estimation of PDs. Banks must use proper credit risk mitigants in capital calculation. Banks must have a credible track record in the use of internal ratings at least for the last 3 years. Banks must disclose in greater detail the rating process, risk factors, validation etc. of the rating system. Internal and External audit must review annually, the banks’ rating system including the quantification of internal ratings. punjab national bank …..the name you can BANK upon
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Areas requiring attention of Auditors
Banks must use appropriate risk weights against the asset classes. Banks must update the credit risk rating at least on annual basis. Banks must have adequately qualified and trained staff for rating process. Banks must compute the default rates on regular basis and these should be validate at regular intervals. Banks must have in place sound stress testing process for the assessment of capital adequacy. Internal rating must be explicitly linked with the banks’ internal assessment of capital adequacy in line with requirements of Pillar 2.
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Thank you and Happy New Year
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