Risk Management Under Basel Ii-session 1

Risk Management under Basel II

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Types of financial risk Equity Risk Market Risk

Interest Rate Risk

Trading Risk Gap Risk

Currency Risk Commodity Risk

Financial Risks

Transaction Risk

Counterparty Risk

Portfolio Concentration Risk

Issuer Risk

Credit Risk Liquidity Risk Operational Risk Regulatory Risk Human Factor Risk

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BASEL I

 1988 ACCORD ACCEPTED BY MORE THAN 100 COUNTRIES  SIMPLE FRAMEWORK  RBI IMPLEMENTED IN 1992  WE HAVE BECOME BASEL I COMPLIANT FROM 31-3-2005

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SHORTCOMINGS OF 1988 ACCORD ♦ INFLEXIBLE ♦ FOCUS PRIMARILY ON CREDIT RISK ♦ BROAD BRUSH APPROACH ♦ USES ARBITRARY RISK CATEGORIES & RISK WEIGHTS ♦ LACK OF INCENTIVES FOR CREDIT RISK MITIGATION TECHNIQUES & RISK MANAGEMENT ♦ DOES NOT COVER OPERATIONAL RISK

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From “Trust Me” to “ Prove & Evidence Me World” Ba s

High

el I

“TRUST ME”

TRUST

“TELL ME”

to

Ba

se l II

“SHOW ME” “PROVE ME”

Low Low

TRANSPARENCY

High

The higher the pressure put on trust The more important transparency and accountability become 09/14/09

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BASEL II Supervisors Consolidated / Home – Host Monetary Authority – Central Bank

Liquidity Spread Capital 

Minimum Required Capital 09/14/09

Training Capital Calculation Pillar I  Validation Co­ordiantion of Information Planning & Co­ordination  of Supervisory activities

Supervisory Review

Coherency  Between local accounting & tax  framework 

Market Discipline 6

NEED FOR NEW ACCORD

 INTRODUCTION OF NEW COMPLEX FINANCIAL PRODUCTS  NEED FOR A MORE RISK SENSITIVE FRAMEWORK  IMPROVEMENT IN RISK MANAGEMENT SYSTEM BY BANKS  BASEL II BUILDS ON BASEL I  PROVIDES A RANGE OF OPTIONS FOR ESTIMATING REGULATORY CAPITAL  REDUCES GAP BETWEEN REGULATORY CAPITAL & ECONOMIC CAPITAL 09/14/09

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PRUDENTIAL REGULATION-CAPITAL ADEQUACY INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT & STANDARDS - BASEL II – 26TH JUNE 2004 THREE MUTUALLY REINFORCING PILLARS PILLAR I – MINIMUM CAPITAL REQUIREMENTS PILLAR II – SUPERVISORY REVIEW PILLAR III- MARKET DISCIPLINE TO ADDRESS RIGIDITIES OF BASEL I & PROMOTE ADOPTION OF STRONG RISK MANAGEMENT SYSTEM BY BANKS

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CAPITAL ADEQUACY  THESE PILLARS ATTEMPT:  COMPREHENSIVE COVERAGE OF RISK  ENHANCES RISK SENSITIVITY OF CAPITAL REQUIREMENT  MENU OF OPTIONS FOR ACCURATE MEASUREMENT

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CAPITAL ADEQUACY

ESSENSE: LEADS TO IMPROVED RISK MANAGEMENT SYSTEM IN BANKS PROMOTES MORE ROBUST SUPERVISORY FRAMEWORK STRENGTHEN MARKET DISCIPLINE LEADS TO GREATER FINANCIAL STABILITY

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Basel I vs Basel II 

   

Single option for computing regulatory capital Only minimum CRAR prescribed Risk weights by regulator on govt, banks, corporate Capital Charge on Credit Risk & Market Risk Minimum CRAR @ 8% for all banks

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 

  

A menu of options In addition to CRAR, prescribes Supervisory Review and Market Disclosures RW linked to external ratings assigned by ECAI or IRB by banks Capital Charge for CR, MR & OR and residual risks under Pillar 2. Discriminatory approach to minimum CRAR

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Basel 2

         

Pillar 1 Minimum Capital Requirement

Capital for Credit Risk

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Pillar 2 Supervisory Review

Pillar 3 Market Discipline

Capital for Market Risk

Capital for Operational Risk

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Approaches for computing Capital charge for Credit Risk          

Standardised Approach (Option 1)

Internal Ratings Based Approach

Foundation IRB Approach (Option 2)

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Advanced IRB Approach (Option 3)

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Methods for computing capital charge for Market Risk

Standardised Method

Maturity Method (Option 1)

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Internal Models Method (Option 3)

Duration Method (Option 2)

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Approaches for computing Capital charge for Operational Risk

         

Basic Indicator Approach (BIA) (Option 1)

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Standardised Approach (SA) / Alternative Standardised Approach (Option 2)

Advanced Measurement Approach (AMA) (Option 3)

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INDIAN SCENARIO ❆ STANDARDISED APPROACH FOR CREDIT RISK AND BASIC INDICATOR APPROACH FOR OPERATIONAL RISK HAS BEEN PRESCRIBED ❆ To be Reported to Board Qtr ending 31-12-2008 ❆ ❆ ❆ ❆

PARALLEL RUN FROM 1-4-2006 CRAR WOULD BE 9% AND COMPONENTS OF CAPITAL WOULD BE SAME ALL SCHEDULED COMMERCIAL BANKS AT SOLO LEVEL – GLOBAL POSITION AND AS WELL AS AT CONSOLIDATED LEVEL TO COMPLY CONSULTATIVE PROCESS

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PILLAR I  MENU OF OPTIONS  RISK WEIGHTS LINKED TO RATINGS ASSIGNED BY EXTERNAL CREDIT ASSESSMENT INSTITUTIONS  RECOGNITION PROCESS IS UNDER WAY BASED ON THE SIX ELIGIBILITY CRITERIA – OBJECTIVITY, INDEPENDENCE, INTERNATIONAL ACCESS/TRANSPARENCY, DISCLOSURE, RESOURCES, CREDIBILITY  ISSUES ON NATIONAL DISCRETION RETAIL PORTFOLIO & CREDIT RISK MITIGATION DECIDED BASED ON CONSULTATIVE PROCESS 09/14/09

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External Credit Assessment Agencies  Recognition Process  Reserve Bank to determine the ratings agencies whose rating can be used to risk weight counterparty exposures.  The Reserve Bank must be satisfied of each of the six eligibility criteria for recognising ECAIs.

 Eligibility criteria

 Objectivity, Independence, International access / Transparency, Disclosure, Resources, Credibility 09/14/09

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Eligibility criteria

 Objectivity – assessment should be rigorous, systematic, validation based on historical experience, rigorous backtesting.  Independence – free from political and economic pressures, conflict of interests  International access / Transparency – assessment to available at equal terms, methodology used by ECAI to be publicly available.  Disclosure – Assessment, definition of default, time horizon, meaning of rating, transition etc.  Resources - resources in terms of human resources for high quality assessments.  Credibility – existence of robust internal procedures and is mainly derived from the above

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Mapping Process

 The New Framework recommends development of a mapping process to assign ratings issued by eligible credit rating agencies to RW available under the SA.  The RW is to be consistent with the level of credit risk.  Unsolicited ratings – solicited only if the issuer of the instrument has requested for a rating and has accepted the rating assigned by the agency.  Banks to use only solicited rating from eligible credit rating agencies  No ratings issued by credit rating agencies on an unsolicited basis should be considered for RW calculation as per SA.

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Use of multiple rating assessments

 Exposures having multiple ratings  If only one rating, that ratings to be used to determine the RW claim  If two ratings are available which map into different risk weights, the higher RW should be applied  If there are three or more, the ratings corresponding to the lowest risk weights should be referred to and referred to and the higher of those two risk weights should be applied

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OPERATIONAL RISK  OPERATIONAL RISK IS DEFINED AS THE RISK OF LOSS RESULTING FROM INADEQUATE OR FAILED INTERNAL PROCESSES PEOPLE AND SYSTEMS OR FROM EXTERNAL EVENTS  THREE METHODOLOGIES FOR COMPUTING OPERATIONAL RISK CAPITAL CHARGE –BASIC INDICATOR APPROACH, STANDARDISED APPROACH AND ADVANCED MEASUREMENT APPROACH

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OPERATIONAL RISK  IN INDIA BANKS TOLD TO ADOPT BASIC INDICATOR APPROACH  GUIDANCE NOTE ON MANAGEMENT OF OPERATIONAL RISK ISSUED ON OCTOBER 14,2005  BANKS MAY USE THIS TO UPGRADE THEIR OP.RISK MGMT.SYSTEMS

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Basic Indicator Approach  Under this approach, banks must hold capital charge equal to the average over the previous three years of a fixed percentage of positive annual gross income.  GI = Net profit (+) Provisions & Contingencies (+) Operating expenses (-) profit on sale of HTM investments (-) income from insurance (-) extraordinary / irregular item of income (+) loss on sale of HTM investments  The charge is expressed as a sum of GI*15%

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OPERATIONAL RISK  DESIGN AND ARCHITECTURE FOR MANAGEMENT OF OPERATIONAL RISK SHOULD BE ORIENTED TOWARDS BANKS’ OWN REQUIREMENTS DICTATED BY    

SIZE & COMPLEXITY OF BUSINESS RISK PHILOSOPHY MARKET PERCEPTION EXPECTED LEVEL OF CAPITAL

 EXACT APPROACH MAY DIFFER BETWEN BANKS  PRESCRIPTIONS IN THE GUIDANCE NOTE ARE INDICATIVE

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Contd..

 Disclosure on Market Risk allows participants to assess the exposure of bank to market risk and review accuracy of internal estimates  Disclosure on Operational Risk gives an indication of approaches adopted by the bank, provides a full range of information to market participants about the quality of risk identification, measurement, monitoring and control  Other aspects – interest rate risk in the banking book as capital charge is not taken into account under Pillar 1 and dealt under Pillar 2.  Gives a comparable information to current and potential level of risk.

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assess

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Achieving Appropriate Disclosure  Supervisors have sufficient powers  Non compliance would attract penalty, including financial penalty  No direct additional capital requirement as a result of disclosure  Where disclosure is a qualifying criterion under Pillar I – There would be a direct sanction

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Disclose where 

Disclosures could be  In the balance sheet  To the stock exchanges  On the web site  In the regulatory reports – which may be disclosed by the regulator



Preferably at one place



If not in the balance sheet, should indicate where additional information may be found



Banks have the choice, unless specified by the Supervisor

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Need for validation 

When these are part of balance sheet disclosures, these are subjected to validation by the auditors



Additional balance sheet disclosures must be in consonance with the audited statements



Disclosures mandated by other regulators are generally subject to sufficient scrutiny (internal control & assessments)



If disseminated in any other manner, banks should ensure that appropriate verification of the information takes place.

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Scope and Frequency of Disclosure  At the end of March each year along with annual financial statements  Banks with more than 100 cr. capital fundsto disclose on website – semi annual  Banks with more than 500 cr. tier I capital, total capital and Capital Adequacy Ratios on a quarterly basis

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Issues in disclosures  Can banks comply ?  Intent  MIS  Cost

 Should disclosure be uniform across banks?  Will it affect a bank’s competitive edge ?  Disclosure to Regulator would suffice ?

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ISSUES,CHALLENGES & CRITICISM  CAPITAL REQUIREMENTS WILL INCREASE ACROSS BOARD  PROFITABILITY STRAINS  RATING REQUIREMENTS/PENETRATION  INCENTIVE TO REMAIN UNRATED  ABSENCE OF HISTORICAL DATABASE  ISSUES IN SUPERVISORY FRAMEWORK  PILLAR III –INFORMATION OVERLOAD  DISADVANTAGE FOR SMALLER BANKS  DISCRIMINATORY AGAINST DEVELOPING COUNTRIES

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CRITICISM     

EXCESSIVE COMPLEXITY REINFORCES PROCYCLICALITY RATING AGENCIES CREDIBILITY PENALISES SMEs DISCRIMINATORY NATURE ESPECIALLY TOWARDS EMERGING ECONOMIES

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IMPLEMENTATION ♥ ♥ ♥ ♥ ♥

♥

IMPLEMENTATION IS A LONG JOURNEY RATHER THAN A DESTINATION GRADUAL, SEQUENTIAL AND CO-ORDINATED MEASURES MAY 2004 – BANKS WERE ADVISED TO EXAMINE OPTIONS UNDER BASLE II PREPARE ROADMAP BY 2004 END FOR MIGRATION JULY 2004 – CEO SEMINAR SENSITISATION ON ISSUES AUGUST 2004 – BANKS TO UNDERTAKE SELF ASSESSMENT OF VARIOUS RISK MANAGEMENT SYSTEMS WITH SPECIFIC REFERENCE TO 3 MAJOR RISK AREAS AND INITIATE REMEDIAL ACTION TO UPDATE SYSTEMS TO MATCH MINIMUM STANDARDS OF BASLE II BANKS ADVISED TO OPERATIONALISE CAAP

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IMPLEMENTATION  FEB 2005 – DRAFT GUIDELINES ON CAPITAL ADEQUACY PLACED IN WEBSITE FOR COMMENTS  OCTOBER 2005 - OPERATIONAL RISK MANAGEMENT GUIDELINES PLACED IN PUBLIC DOMAIN  CONSULTATIVE PROCESS – STEERING COMMITTEE 14 BANKS AND IBA VARIOUS SUB-GROUPS  CGMS’ GROUP TO IDENTIFY RATING AGENCIES TO BE RECOGNISED  RBI has advised Banks to adopt New Capital adequacy Framework for reporting to their Board w.e.f. Dec 31, 2008 Qtr. 09/14/09

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Implementation issues for banks

 Upgrade MIS, risk management systems and technical skills of staff.  Banks with limited systemic relevance to continue with Basel I.  Some banks migrating to IRB later than 2006.  Cross-border issues for banks functioning under different regimes.  Data requirement for operational risk, like  prioritising risk control amongst business lines  determining period of risk measurement  scenario analysis.

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BASEL II & IT  DEVELOPING DATA ROAD MAP  DEFINING TECHNOLOGY ARCHITECHURE WITH FOCUS ON:    

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SCALABILITY AVAILABILITY SECURITY GENERATION OF MIS

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BASEL II – Where we are now?       

10 years in its creation Globally Banks have spent about £10bn - £20bn on its implementation Many banks have started to report under Basel II Significant improvement over Basel I BUT …. Still needs improvement Greater importance of Pillar 2 Basel Committee due to release a paper shortly

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Basel II - Enhancements          

Trading book risk – inclusion of “Event Risk” Greater emphasis on Stress Testing Review of Off-Balance Sheet exposures Treatment of securitisations Counterparty risk – reducing credit default swap risk Liquidity External Audit Quality Fair value accounting Improved disclosure Others??

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Tier 1 Capital and Stress Testing       

Increased attention to Tier 1 ratios Need to have sufficient Tier 1 capital after a severe stress event. Increased attention to severe stress results Raises pro-cyclicality of Basel II Consideration of provisioning policies More emphasis on building up capital in ‘good times’ Implications for banking returns

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IMPACT OF PROCYCLICALITY UNDER BASEL II IMPACT OF A RECESSION ON BASEL II TIER 1 CAPITAL RATIO UNDER A-IRB 20%

Impact of increased RWA and losses on stress Tier 1 +17%

10%

0%

-10%

0%

QIS 4&5 Average Results: Tier 1 -10%

Impact of increased ECL post stress: Tier 1 -5%

-20% Change in Tier 1 Ratio

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STRESS TESTING       

Increased importance Reverse stress test proposed Regulators setting stress testing assumptions Regulators set Basel II parameters if data is lacking Cover all risks Informs forward planning, capital requirements and risk appetite. Contingency capital plans.

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USE OF STRESS TESTING RESULTS 

Severe but plausible stress test across whole bank.



Identify concentrations:  Single large exposures  Large losses as a result of large moves of a specific factor (eg house prices)  Consider secondary effects and changes in historic correlations.



Identify portfolios with ‘Fat Tails’ e.g.    

Secondary mortgages and some sub-prime mortgages Leveraged or Bridge Loans Originate to distribute portfolios awaiting sale Basis risk of ‘well hedged’ positions.

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DATA QUALITY 

Good quality risk data vital to optimise Basel II capital requirement.



Poor quality leads to conservative capital estimates and potentially excessive capital usage.



Credit and finance data need to be, as near as possible, the same.    

Settlements outstanding, Deferred fees Impaired counterparties Correct mark to market

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DATA QULAITY (continued) 

Include non finance data       

Legal netting where available Full collateral data Risk ratings assigned Counterparty identified Comprehensive netting Legal vehicle used Identify defaults and recoveries promptly and comprehensively

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Accurate Data for models 

Exposure at Default:  Volume of data limited so changes can have a disproportionate effect.  Particularly noticeable for credit cards and undrawn wholesale commitments.  High quality risk management of use of un-drawn commitments will have a significant benefit in Basel II capital requirements.



Loss Given Default  Evidence of downturn LGD and its variation across cycle.  Management of defaults and recoveries.  Sectoral and geographic analysis.

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POTENTIAL TO OPTIMISE CAPITAL UNDER BASEL II 

More difficult than Basel I



Explore those that make sense for your bank – e.g. in Retail:

 Potential to sell defaulted credits which are difficult to collect  Reduce undrawn commitments



Global banks exploring those that make sense for your bank – e.g. in Wholesale:

    

Cancel swaps Reduced intra group exposure CDS hedging of higher risk exposures Banking book/trading book split Undrawn commitments – especially if under 1 year.  Collateralised or covered by parent guarantee.

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RETURN ON BASEL II CAPITAL: 

Given previous comments there is considerable pressure on banks’ balance sheets



Most significant ratio to many banks is the Tier 1 regulatory ratio.



Need to optimise return on Tier 1 capital



Reduce assets utilisation



Risk has a vital role in helping identify opportunities.

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