Risk Management and Basel II

1. Risk Management and Basel II Indian Institute of Banking and Finance

2. How do banks make money? • By playing “term” of funds: Long v/s short. • By playing risk levels- accept lower risk and place in higher risk- play safety as a market mantra • Dispersed source v/s concentrated use. • Trading in the market • Essentially by taking risk

4. Risk Definition and features Risk: Event likely to cause loss/variability/damage to income and reputation Features: • Fairly known- Cannot be avoided. • Probabilistic and generic • Ascertainable, although not always quantifiable • Essential for intermediation process. • Risk and Reward go together • Interrelated/ Collectively exhaustive but not mutually exclusive Risk is an opportunity

5. Generic and Unique risks • Industry • Unit/firm/company related • Location specific • Ownership related • Sector specific • HRD/Structure related

6. Decision ,Indecision Business cycles/ Seasonality Economic/Fiscal changes Policy Changes Market movements Events Political compulsions Regulations Human resources, skill sets Competition Technology Non-availability of information Sources of Risk

7. Types of Risks • Credit: Default/delay: Impacts Solvency-Capacity to service obligation, • Liquidity: Inability to meet committed payments, inability to exit an investment. • Interest Rate: Changes in the market rate causing income variability • Exchange: Fluctuation in currency rates, prices becoming adverse for the company • Market: Interplay of above on trading profits • Legal: • Operational: Failure of Men, Machine, Monitoring, Methods

8. Basel II The global financial regulatory framework is undergoing important changes… USA PATRIOT ACT FATF RECOMMENDATIONS Risk Management Anti-Money Laundering Corporate Governance …and money laundering and corporate governance issues have become entwined with operational risk management

9. Goals of risk Management Safety and soundness of banks. Ensuring a level playing field. Capital Adequacy Ratio (1) own funds (i.e. available capital and reserves) (2) risk-weighted assets (i.e. the amount of money the bank has put at risk in the course of its business) A level playing field !! Source: BIS

10. How to manage risk • Hedging • Exposure limits • Reserves and Provisioning More importantly by having adequate capital

11. Basel I • IRAC norms- uniform across institutions, products and performance • Capital adequacy- Uniform across the commercial banking- coop banking will catch up shortly

12. Lessons Of Basel I Risk is an opportunity • Better NPA Management- varieties of ways • New Institutions ( ARC) Laws ( Sarfaesi) • Almost all banks and RRBs in good financial health- meet CRAR nomr • Explosion of new- customer centric products • More employment.

13. Basel II • Primarily for internationally active banks • RBI will take view on other banks- It is safe that all banks comply • CRAR @ 8%on risk weight. But weights and loss estimates differ- • Basel II is capital accord. Other risk management norms will happen • F.M says “ Indian Banks will need additional 60,000 Crores in the next few years”- to meet with growth needs.

14. Three Pillars of Basel II SupervisoryReview Minimum Capital Market Discipline The new Basel Accord is based on Three Pillars • Advanced methods for capital allocation • Capital charge for operational risk • Focus on internal capabilities • Supervisors to review banks internal assessment and strategies • Focus on disclosure

15. Basle II. Minimum Capital Requirements-Pillar 1 • Sets minimum acceptable capital • Capital arrived by enhanced approach with credit ratings • External or Public rating • Internal rating • Explicit treatment to operational risk • ALM risk not treated but included in

16. Supervisory Review _ Four Principles- Pillar 2 • Banks must attain solvency relative to their risk profile • Supervisors should review each bank’s own risk assessment & capital strategies • Banks should maintain excess of minimum capital • Regulators would intervene at an early stage • Possibility of rewarding banks with better risk management systems. • RBI has already taken steps to conduct supervisory review

17. Market Discipline- Pillar 3 • Improved disclosure of • Capital structure • Risk measurement and management practices • Risk profile • Capital adequacy

18. Credit Risk -Approaches

19. Credit Risk Approaches

20. Credit Risk Approaches

21. Computation of Capital Standardized No change over 1988 Foundation No change over 1988 in VaR Market Risk Our country is relatively advanced in this area Advanced No change over 1988 in VaR

22. Computation of Capital Standardized Capital change based on single risk indicator Foundation Capital based on business lines and industry standards Operational Risk Advanced Capital based on business lines and internally calculated standards

23. Operational Risk Approaches

24. Decision areas for Banks • Choice of methodology and convincing the regulators • IT supports needed • Software requirements • Staff training on compliance • Consultancy requirements • Risk mitigation opportunities • Outsourcing possibilities • New jobs creation • Implementation cost and time

25. BASLE II IS ALL ABOUT A RESPONSIVE AND SOPHESTICATED RISK MANAGEMENT SYSTEM • R = Risk = Function of Uncertainty U • U = Function of Quality Information QI • QI = Function of Accuracy/ Timeliness/ Relevance/ Adequacy A, T, R, Ad • A = Function of IT • T = Function of IT • R and Ad = Function of IT, Management Science, Modeling amenable to establish mathematical relationship

26. Risk Management – a data intensive function Credit Risk Market Risk Operational Risk Banks • Borrower Data • Guarantor Data • Asset-specific Data • Default Data • Data on Recoveries • External Default Data • Data on Rating and Migration • Macro & Industry Data • Correlation Data • Data on Exchange Rates • Data on Interest Rates • Data on Security Prices • Data on Correlations • Data on Instruments (non-linear) • Loss Event Data • Causal Data • Loss Effect • Key Risk Indicators (KRIs) • Proxies • Risk Inventories • Structured Self Assessment Data • External Data Transaction Data Operational CRM Data Analytical CRM Data Risk Management Data Economy & Industry Data

27. Basle Accord and IT • Basle II promises significant business benefits to those who have systems in place to access and utilize far more detailed and precise information • Integration of data on finance, operations and risk management necessary • Opportunity to get out of legacy systems and procedures including IT system • Fundamental rethinking on how a bank’s data and information is provided and controlled • Pillars are interdependent and must be addressed to concurrently

28. Basle Accord and IT Internal Rating based approaches revolve around Probability of default Loss given default Exposure at default Other parameters Main requirements would include Defining and capturing loss data Capturing and extracting exposure data Identifying and capturing risk mitigation data Data issues would be Sources/ Data types/ Quality requirements and Granularity (level of data)

29. Basle Accord and IT Operational Risk Management pre-supposes • Framework and systems in data integration • Low frequency-high severity occurrences • Structure for risk management and interaction amongst functionaries • Potential for mitigation, outsourcing and alike issues • Shared facilities feasibility • More synergy and little overlap

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