CAIIB- Risk Management Module D Capital Management & Profit planning by Shri Amar J.Nayyar. Balance Sheet . Principles. Liabilities- Taken at book value Assets - The lower of book value or market value
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.
Addressed mainly credit risk and
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.
Replaces existing ’one-size-fits-all’ frame work with several
options for banks.
Provides guidelines for supervisors for effective implementation.
Clamps disclosure norms about risk management practices.
The revised accord provides incentives to banks to improve
their risk management systems.
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 > 5yrs., loan loss reserves, revaluation reserves, investment fluctuation reserves, and limited life preference shares ) and
Tier- III capital (short term subordinated debt >2yrs & < 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 < 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
The total capital ratio must not be lower than 8%
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
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 bank’s 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.
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
The minimum capital required comprises two components:
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 ).
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.
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.
Here, bank’s 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, bank’s 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.
light of changing environment, legal frame work, experience etc.
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
The supervisory duties are guided by four principles
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.
- Standard assets
-Doubtful assets and
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.
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.
Standardised approach for credit risk and Basic Indicator Approach for operational risk.
Banks shall continue to apply standardised duration approach for market risk.
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.