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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

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Caiib risk management module d capital management profit planning by shri amar j nayyar l.jpg
CAIIB- Risk ManagementModule DCapital Management&Profit planningby Shri Amar J.Nayyar

Principles l.jpg

  • 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.

Basel 1 l.jpg

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.

The basel ii accord l.jpg
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.

Components of capital l.jpg
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 > 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

Pillar 1 minimum capital requirements l.jpg
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

Pillar i mcr capita l for credit risk l.jpg

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.

Pillar i mcr capita l for market risk l.jpg

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

Pillar i mcr capita l for matket risk l.jpg

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 ).

Pillar i mcr capita l for operational risk l.jpg

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.


Pillar i mcr capita l for operational risk contd l.jpg

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, 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.

Prevention and control of operational risks l.jpg
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.

Pillar ii supervisory review process l.jpg
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

Supervisory review process four principles l.jpg
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 bank’s capital is sliding below the minimum regulatory capital.


Pillar ii supervisory review process16 l.jpg
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.

Pillar iii market discipline l.jpg
Pillar- III : Market Discipline

  • Disclosure norms to enable the market to assess a bank’s 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.


Pillar iii market discipline contd l.jpg
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.

Asset classification and provisioning norms l.jpg
AssetClassification 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.

Provisioning norms l.jpg
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%.

Profit planning l.jpg
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.


Profit planning contd l.jpg
Profit Planning (Contd.)

  • Banks have to optimise the allocation of funds amongst


    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.

Slide23 l.jpg

  • 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.

Slide24 l.jpg

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.

Contact no 9322670458 email nayyar@pnbrscmbi com l.jpg
contact no.:9322670458email: