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CAIIB Paper 2 (BFM), Module B: Risk

Management
Index

No. of Unit Unit Name

Unit 1 Risk and Basic Risk Management
Framework
Unit 2 Risk in Banking Business
Unit 3 Risk Regulations In Banking Industry
Unit 4 Market Risk
Unit 5 Credit Risk
Unit 6 Operational Risk and Integrated Risk
Management
Unit 7 Liquidity Risk Management
Unit 8 Basel II Framework on Liquidity
Standards

Unit 1: Risk and Basic Risk Management

Framework
What Is Risk?
In most cases, we observe that there is deviation in what we achieve from what we had
planned or what we had expected. This unpredictability of future is due to uncertainties
associated with the steps that we undertake in the process or various external factors that
influence the processes that are necessary to achieve our planned objective.

We may define 'Risks 'as uncertainties resulting in adverse outcome, adverse in relation to
planned objective or expectations. 'Financial Risks' are uncertainties resulting in adverse
variation of profitability or outright losses.

Uncertainties associated with risk elements impact the net cash flow of any business or
investment. Under the impact of uncertainties, variations in net cash flow take place. This
could be favourable as well as unfavourable. The possible unfavourable impact is the 'RISK’
of the business.

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Lower risk implies lower variability in net cash flow with lower upside and downside
potential. Higher risk would imply higher upside and downside potential.

• Lower risk: implies lower variability in net cash flow with lower upside and
downside potential. Higher risk would imply higher upside and downside potential.
• Zero Risk would imply no variation in net cash flow. Return on zero risk investment
would be low as compared to other opportunities available in the market.

Basic Risk Management Framework

The basic considerations that should be taken into account for designing a risk
management framework in an organisation are as follows:

1.Management of risk is a major concern for the top management. Successful

implementation of risk management process emanates from the top management and the
main challenge centres on facilitating the implementation of risk and business policies
simultaneously in a consistent manner. Modern best practices consist of setting risk limits
based on economic measures of risk while ensuring the best risk adjusted return keeping in
view the capital that has been invested in the business. It is a question of taking a balanced
view on risks and returns and that too within the constraints of available capital.

2.Management of risks begins with their identification and quantification. It is only after
risks are identified and measured that we may decide to accept the risks or to accept the
risks at a reduced level by undertaking steps to mitigate the risks, either fully or partially.
In addition, pricing of the transaction should be in accordance with the risk content of the
transaction.

3. Risk management happens to be a job that requires special skills and has an objective
which is more orientated towards the control aspect of the business, it requires a separate
setup in the organization.

Response to these considerations calls for risk management framework in an organization

that has well articulated processes covering the following areas:

• Organization for Risk Management

• Risk Identification
• Risk Measurement
• Risk Pricing
• Risk Monitoring and Control
• Risk Mitigation

Organisation for Risk Management

Usually, risk management organization consists of:

• The Board of Directors

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• The Risk Management Committee of the Board

• The Committee of senior-level executives
• The Risk management support group

Risk Identification

Nearly all transactions undertaken would have one or more of the major risks, i.e.,
liquidity risk, interest rate risk, market risk, default or credit risk and operational risk with
their manifestations in different dimensions. Although all these risks are contracted at the
transaction level, certain risks such as risk and interest rate risk are managed at the
aggregate or portfolio level. Risks such as credit risk, operational risk and market risk arising
from individual transactions are taken cognizance of, at the transaction-level as well as at
the portfolio-level.

Risk Measurement

Risk management relies on the quantitative measures of risk. The risk measures seek to
capture variations in earnings, market value, losses due to default, etc., (referred to as
target variables), arising out of uncertainties associated with various risk elements.
Quantitative measures of risks can be classified into three categories

• Based on Sensitivity
• Based on Volatility
• Based on Downside Potential

Sensitivity: Sensitivity captures deviation of a target variable due to unit movement of a

single market parameter. Only those market parameters, which drive the value of the target
variable are relevant for the purpose.

Volatility: It is possible to combine sensitivity of target variables with the instability of the
underlying parameters. The volatility characterises the stability or instability of any random
variable. It is a common statistical measure of dispersion around the average of any random
variable such as earnings, mark-to-market values, market value, losses due to default, etc.

Downside Potential: Risk materialises only when earnings deviate adversely. Volatility
captures both upside and downside deviations. Downside potential only captures possible
losses ignoring the profit potential. It is the adverse deviation of a target variable.

Risk Pricing

Risks in banking transactions impact banks in two ways. Firstly, banks have to maintain
necessary capital, at least as per regulatory requirements. The capital required is not
without costs. The cost of capital arises from the need to pay investors in bank's equity in
the form dividends and for internal generation of capital necessary for business growth.
Each banking transaction should be able to generate necessary surplus to meet this costs.
The pricing of transaction must take into account the factors discussed in this parą.

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Pricing, therefore, should take into account the following:

• Cost of Deployable Funds

• Operating Expenses
• Loss Probabilities
• Capital Charge
• Profit Margin or Return on Networth

Risk Monitoring and Control

The key driver in managing a business is seeking enhancement in risk-adjusted return on

capital (RAROC). Therefore, the approach to risk management cannot be in isolation or in
stand-alone mode. The approach to risk management centres on facilitating
implementation of risk and business policies simultaneously in a consistent manner. Modern
best practices consist of setting risk limits based on economic measures of risk while
ensuring the best risk adjusted return, keeping in view the capital that has been invested in
the business. It is a question of taking a balanced view on risks and returns and that too
within the constraints of available capital.

In order to achieve the above objective, banks put in place the following:

• An organizational structure.
• Comprehensive risk measurement approach.
• Risk Management Policies adopted at the corporate level, which are consistent with
the broader business strategies, capital strength, management expertise and risk
appetite.
• Guidelines and other parameters used to govern risk taking including detailed
structure of prudential limits, discretionary limits and risk-taking functions.

Risk Mitigation

Since risks arise from uncertainties associated with the risk elements, risk reduction is
achieved by adopting strategies that eliminate or reduce the uncertainties associated with
the risk elements. This is called "Risk Mitigation”.

Unit 2: Risk in Banking Business

Risk Identification In Banking Business
Banking business lines are many and varied. Commercial banking, corporate finance, retail
banking, trading and investment banking and various financial services form the main
business lines of banks Within each line of business, there are sub-groups and each sub-
group contains a variety of financial activities. Bank's clients may vary from retail consumer
segment to mid-market corporate/large corporate financial institutions. Banking services
may differ appreciably for each segment even for similar services.

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Business Lines of Banking Industry

Business Lines Sub-groups Activities
Corporate Finance Corporate Finance Mergers and acquisitions,
Municipal/Government underwriting privatisations,
Finance securitisation, research,
Merchant Banking debt (government, high
Advisory Services yield), equity, syndications,
IPO, secondary private
placements
Trading and Sales Sales Fixed income, equity,
Market making foreign exchanges,
Proprietary Positions commodities, credit,
Treasury funding, own position
securities, lending and
repos, brokerage, debt,
prime brokerage
Retail Banking Retail Banking Retail Lending & Deposits,
Banking Services, Trust and
Estates

Private Banking Private Lending & Deposits,

Banking Services, Trust and
Estates, Investment Advice

Card Services Merchant/Commercial

Corporate Cards, Private
Labels and Retail

Commercial Banking Commercial Banking Project finance, real estate,

export finance, trade
finance, factoring, leasing,
lending, guarantees, bills of
exchange
Payments and Settlement External Clients Payments and collections,
funds transfer, clearing and
settlement

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Agency Services Custody Escrow, depository receipts,

securities lending
(customers), corporate
Corporate Agency actions
Corporate Trust Issuer and paying agents
Asset Management Discretionary Fund Pooled, segregated, retail,
Management institutional, closed, open,
Non-Discretionary Fund private equity
Management Pooled, segregated, retail,
institutional, closed, open
Retail brokerage Retail Brokerage Execution and full service

From the risk management point of view, banking business lines may be grouped broadly
under the following major heads.

• The Banking Book

• The Trading Portfolio
• Off-Balance Sheet Exposures

The Banking Book

The banking book includes all advances, deposits and borrowings, which usually arise from
commercial and retail banking operations. All assets and liabilities in banking book have
the following characteristics:

• They are normally held until maturity.

• Accrual system of accounting is applied.
• They are not subjected to MTM (mark to market) exercise.
• They attract capital charge on credit risk and not on market risk.

The Trading Book

The trading book includes all the assets that are marketable, i.e., they can be traded in the
market. Contrary to the characteristics of assets and liabilities held in the banking book, the
trading book assets have the following characteristics:

• They are normally not held until maturity and positions are liquidated in the market
after holding the assets for a certain period
• Mark-to-Market system is followed and the difference between the market price and
the book value is taken to profit and loss account.

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The trading book mostly comprises of fixed income securities, equities, foreign exchange
holdings, commodities, etc., held by the bank on its own account.

Off-Balance Sheet Exposures

Off-balance sheet exposures are contingent in nature. Where banks issue guarantees,
committed or backup credit lines, letters of credit, etc., banks face payment obligations
contingent upon some event. These contingencies adversely affect the revenue generation
of banks. Banks may also have contingent assets (for example, a bank may have purchased
insurance to protect against certain negative events). Here banks are the beneficiaries
subject to certain contingencies. Derivatives are off-balance sheet market exposures. They
may be swaps, futures, forward contracts, foreign currency contracts, options, etc.

Banking Risks - Definitions

From the discussion above, we may summarise the major risks in banking business or
“Banking Risks'. They are listed as follows:

• Liquidity Risk
• Interest Rate Risk
• Market Risk
• Default or Credit Risk
• Operational Risk

Liquidity Risk

The liquidity risk of banks arises mainly from funding of long-term assets by short-term
liabilities, thereby making the liabilities subject to rollover or refinancing risk. Liquidity
Risk is defined as the inability to obtain funds to meet cash flow obligations at a reasonable
rate.

• Funding Risk: This arises from the need to replace net outflows due to unanticipated
withdrawal non-renewal of deposits (wholesale and retail)/premature closure of
term deposits;
• Time Risk: This arises from the need to compensate for non-receipt of expected
inflows of funds i.e. performing assets turning into non-performing assets; or
borrowers not repaying their instalments (EMI) on due dates; and
• Call Risk: This arises due to crystallization of contingent liabilities since customers
are not meeting their commitments on due dates. This may also arise when a bank
may not be able to undertake profitable business opportunities when it arises.

Interest Rate Risk

Interest Rate Risk (IRR) is the exposure of a Bank's revenue to adverse movements in
interest rates. Interest Rate Risk (IRR) refers to potential adverse impact on Net Interest

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Income or Net Interest Margin or Market Value of Equity (MVE), caused by changes in
market interest rates. It may be defined as the risk of changes in the financial value of assets
or liabilities (or inflows/outflows) because of fluctuations in interest rates.

• Gap or Mismatch Risk: A gap of mismatch risk arises from holding assets and
liabilities and off-balance sheet items with different principal amounts, maturity
dates or repricing dates, thereby creating exposure to unexpected changes in the
level of market interest rates.
• Basis Risk: The risk that the interest rate of different assets, liabilities and off-
balance sheet items may change in different magnitude is termed as basis risk.
• An example of basis risk would be to say in a rising interest rate scenario asset
interest rate may rise in different magnitude than the interest rate on corresponding
liability creating variation in net interest income.
• Yield Curve Risk: In case the banks use two different instruments maturing at
different time horizon for pricing their assets and liabilities, any non-parallel
movements in yield curves would affect the NII.
• Reinvestment Risk: Uncertainty with regard to interest rate at which the future cash
flows could be reinvested is called reinvestment risk. Any mismatches in cash flows
would expose the banks to variations in NII as the market interest rates move in
different directions.
• Net Interest Position Risk: Where banks have more earning assets than paying
liabilities, interest rate risk arises when the market interest rates adjust downwards.
Such banks will experience a reduction in NII as the market interest rate declines and
increases when interest rate rises. Its impact is on the earnings of the bank or its
impact on the economic value of the bank's assets, liabilities and OBS positions.

Market Risk

Market risk is the risk of adverse deviations of the mark-to-market value of the trading
portfolio, due to market movements, during the period of holding. This results from adverse
movements of the market prices of interest rate instruments, equities, commodities and
currencies. Market Risk is also referred as Price Risk.

• Forex Risk: Forex risk, also termed as Exchange Risk, is the 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, either spot or forward, or a combination of the two, in
an individual foreign currency.
• Marker Liquidity Risk: Market liquidity risk arises when a bank is unable to conclude
a large transaction in a particular instrument near the current market price.

Default or Credit Risk

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Credit Risk is most simply defined as the potential of a bank borrower or counterparty fail
to meet its obligations in accordance with agreed terms. For most banks, loans and
corporate bonds are the largest and most obvious source of credit risk.

• Counterparty Risk: This is a variant of credit risk and is related to non-performance

of the trading partners due to counterparty's refusal and or inability to perform.
Normally such defaults happen in Call money borrowing between banks since it is
purely unsecured. The counter-party risk is generally viewed as a transient financial
risk associated with trading rather than standard credit risk.
• Country Risk: This is also a type of credit risk where non-performance by a borrower
or counter-party arises due to constraints or restrictions imposed by a country. In
this case, the reasons for non-performance are external factors on which the
borrower or the counterparty has no control.

Operational Risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people and systems or from external events. Strategic risk and reputation risk, though in
the nature of operational risk, are not covered under the definition of operational risk by
BCBS.

• Transaction Risk: Transaction risk is the risk arising from fraud, both internal and
external, failed business processes and the inability to maintain business continuity
and manage information.
• Compliance Risk: Compliance risk is the risk of legal or regulatory sanction, financial
loss or reputation loss that a bank may suffer as a result of its failure to comply with
any or all of the applicable laws, regulations, codes of conduct and standards of good
practice. It is also called integrity risk since a bank's reputation is closely linked to its
adherence to principles of integrity and fair dealing.
• Strategic Risk: Strategic Risk is the risk arising from adverse business decisions,
improper implementation of decisions, or lack of responsiveness to industry
changes. This risk is a function of the compatibility of an organisation's strategic
goals, the business strategies developed to achieve those goals, the resources
deployed against these goals and the quality of implementation. In short, this risk
calls for whether there is gap between the strategy aimed at and implemented. If
there is a gap, then the strategy is not implemented in letter and spirit.
• Reputation Risk: Reputation Risk is the risk arising from negative public opinion. This
risk may expose the institution to litigation, financial loss, or a decline in customer
base. Risks faced by banking and financial services may be summarised as shown in

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Risks in Banking and Financial Services

Liquidity Risk Intt Rate Market Risk Credit Risk Operational Other Risk
Risk Risk

Forex Risk Reputation Risk

Funding Risk Counter Party Risk

Strategic Risk
Time Risk Price Risk Counter Risk

Fraud Risk Communication Risk

Liquidation Risk
Call Risk
Documentation Risk Transaction Risk

Gap Mismatch Risk Yield Curve Risk Competence Risk Model Risk

Basis Risk Embedded Option Risk Cultural Risk External Events Risk

Reinvestment Risk Liquidity Risk Legal Risk Regulatory Risk

Compliance Risk System Risk

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Unit 3: Risk Regulations In Banking Industry

Regulation of Banking Industries - Necessities And Goals

Banking and financial services, all over the world, are regulated usually by the Monetary
Authority of the land. This is because banking and financial services are the backbone of an
economy. A healthy and strong banking system is a must for any economy to function
smoothly and to prosper. As we have seen, banks have risks and risk taking is their business.
But if risk-taking is not regulated properly, banks may fail and it would have a disastrous
effect on the economy. Therefore, Monetary Authorities across the world regulate
functioning of the banks. In India, this function, as we all know, is with Reserve Bank of
India, Country's monetary authority.

Regulations have several goals. They are:

• Improving the safety of the banking industry, by imposing capital requirements in

line with bank's risks.

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Note: Regulatory Authorities impose recognition of the core concept of the capital
adequacy principle and of 'risk-based capital', which means banks' capital should be
in line with risks. This implies a quantitative assessment of risks as well.

• Levelling the competitive playing field of banks through setting common benchmarks
for all players.
• Promoting sound business and supervisory practices.
• Controlling and monitoring Systemic Risk'.
• Protecting interest of depositors as depositors cannot impose a real market
discipline on banks.

Systemic Risk

Systemic risk is the risk of failure of the whole banking system. An Individual bank's failure is
one of the major sources of the systemic risk. This happens because of high inter-relations
that exist on a ongoing basis between banks through mutual lending and borrowing and
other commitments.

Basel Committee on Banking Supervision

Why BCBS?

On 26th June 1974, a number of banks had released Deutschmarks to Bank Herstatt in
Frankfurt in exchange for dollar payments that were to be delivered in New York. Due to
differences in time zones, there was a lag in dollar payments to counterparty banks during
which Bank Herstatt was liquidated by German regulators (Bundesbank), i.e., before the
dollar payments could be effected.

Note: The risk of settlement that arises from time-difference came to be known as 'Herstatt
Risk'.

The Basel Committee has the following five groups:

• Policy Development Group

• Supervision and Implementation Group
• Basel Consultative Group
• Macro prudential Supervision Group
• Accounting Experts Group

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The five Committee groups report directly to the BCBS Chairman and form part of its
permanent internal structure. Within each group are working groups - which support
specified technical work - and task forces - which undertake specific tasks for a limited time.
High-level task forces are also in place to support broader goals outside the Committee
groups' primary activities.

BASEL NORM
Basel is a city in Switzerland which is also the headquarters of Bureau of International
Settlement (BIS).
The Bank for International Settlements (BIS) established on 17 May 1930, is the world's
oldest international financial organisation. There are two representative offices in the Hong
Kong and in Mexico City.

BASEL- I

• In 1988, The Basel Committee on Banking Supervision (BCBS) introduced capital

measurement system called Basel capital accord, also called as Basel 1.
• It focused almost entirely on credit risk, It defined capital and structure of risk
weights for banks.
• The minimum capital requirement was fixed at 8% of risk-weighted assets
(RWA).
• India adopted Basel 1 guidelines in 1999.
• In India, however banks are required to maintain a minimum Capital-to-risk
weighted Asset ratio (CRAR) of 9% on an ongoing basis.

BASEL- II

In 2004, Basel II guidelines were published by BCBS, which were considered to be the
refined and reformed versions of Basel I accord.
Three Pillars of Basel II
(i)First Pillar: Minimum capital Requirement
(a)Calculation of minimum capital requirements and constituents of capital
(b)Credit Risk
-Standardized Approach
-Internal Ratings-based Approach
- Securitisation Framework

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(c)Market Risk
(d)Operational Risk
(ii)Second Pillar: Supervisory review process
(iii)Third Pillar: Market Discipline.

First Pillar: Minimum capital Requirement

The Capital base of the bank consist of the following three types of capital element. Tier 1,
Tier 2 and Tier 3 capital. The sum of Tier 1, Tier 2 and Tier 3 element will be eligible for
inclusion in the capital base, subject to the following limits.
(a)Total of Tier 2 (Supplementary) elements will be limited to a maximum of 100% of the
Tier 1 element.
(b)Subordinated term debt will be limited to a maximum of 50% of Tier 1 elements.
(c)Tier 3 capital will be limited to 250% of a bank’s Tier 1 capital that is required to support
market risks.
(d)Where general provisions/general loan –loss reserves include amounts reflecting lower
valuations of assets or latent but unidentified losses present in the balance sheet, the
amount of such provisions or reserves will be limited to a maximum of 1.25% point.
(e)Asset revaluation reserves, which take the form of latent gains on unrealized securities,
will be subject to a discount of 55%.

Second Pillar: Supervisory review process

The section discusses the key principles of supervisory review, risk management guidance
and supervisory transparency and accountability, produced by the committee with respect
to banking risks. This includes guidance relating to, among other things, the treatment of
interest rate risk in the banking book, credit risk, operational risk etc.
Four key of Principles of Supervisory Review:
The Committee has identified four key principles of supervisory review, which complement
those outlined in the extensive supervisory guidance that has been developed by the
committee.
Principle 1: Banks should have a process for assessing their overall capital adequacy in
relation to their risk profile and a strategy for maintaining their capital levels.
Principle 2: Supervisors should review and evaluate Bank’s internal capital adequacy
assessments and strategies, as well as their ability to monitor and ensure their compliance
with regulatory capital ratios. Supervisors should take appropriate supervisory action if they
are not satisfied with the result of this process.

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Principle 3: Supervisors should expect banks to operate above the minimum regulatory
capital ratios and should have the ability to require banks to hold capital in excess of the
minimum.
Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from
falling below the minimum levels required to support the risk characteristics of a particular
bank and should require rapid remedial action if capital is not maintained or restored.

Third Pillar: Market Discipline

• Disclosure Requirements
• Guiding Principles
• Achieving Appropriate Disclosure

BASEL - III

Basel III or Basel 3 released in December, 2010 is the third in the series of Basel Accords.
These accords deal with risk management aspects for the banking sector. So we can say that
Basel III is the global regulatory standard on bank capital adequacy, stress testing and
market liquidity risk. (Basel I and Basel II are the earlier versions of the same, and were
less stringent).
The RBI issued Guidelines based on the Basel III reforms on capital regulation on May 2
2012, to the extent applicable to banks operating in India. The Basel III capital regulation has
been implemented form April 1, 2013 in India in phase and it will be fully implemented as
on March 31, 2019 but Extended.

• In Basel 3, implementation of CCB extended from 31.03.20 to

30.09.20 (further changed to 1.4.2021).
• In Basel 3, implementation of NSFR extended from 1.4.20 to
1.10.20 (further changed to 1.4.2021)

Aims of the Basel III

• Improve the banking sector’s ability to absorb ups and downs arising from
financial and economic instability
• Improve risk management ability and governance of banking sector
• Strengthen banks’ transparency and disclosures

What are the major changes proposed in Basel iii over earlier
accords i.e. Basel I and Basel II?

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Better Capital Quality: One of the key elements of Basel 3 is the introduction of much
stricter definition of capital. Better quality capital means the higher loss-absorbing capacity.
This in turn will mean that banks will be stronger, allowing them to better withstand periods
of stress.
Capital Conservation Buffer: Another key feature of Basel iii is that now banks will be
required to hold a capital conservation buffer of 2.5%. The aim of asking to build
conservation buffer is to ensure that banks maintain a cushion of capital that can be used to
absorb losses during periods of financial and economic stress.
Countercyclical Buffer: This is also one of the key elements of Basel III. The countercyclical
buffer has been introduced with the objective to increase capital requirements in good
times and decrease the same in bad times. The buffer will slow banking activity when it
overheats and will encourage lending when times are tough i.e. in bad times. The buffer will
range from 0% to 2.5%, consisting of common equity or other fully loss-absorbing capital.
Minimum Common Equity and Tier 1 Capital Requirements: The minimum requirement for
common equity, the highest form of loss-absorbing capital, has been raised under Basel III
from 2% to 4.5% of total risk-weighted assets. The overall Tier 1 capital requirement,
consisting of not only common equity but also other qualifying financial instruments, will
also increase from the current minimum of 4% to 6%. Although the minimum total capital
requirement will remain at the current 8% level, yet the required total capital will increase
to 10.5% when combined with the conservation buffer.
Leverage Ratio: A review of the financial crisis of 2008 has indicted that the value of many
assets fell quicker than assumed from historical experience. Thus, now Basel III rules
include a leverage ratio to serve as a safety net. A leverage ratio is the relative amount of
capital to total assets (not risk-weighted). This aims to put a cap on swelling of leverage in
the banking sector on a global basis. 3% leverage ratio of Tier 1 will be tested before a
mandatory leverage ratio is introduced in January 2018.
Liquidity Ratios: Under Basel III, a framework for liquidity risk management will be created.
A new Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are to be
introduced in 2015 and 2018, respectively.
Systemically Important Financial Institutions (SIFI): As part of the macro-prudential
framework, systemically important banks will be expected to have loss-absorbing capability
beyond the Basel III requirements. Options for implementation include capital surcharges,
contingent capital and bail-in-debt.

Comparison of Capital Requirements under Basel II and Basel III

As a percentage of risk weighted assets

Basel II Basel III
(January 2019)

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A= (B+D) Minimum Total Capital 8.0 8.0

B Minimum Tier 1 Capital 4.0 6.0
C Of which: Minimum 2.0 4.5
common equity Tier 1
capital
D Maximum Tier 2 Capital 4.0 2.0
(Within Total capital)
E Capital conservation -- 2.5
buffer (CCB)
F=C+E Minimum Common Equity 2.0 7.0
Tier 1 capital +CCB
G=A+E Minimum Total capital 8.0 10.5
+CCB

Minimum Regulatory Capital Prescriptions (as percentage of risk

weighted assets)

RBI Prescriptions
Basel II Basel III Basel II
Current (March 31, (January 2019)
2018)
A= (B+D) Minimum Total 9.0 9.0 8.0
Capital
B Minimum Tier 1 6.0 7.0 6.0
Capital
C Of which: Minimum 3.6 5.5 4.5
common equity Tier 1
capital
D Maximum Tier 2 3.0 2.0 2.0
Capital (Within Total
capital)
E Capital conservation -- 2.5 2.5
buffer (CCB)
F=C+E Minimum Common 3.6 8.0 7.0
Equity Tier 1 capital
+CCB

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G=A+E Minimum Total -- 11.5 10.5

capital +CCB
H Leverage Ratio (Ratio -- 4.5 3.0
to total Assets)

Composition of Regulatory Capital

General

Banks are required to maintain a minimum Pillar 1 Capital to Risk-weighted Assets Ratio
(CRAR) of 9% on an on-going basis (other than capital conservation buffer and
countercyclical capital buffer etc.). The Reserve Bank will take into account the relevant risk
factors and the internal capital adequacy assessments of each bank to ensure that the
capital held by a bank is commensurate with the bank's overall risk profile. This would
include, among others, the effectiveness of the bank's risk management systems in
identifying, assessing/measuring, monitoring and managing various risks including interest
rate risk in the banking book, liquidity risk, concentration risk and residual risk. Accordingly,
the Reserve Bank will consider prescribing a higher level of minimum capital ratio for each
bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk
management systems. Further, in terms of the Pillar 2 requirements, banks are expected to
operate at a level well above the minimum requirement. A bank should compute Basel III
capital ratios in the following manner:

Common Common Equity Tier 1 Capital

Equity Tier 1 Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
capital ratio

Tier 1 capital Eligible Equity Tier 1 Capital

ratio (CETI + Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
AT1)

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Total Capital Eligible Total Capital

(CRAR)# Credit Risk RWA+ Market Risk RWA + Operational Risk RWA

* RWA = Risk weighted Assets;

# Capital to Risk Weighted Asset Ratio

Elements of Regulatory Capital and the Criteria for their Inclusion in

the Definition of Regulatory Capital

Components of Capital

Total regulatory capital will consist of the sum of the following categories:

(i) Tier 1 Capital (going-concern capital)

(a) Common Equity Tier 1
(b) Additional Tier 1
(ii) Tier 2 Capital (gone-concern capital)

From regulatory capital perspective, going-concern capital is the capital which can absorb
losses without triggering bankruptcy of the bank. Gone-concern capital is the capital which
will absorb losses only in a situation of liquidation of the bank.

Limits and Minima

• As a matter of prudence, it has been decided that scheduled commercial banks

(excluding Local Area Banks and Regional Rural Banks) operating in India shall
maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs)
i.e. capital to risk weighted assets (CRAR). This will be further divided into different
components as described hereunder.
• Common Equity Tier 1 (CETI) capital must be at least 5.5% of risk-weighted assets
(RWAS) i.e. for credit risk + market risk + operational risk on an ongoing basis.

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• Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the
minimum Tier 1 capital, Additional Tier 1 capital can be admitted maximum at 1.5%
of RWAS.
• Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an
ongoing basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted
maximum up to 2%.
• If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital
ratios, then the excess Additional Tier 1 capital can be admitted for compliance with
the minimum CRAR of 9% of RWAS.
• In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks
are also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in
the form of Common Equity Tier 1 capital. Details of operational aspects of CCB are
given in RBI Circular.

Capital Charge for Credit Risk

Under the Standardised Approach, the rating assigned by the eligible external credit rating
agencies will largely support the measure of credit risk. The Reserve Bank has identified
the external credit rating agencies that meet the eligibility criteria specified under the
revised Framework. Banks may rely upon the ratings assigned by the external credit rating
agencies chosen by the Reserve Bank for assigning risk weights for capital adequacy
purposes as per the mapping furnished in the RBI Guidelines.

The Circular issued by the Reserve Bank of India has laid down detailed guidelines on the
capital adequacy requirements and the risk weights to be applied in case of the following
claims:

• Claims on Domestic Sovereigns

• Claims on Foreign Sovereigns
• Claims on Public Sector Entities (PSES)
• Claims on Multilateral Development Banks, Bank for International Settlements and
the International Monetary Fund
• Claims on Banks (Exposure to capital instruments)
• Claims on Primary Dealers

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• Claims on Corporates, Asset Finance Companies and Non-Banking Finance

Companies- Infrastructure Finance Companies
• Claims included in the Regulatory Retail Portfolios
• Claims secured by Residential Property
• Claims Classified as Commercial Real Estate Exposure
• Non-Performing Assets (NPAs)
• Specified Categories Venture Capital Funds
• Other Assets like loans and advances to bank's own staff
• Off-Balance Sheet Items
• Securitisation Exposures
• Capital Adequacy Requirement for Credit Default Swap (CDS) Positions in the
Banking Book

Eligible Credit Rating Agencies

Reserve Bank has undertaken the detailed process of identifying the eligible credit rating
agencies, whose ratings may be used by banks for assigning risk weights for credit risk. In
line with the provisions of the Revised Framework, where the facility provided by the bank
possesses rating assigned by an eligible credit rating agency, the risk weight of the claim will
be based on this rating

In accordance with the principles laid down in the Revised Framework, the Reserve Bank of
India has decided that banks may use the ratings of the following domestic credit rating
agencies for the purposes of risk weighting their claims falling under Corporate exposures
for capital adequacy purposes:

• Brickwork Ratings India Pvt. Limited (Brickwork);

• Credit Analysis and Research Limited;
• CRISIL Limited;
• ICRA Limited;
• India Ratings and Research Private Limited (India Ratings); and
• SMERA Ratings Ltd. (SMERA)
• INFORMERICS Valuation and Rating Pvt. Ltd (from June, 2017)

The Reserve Bank of India has decided that banks may use the ratings of the following
international credit rating agencies (arranged in alphabetical order) for the purposes of risk
weighting their claims for capital adequacy purposes where specified:

• Fitch;

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• Moody's; and
• Standard & Poor's

Internal Rating Based Approach

One of the most innovative aspects of the New Accord is the IRB approach to
measurement of capital requirements for credit risk. The IRB Approach offers the following
two options: Foundation IRB Approach (FIRB) and Advanced IRB Approach (AIRB) version.
The IRB approach differs substantially from the standardised approach to the extent that
banks' internal assessments of key risk parameters serve as primary inputs to capital
calculation. Since the approach is based on banks' internal assessments, the potential for
more risk-sensitive capital requirements is substantial. The salient features of IRB Approach
are as under:

• The IRB Approach computes the capital requirements of each exposure directly
before computing the risk-weighted assets.
• Capital charge computation is a function of the following parameters:

(i)Probability of Default (PD)

(ii)Loss Given the Default (LGD)

(iii)Exposure at Default (EAD)

(iv)Maturity (M)

The risk-weighted assets are derived from the capital charge computation.

• Probability of Default (PD), which measures the likelihood that the borrower will
default over a time given horizon.
• Loss Given Default (LGD), which measures the proportion of the exposure that will
be lost if a default occurs.
• Exposure At Default (EAD), which for loan commitment measures the amount of the
facility that is likely to be drawn in the event of a default.
• Maturity (M), which measures the remaining economic maturity of the exposure.

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Table Differences between Foundation and Advanced IRB Approaches

Parameter Foundation IRB Advanced IRB

PD Bank Bank

LGD Supervisor Bank

EAD Supervisor Bank

M Bank or Supervisor Bank

Risk Weight Function provided by the Function provided by the committee

committee

Data Historical data to estimate PD [5 Historical loss data to estimate LGD (7

Requirement years] years) and historical exposure data to
estimate EAD (7 years) ] plus that for PD
estimation

Credit Risk Mitigation

General Principles

Banks use a number of techniques to mitigate the credit risks to which they are exposed.
For example, exposures may be collateralised in whole or in part by cash or securities,
deposits from the same counterparty, guarantee of a third party, etc.

The general principles applicable to use of credit risk mitigation techniques are as under:

• No transaction in which Credit Risk Mitigation (CRM) techniques are used should
receive a higher capital requirement than an otherwise identical transaction where
such techniques are not used.
• The effects of CRM will not be double counted. Therefore, no additional supervisory
recognition of CRM for regulatory capital purposes will be granted on claims for
which an issue-specific rating is used that already reflects that CRM.

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• Principal-only ratings will not be allowed within the CRM framework.

• While the use of CRM techniques reduces or transfers credit risk, it simultaneously
may increase other risks (residual risks). Residual risks include legal, operational,
liquidity and market risks. Therefore, it is imperative that banks employ robust
procedures and processes to control these risks, including strategy, consideration of
the underlying credit; valuation; policies

Capital Charge for Market Risk

Market risk is defined as the risk of losses in on-balance sheet and off-balance sheet
positions arising from movements in market prices.

The market risk positions subject to capital charge requirement are:

• The risks pertaining to interest rate related instruments and equities in the trading
book; and
• Foreign exchange risk (including open position in precious metals) throughout the
bank (both banking and trading books).

Scope and Coverage of Capital Charge for Market Risks

These guidelines seek to address the issues involved in computing capital charges for
interest rate related instruments in the trading book, equities in the trading book and
foreign exchange risk (including gold and other precious metals) in both trading and banking
books. Trading book for the purpose of capital adequacy will include:

• Securities included under the Held for Trading category

• Securities included under the Available for Sale category
• Open gold position limits
• Open foreign exchange position limits
• Trading positions in derivatives, and
• Derivatives entered into for hedging trading book exposures

The minimum capital requirement is expressed in terms of two separately calculated

charges,

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• “specific risk” charge for each security, which is designed to protect against an
adverse movement in the price of an individual security owing to factors related to
the individual issuer, both for short (short position is not allowed in India except in
derivatives and Central Government Securities) and long positions, and
• “general market risk” charge towards interest rate risk in the portfolio, where long
and short positions (which is not allowed in India except in derivatives and Central
Government Securities) in different securities or instruments can be offset.

Capital Charge for Operational Risk

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. This definition includes legal risk,
but excludes strategic and reputational risk. Legal risk includes, but is not limited to,
exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well
as private settlements.

The Measurement Methodologies

The New Capital Adequacy Framework (NCAF) outlines three methods for calculating
operational risk capital charges in a continuum of increasing sophistication and risk
sensitivity:

• The Basic Indicator Approach (BIA);

• The Standardised Approach (TSA); and
• Advanced Measurement Approaches (AMA).

The Basic Indicator Approach

Under the Basic Indicator Approach, banks must hold capital for operational risk equal to
the average over the previous three years of a fixed percentage (denoted as alpha) of
positive annual gross income. Figures for any year in which annual gross income is negative
or zero should be excluded from both the and numerator denominator when calculating the
average. If negative gross income distorts a bank's Pillar 1 capital charge, Reserve Bank will

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consider appropriate supervisory action under Pillar 2. The charge may be expressed as
follows:

KBIA = [ ∑ (GI1……n x α ●)]/n

Where:

KBIA = the capital charge under the Basic Indicator Approach

GI = annual gross income, where positive, over the previous three years

n = number of the previous three years for which gross income is positive

α = 15 per cent, which is set by the BCBS, relating the industry wide level of required capital
to the industry wide level of the indicator.

Gross income is defined as "Net interest income" plus "net non-interest income".

It is intended that this measure should:

• be gross of any provisions (e.g. for unpaid interest) and write-offs made during the
year,
• be gross of operating expenses, including fees paid to outsourcing service providers,
in addition to fees paid for services that are outsourced, fees received by banks that
provide outsourcing services shall be included in the definition of gross income;
• exclude reversal during the year in respect of provisions and write-offs made during
the previous year
• exclude income recognised from the disposal of items of movable and immovable
property;
• exclude realised profits/losses from the sale of securities in the "held to maturity”
category;
• exclude income from legal settlements in favour of the bank;
• exclude other extraordinary or irregular items of income and expenditure; and
• exclude income derived from insurance activities (i.e. income derived by writing
insurance policies) and insurance claims in favour of the bank.

Features of a Sound Risk Management System

A sound risk management system should have the following key features:

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• Active board and senior management oversight;

• Appropriate policies, procedures and limits;
• Comprehensive and timely identification, measurement, mitigation, controlling,
monitoring and reporting of risks;
• Appropriate management information systems (MIS) at the business and firm-wide
level; and
• Comprehensive internal controls.

PILLAR 3 - MARKET DISCIPLINE

The purpose of Market discipline is to complement the minimum capital requirements

(detailed under pillar 1) and the supervisory review process (detailed under Pillar 2). The
aim is to encourage market discipline by developing a set of disclosure requirements which
will allow market participants to assess key pieces of information on the scope of
application, capital, risk exposures, risk assessment processes and hence, the capital
adequacy of the institution.

In principle, banks' disclosures should be consistent with how senior management and the
Board of Directors assess and manage the risks of the bank. Under Pillar 1, banks use
specified approaches/ methodologies for measuring the various risks they face and the
resulting capital requirements. It is believed that providing disclosures that are based on a
common framework is an effective means of informing the market about a bank's exposure
to those risks and provides a consistent and comprehensive disclosure framework that
enhances comparability.

Scope and Frequency of Disclosures

Pillar 3 applies at the top consolidated level of the banking group to which the Capital
Adequacy Framework applies. Disclosures related to individual banks within the groups
would not generally be required to be made by the parent bank. An exception to this arises
in the disclosure of capital ratios by the top consolidated entity where an analysis of
significant bank subsidiaries within the group is appropriate, in order to recognise the need
for these subsidiaries to comply with the Framework and other applicable limitations on the
transfer of funds or capital within the group. Pillar 3 disclosures will be required to be made

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by the individual banks on a stand-alone basis when they are not the top consolidated entity
in the banking group.

Banks are required to make Pillar 3 disclosures as per RBI Guidelines at least on a half yearly
basis, irrespective of whether financial statements are audited, with the exception of
following disclosures:

• Table DF-2: Capital Adequacy;

• Table DF-3: Credit Risk: General Disclosures for All Banks; and
• Table DF-4: Credit Risk: Disclosures for Portfolios Subject to the Standardised
Approach.

Leverage Ratio

Definition, Minimum Requirement and Scope of Application of the Leverage Ratio

Definition and minimum requirement: exposure

The Basel III leverage ratio is defined as the capital measure (the numerator) divided by the
measure (the denominator), with this ratio expressed as a percentage

Leverage ratio = Capital Measure/Exposure Measure

Regulatory Capital Requirement for Indian Banks under Basel III

Elements of Common Equity Tier 1 Capital:

Indian Banks

Elements of Common Equity component of Tier 1 capital will comprise the following:

• Common shares (paid-up equity capital) issued by the bank which meet the criteria
for classification as common shares for regulatory purposes;
• Stock surplus (share premium) resulting from the issue of common shares;
• Statutory reserves;
• Capital reserves representing surplus arising out of sale proceeds of assets;
• Other disclosed free reserves, if any;
• Balance in Profit & Loss Account at the end of the previous financial year;

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• Banks may reckon the profits in current financial year for CRAR calculation on a
quarterly basis provided the incremental provisions made for non-performing assets
at the end of any of the four quarters of the previous financial year have not
deviated more than 25% from the average of the four quarters. The amount which
can be reckoned would be arrived at by using the following formula:

EPt = {NPt - 0.25*D*t}

Where;

EPt = Eligible profit up to the quarter 't' of the current financial year; t varies from 1 to 4

NPt = Net profit up to the quarter 't'

D = average annual dividend paid during last three years

• Revaluation Reserves at a discount of 55%;

• While calculating capital adequacy at the consolidated level, common shares issued
by consolidated subsidiaries of the bank and held by third parties (i.e. minority
interest) which meet the laid down criteria; and
• Less: Regulatory adjustments/deductions applied in the calculation of Common
Equity Tier! capital (i.e. to be deducted from the sum of items (i) to (viii)].

Foreign Banks' Branches

Elements of Common Equity Tier 1 capital will remain the same and consist of the
following:

• Interest-free funds from Head Office kept in a separate account in Indian books
specifically for the purpose of meeting the capital adequacy norms;
• Statutory reserves kept in Indian books;
• Remittable surplus retained in Indian books which is not repatriable so long as the
bank functions in India;
• Interest-free funds remitted from abroad for the purpose of acquisition of property
and held in a separate account in Indian books provided they are non-repatriable
and have the ability to absorb losses regardless of their source;

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• Capital reserve representing surplus arising out of sale of assets in India held in a
separate account and which is not eligible for repatriation so long as the bank
functions in India, and
• Less: Regulatory adjustments/deductions applied in the calculation of Common
Equity Tier 1 capital [i.e. to be deducted from the sum of items (i) to (v)].

Definitions and General Terminology

Counterparty Credit Risk (CCR) is the risk that the counterparty to a transaction could
default before be final settlement of the transaction's cash flows. An economic loss would
occur if the transactions or portfolio of transactions with the counterparty has a positive
economic value at the time of default. Unlike a firm's exposure to credit risk through a loan,
where the exposure to credit risk is unilateral and only the lending bank faces the risk of
loss, CCR creates a bilateral risk of loss : the market value of the transaction can be positive
or negative to either counterparty to the transaction. The market value is uncertain and can
vary over time with the movement of underlying market factors.

Securities Financing Transactions (SFTs) are transactions such as repurchase agreements,

reverse repurchase agreements, security lending and borrowing, collateralised borrowing
and lending (CBLO) and margin lending transactions, where the value of the transactions
depends on market valuations and the transactions are often subject to margin agreements.

Hedging Set is a group of risk positions from the transactions within a single netting set for
which only their balance is relevant for determining the exposure amount or EAD under the
CCR standardised method.

Current Exposure is the larger of zero, or the market value of a transaction or portfolio of
transactions within a netting set with a counterparty that would be lost upon the default of
the counterparty, assuming no recovery on the value of those transactions in bankruptcy.
Current exposure is often also called Replacement Cost.

Credit Valuation Adjustment is an adjustment to the mid-market valuation of the portfolio

of trades with a counterparty. This adjustment reflects the market value of the credit risk
due to any failure to perform on contractual agreements with a counterparty. This

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adjustment may reflect the market value of the credit risk of the counterparty or the market
value of the credit risk of both the bank and the counterparty.

One-Sided Credit Valuation Adjustment is a credit valuation adjustment that reflects the
market value of the credit risk of the counterparty to the firm, but does not reflect the
market value of the credit risk of the bank to the counterparty.

A central counterparty (CCP) is a clearing house that interposes itself between

counterparties to contracts traded in one or more financial markets, becoming the buyer to
every seller and the seller to every buyer and thereby ensuring the future performance of
open contracts.

A qualifying central counterparty (QCCP) is an entity that is licensed to operate as a CCP

(including a license granted by way of confirming an exemption), and is permitted by the
appropriate regulator overseer to operate as such with respect to the products offered.

A Clearing member is a member of, or a direct participant in, a CCP that is entitled to enter
into a transaction with the CCP, regardless of whether it enters into trades with a CCP for its
own hedging, investment or speculative purposes or whether it also enters into trades as a
financial intermediary between the CCP and other market participants.

A client is a party to a transaction with a CCP through either a clearing member acting as a
financial intermediary, or a clearing member guaranteeing the performance of the client to
the CCP.

Initial margin means a clearing member's or client's funded collateral posted to the CCP to
mitigate the potential future exposure of the CCP to the clearing member arising from the
possible future change in the value of their transactions.

Variation margin means a clearing member's or client's funded collateral posted on a daily
or intraday basis to a CCP based upon price movements of their transactions.

Trade exposures include the current and potential future exposure of a clearing member or
a client to a CCP arising from OTC derivatives, exchange traded derivatives transactions or
SFTs, as well as initial margin.

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Default funds, also known as clearing deposits or guarantee fund contributions (or any
other names), are clearing members' funded or unfunded contributions towards, or
underwriting of, a CCP's mutualised loss sharing arrangements. The description given by a
CCP to its mutualised loss sharing arrangements is not determinative of their status as a
default fund; rather, the substance of such arrangements will govern their status.

Offsetting transaction means the transaction leg between the clearing member and the CCP
when the clearing member acts on behalf of a client (e.g. when a clearing member clears or
novates a client's trade).

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Unit 4: Market Risk

Market Risk In Banks

Banks also have several activities and undertake transactions that result in market exposure.
They are not immune to these risks and have to face them too. All such transactions are
reflected in the trading book.

A trading book consists of a bank's proprietary positions in financial instruments covering-

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• Debt Securities
• Equity
• Foreign Exchange
• Commodities (not permitted in our country presently)
• Derivatives held for Trading

The trading book also includes positions in financial instruments arising from matched
principal brokering and market making, or positions taken in order to hedge other
elements of the trading book.

The proprietary positions are held with trading intent and with the intention of benefiting in
the short-term, from actual and/or expected differences between their buying and selling
prices or hedging other elements in the trading book.

A bank's trading book exposure has the following risks, which arise due to adverse changes
in the market variables such as interest rates, currency exchange rate, Commodity prices,
market liquidity, etc., and their volatilities impact the bank's earnings and capital adversely.

1.Market Risk

2.Liquidity Risk

• Asset Liquidity Risk

• Market Liquidity Risk

3.Credit and Counterparty risks

Note: The market liquidity risk is different from funding the liquidity risk that arises due to
asset-liability mismatch and is a subject matter of Asset Liability management.

Market Risk

Market risk is the risk of adverse deviations of the mark-to-market value of the trading
portfolio, due to market movements, during the period required to liquidate the
transactions. The period of liquidation is critical to assess such adverse deviations. If the
period of liquidation of the position gets longer, the possibilities of larger adverse deviations
from the current market value also increase.

Trading Liquidity Risk

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Trading liquidity is the ability to freely transact in markets at reasonable prices. Trading
liquidity is ability to liquidate positions without --

• Affecting market prices

• Attracting the attention of other market participants.

Trading liquidity allows one to transact without compromising on counter-party quality.

Liquidation involves asset and market liquidity risks. Price volatility is not the same in high-
liquidity and poor-liquidity situations.

The liquidity issue becomes critical in emerging markets. Prices in emerging markets often
diverge considerably from a theoretical 'fair value'. Liquidation risk arise from lack of trading
liquidity and results in

• Adverse change in market prices

• Inability to liquidate position at a fair market price
• Large price changes caused by liquidation of position
• Inability to liquidate position at any price

Credit and Counterparty Risks

Markets value the credit risk of issuers and borrowers and it reflects in prices. Credit risk
of traded debts, such as bonds and debentures and commercial papers, etc., is indicated
by Credit Rating given by rating agencies. Credit rating indicates the risk level associated
with the instruments and is factored into as add-ons to the risk-free rate of the
corresponding maturity. The lower the risk level, the lower is the spread over risk-free rate.

Market Risk Management Framework

Market risk management involves finding answer to four key questions.

• What are the risks?

• What is the quantum? How much could the price change? What would be the effect
on profit and loss?
• How can we monitor and control price risk?
• Can we reduce the risk? And, if so, then how?

Management processes for market risk management are designed essentially to answer
these questions. Accordingly, management processes are sub-divided into the following
four parts:

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• Risk Identification
• Risk Measurement
• Risk Monitoring and Control
• Risk Mitigation

An effective market risk management framework in a bank comprises of risk identification,

setting up of limits and triggers, risk monitoring, models of analysis that value positions or
measure market risk, risk reporting, etc.

Financial instrument take their price from the market and that depends upon the
interaction of market variables. Hence, market risk management processes do not have a
risk pricing process.

But, management of market risk needs an organisation structure in place that can carry out
the functions required for the purpose.

Organisation Structure

Management of market risk is a major concern of the top management of banks.

Successful implementation of risk management process emanates from the top
management in the bank. The main challenge centres on facilitating implementation of risk
and business policies simultaneously in a consistent manner. Modern best practices consist
of setting risk limits based on economic measures of risk while ensuring the best risk
adjusted return keeping in view the capital that has been invested in the business. It is a
question of taking a balanced view on risks and returns and within the constraints of
available capital. Usually, Market Risk Management organisation would consist:

• The Board of Directors

• The Risk Management Committee
• The Asset-Liability Management Committee (ALCO)
• The ALM Support Group/Market Risk Group
• The Middle Office

The Risk Management Committee is a Board level Sub-Committee. The responsibilities of

Risk Management Committee with regard to market risk management aspects include the
following:

• Setting guidelines for market risk management and reporting

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• Ensuring that market risk management processes conform to the policy

• Setting up prudential limits and their periodical review
• Ensuring robustness of measurement of risk models
• Ensuring proper manning for the processes

The Asset-Liability Management Committee (ALCO) is responsible for implementation of risk

and business policies simultaneously in a consistent manner and decides on the business
strategy to achieve these objectives. Its role encompasses the following:

• Product pricing for deposits and advances

• Maturity profile and mix of incremental assets and liabilities
• Articulating interest rate view of the bank
• Funding policy
• Transfer pricing
• Balance sheet management It set

Risk Identification

All products and transactions should be analysed for risks associated with them. While,
various risks associated with a standardised product stand analyzed, the risks in case of a
non-standard products need to be analysed. Therefore, the approach to deal in standard
and non-standard products differs. We have seen under the general approach to risk
management that the guidance for risk taking at the transaction level comes from the
corporate level. It applies to the management of market risk too.

• Usually all standard products would have 'Product Programme' for each of them. All
Risk- Taking Units operate within an approved Product Programme'. Product
programme defines procedures, limits and controls for all aspects of the product.
The product programme also specifies market risk measurement at an individual
product level and at aggregate portfolio level.
• New products or non-standard products may operate under a 'Product Transaction
Memorandum' on a temporary basis while a full Market Risk Product programme is
being prepared.

Risk Measurement

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Market risk management framework is heavily dependent upon the quantitative

measures of risk. The market risk measures seek to capture variations in market value
arising out of uncertainties associated with various risk elements. These provide an
objective measure of market risk in a transaction or of a portfolio. Market risk measures are
based on -

• Sensitivity

• Downside Potential

Sensitivity

Sensitivity, as had been stated deviation of market price due to unit movement of a single
market parameter. Supply-demand position, interest rate, market liquidity, inflation,
exchange rate, stock prices, etc., are the market parameters, which drive market values. For
example, change in interest rate would drive the market value of bonds and forward foreign
exchange held in a portfolio. If liquidity in the market increases, it may result in increased
demand which in turn may increase the market price.

Basis Point Value (BPV)

This is the change in value due to 1 basis point (0.01%) change in the market yield. This is
used as a measure of risk. The higher the BPV of a bond, higher is the risk associated with
the bond. Computation of BPV is quite simple.

For example, a 5 year 6% semi-annual bond @ market yield of 8%, has a price of Rs. 92,
which rises to Rs. 92.10 at a yield of 7.95%. So, for one BP fall in yield, market price changes
by Rs. 0.02 or gains by Rs. 2,000 per Rs. 1 crore face value. BPV of the bond is, therefore, Rs.
2,000. per crore face value.

This also helps us to quickly calculate profit or loss for a given change of yield. If the yield on
a bond with BPV of 2,000 declines by 8 BPs, then that would result in a profit of 8 X 2000 =
Rs. 16,000 per crore of face value. If one is holding Rs. 10,00,000 face value of this bond, he
makes a profit of Rs. 1,600.

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BPV changes with the remaining maturity. Suppose the bond described above has 5 years to
mature and the present BPV is 2000, the BPV will decline with time and on the day of
maturity it will be zero.

Duration or Modified duration is Macaulay's duration discounted by 1 period yield to

maturity,

The longer the duration of a security, the greater will be the price sensitivity to yield
changes and the higher would be the risk associated with the bond. Bond price changes can
be estimated with the help of modified duration by using the following relationship.

Approx % change in price = — modified duration X yield change

Downside Potential

Risk materializes only when earnings deviate adversely. Downside potential captures the
possible losses only and ignores the profit potential. Downside risk is the most
comprehensive measure of risk as t integrates sensitivity and volatility with the adverse
effect of uncertainty. This is the measure that is most relied upon by banking and financial
service industry as also the regulator.

Yield Vs Price Volatility

Yield volatility is the degree of variance in yield. This is largely unaffected by time and
duration. The volatility rises as yields fall.

Price volatility is degree of variance in price. This is largely unaffected by yield and
substantially affected by time and duration.

Price Volatility = (Yield volatility BPV x Yield)/Price

There are three main approaches to calculating value-at-risk:

• The correlation method, also known as the variance/covariance matrix method

• Historical simulation
• Monte Carlo simulation

Why VaR is Useful?

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• Good tool for all banks, financial institutions, multinationals, fund managers for
protection of customers, shareholders, employees and overall franchise of the
business.
• Translates portfolio exposures into potential impact on Profit and Loss.
• Aggregates and reports multi-product, multi-market exposures into one number.
• Meets external risk management disclosure and expectations.
• A vital component of current best practices in risk measurement.
• Embraced by practitioners, regulators and academicians.
• Valuable as a probabilistic measure of potential losses.

Limitation of VaR

VaR is not worst-case scenario. It does not measure losses under any particular market
conditions. VaR by itself - is not sufficient for risk measurement. Measures to get over the
limitation include back testing and model calibration and scenario analysis and stress
testing.

Role of VaR in Control and Monitoring

• Estimating Valatility
• Back Testing
• Stress Testing

Risk Reporting

Risk report should enhance risk communication across different levels of the bank, from
the trading desk to the CEO. In order of importance, senior management reports should
be -

• Regular and in time

• Reasonably accurate

• Including highlights of portfolio risk concentrations & exceptional events

• Containing written commentary

• Concise.

Managing Trading Liquidity

Risk of trading liquidity is managed by avoiding –

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• Large market share in any given type of asset

• Infrequently traded instruments

• Instruments with unusual tenors

• One-sided liquidity in the market

Risk Terminology in Risk Measurement

Say Mr. Abhinav takes a position in stock 'A' and wants to explain to his 'Boss' about the
market position. He can explain the position in three possible ways:

• He tells his Boss that he purchased 1,000 shares of stock ‘A’ at Rs. 600 per share
• He tells his Boss that he has taken a Rs. 600,000 position in stock ‘A’
• He tells his Boss that he invested in stock "A" . He explains that if price changes by
1%, he would have an impact of Rs. 6,000. But since the price is expected to
fluctuate 3% daily (daily volatility - figure estimated from past data), he estimates
the daily potential loss to be Rs. 41,868

Mr. Abhinav’s position analysis using risk terminology will be:

• Market factor - Stock price

• Market Factor Sensitivity - Rs. 6,000 (1% of total position)
• Volatility (Daily) - 3%
• Defeasance period - 1 day (i.e., to sell the stock)
• Defeasance factor - at 3% volatility it is 3 x 2.326 (@ 99% Confidence level)
• Value at Risk (VaR) - Rs. 41,868 - This is also the potential loss amount under normal
market conditions.

Risk Mitigation

Market risk arises due to volatility of financial instruments. The volatility of financial
instruments is instrumental for both profits and risk. Risk mitigation in market risk, i.e.,
reduction in market risk is achieved by adopting strategies that eliminate or reduce the
volatility of the portfolio. However, there are couple of issues that are also associated with
risk mitigation measures

• Risk mitigation, measures aim to reduce downside variability in net cash flow but it
also reduces the upside potential or profit potential simultaneously,
• In addition risk mitigation strategies, which involve counterparty, will always be
associated with counterparty risk. Of course, where counterparty is an established

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'Exchange' or a central counterparty, counterparty risk gets reduced very

substantially. In OTC deals, counterparty risk would depend upon the risk level
associated with party to the contract.

Unit 5: Credit Risk

Organisation Structure
Organisation for credit risk management is created with the objective of achieving
compatibility in risk and business policies and to ensure their simultaneous
implementation in a consistent manner. It involves setting risk limits based on the objective
measures of risk and simultaneously ensuring optimum risk adjusted return keeping in view
the capital constraints. It is a question of bank's policy in balancing risks, returns and capital.
Organisation for credit risk management should be able to achieve it. Usually, Credit Risk
Management organisation would consist of:

• The Board of Directors

• The Risk Management Committee

• Credit Policy Committee (CPC)

• Credit Risk Management Department

The Board of Directors has the overall responsibility for management of risks. The Board
articulates credit risk management policies, procedures, aggregate risk limits, review
mechanisms and reporting and auditing systems. The Board decides the level of credit risk
for the bank as a whole, keeping in view its profit objective and capital planning.

The Risk Management Committee is a Board level Sub-Committee. The responsibilities of

Management Committee with regard to credit risk management aspects include the
following:

• Setting guidelines for credit risk management and reporting

• Ensuring that credit risk management processes conform to the policy

• Setting up prudential limits and their periodical review

• Ensuring robustness of measurement of risk models

• Ensuring proper manning for the processes Management

Credit Policy Committee (CPC), also called Credit Control Committee/Credit Risk
Management Committee (CRMC) deals with issues relating to credit policy and procedures
and to analyse, manage and control credit risk on a bank wide basis. The Committee
formulates policies on standards for presentation of credit proposals, financial covenants,

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rating standards and benchmarks, delegation of credit approving powers, prudential limits
on large credit exposures, asset concentrations, standards for loan collateral, portfolio
management, loan review mechanism, risk concentrations, risk monitoring and evaluation
pricing of loans, provisioning, regulatory/legal compliance, etc.

Credit Risk Management Department (CRMD), which is independent of the Credit

Administration Department, enforces and monitors compliance of the risk parameters and
prudential limits set by the CPC/CRMC. The CRMD also lays down risk assessment systems,
monitors quality of loan portfolio identifies problems and corrects deficiencies, develops
MIS and undertakes loan review/audit. Department undertakes portfolio evaluations and
conducts comprehensives studies on the environment to test the resilience of the loan
portfolio.

Risk Identification
Credit risk arises from potential changes in the credit quality of a borrower. It has two
components: default risk and credit spread risk.

Default Risk

Default risk is driven by the potential failure of a borrower to make promised payments,
either partly or wholly. In the event of default, a fraction of the obligations will normally be
paid. This is known as recovery the rate

Credit Spread Risk or Downgrade Risk

If a borrower does not default, there is still risk due to worsening in credit quality. This
results in the possible widening of the credit-spread. This is credit-spread risk. Usually this is
reflected through rating downgrade. It is normally firm-specific.

Default risk and downgrade risk are transaction level risks. Risks associated with the credit
portfolio as a whole are termed portfolio risks. Portfolio risk has two components

• Systematic or Intrinsic Risk

• Risk Concentration Risk

Systematic or Intrinsic Risk

As we have seen in Para 7.47, portfolio risk is reduced due to diversification. If a portfolio
is fully diversified, i.e. diversified across geographies, industries, borrowers, markets, etc.,
equitably, then the portfolio risk is reduced to a minimum level. This minimum level
corresponds to the risks in the economy which it is operating. This is systematic or intrinsic
risk.

Concentration Risk

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If the portfolio is not diversified that is to say that it has higher weight in respect of a
borrower or geography or industry, etc., the portfolio gets concentration risk.

A portfolio is open to the systematic risk i.e., the risks associated with the economy. If
economy as a whole does not perform well, the portfolio performance will be affected. That
is why when an economy stagnates or faces negative or reduced growth, credit portfolio of
banking industry as a whole shows indifferent performance. Credit portfolio having
concentration in any segment would be affected if the segment does not perform well.

Measuring and managing credit risk, whether for loans, bonds or derivative securities, has
become a key issue for financial institutions. The risk analysis can be performed either for
stand-alone trades or for portfolios as a whole. Banks adopt the risk analysis in the following
manner.

• Standalone analysis for Corporate exposures.

• Portfolio analysis for Retail lending exposures.

The following chart outlines financial risks in lending as shown in Figure:

Credit Risk

Portfolio Risk Transaction Risk

Concentration Risk
Systematic Risk Default Risk Downgrade Risk

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Risk Measurement
Measurement of credit risk consists of

• Measurement of risk through credit rating/scoring;

• Quantifying the risk through estimating expected loan losses, i.e., the amount of loan
losses that bank would experience over a chosen time horizon (through tracking
portfolio behaviour over 5 or more years) and unexpected loan losses i.e. the
amount by which actual losses exceed the expected loss (through standard deviation
of losses or the difference between expected loan losses and some selected target
credit loss quartile).

Credit Rating - Why is it Necessary?

Credit Rating of an account is done with the primary objective to determine whether the
account, after the expiry of a given period, would remain a performing asset, i.e., it will
continue to meet its obligation to its creditors, including Bank and would not be in default.
In other words, credit rating exercise seeks to predict whether the borrower would have the
capability to honour its financial commitment in future to the rest of the world.

A Credit Rating depicts the credit quality of the borrower and depicts his default. A credit
rating process normally would consist of the following parameters:

• Financial Parameter.

• Management Parameter.

• Industry Parameter.

• Business Parameter,

Credit Risk Control and Monitoring

Risk taking through lending activities needs to be supported by a very effective control
and monitoring mechanism, firstly because this activity is widespread, and secondly,
because of very high share of credit risk in the total risk taking activity of a bank. An
elaborate and well-communicated policy at transaction level that articulates guidelines for
risk taking, procedural guidelines and an effective monitoring system is necessary. This is
also necessary to achieve the desired portfolio. Active portfolio management is required to
keep up with the dynamics of the economy. It is also necessary to monitor it.

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Consequently, credit risk control and monitoring is directed both at transaction level and
portfolio level.

It must be mentioned here that an appropriate credit information system is the basic
prerequisite for effective control and monitoring. A comprehensive and detailed MIS
(Management Information System) and CIS (Credit Information System) is the backbone for
an effective CRM System. There is also a need to review the existing MIS available from HO
and branches and the applicability of data for analysis purposes. A detailed MIS and CIS
structure should be set up and enforced for future data requirements.

Credit Risk Policies and Guidelines at Transaction Level

The instruments of Credit Risk Management at transaction level are:

• Credit Appraisal Process

• Risk Analysis Process

• Credit Audit and Loan Review

• Monitoring Process

There is a need to constantly improve the efficiency for each of these processes in
objectively identifying the credit quality of borrowers, enhancing the default analysis,
capturing the risk elements adequately for future reference and providing an early warning
signal for deterioration in the credit risk of borrowers.

Credit risk taking policy and guidelines at transaction level should be clearly articulated in
the Bank's Loan Policy Document approved by the Board. Standards and guidelines should
be outlined for

• Delegation of Powers

• Powers Credit Appraisals

• Rating Standards and Benchmarks (derived from the Risk Rating System)

• Pricing Strategy

• Loan Review Mechanism

Credit Approving Authority

Each Bank should have a carefully formulated scheme of delegation of powers. The banks
should also evolve multi-tier credit approving system where the loan proposals are
approved by an 'Approval Grid' or a Committee'. The 'Grid' or 'Committee', comprising at
least 3 or 4 officers, may approve the credit facilities above a specified limit and invariably
one officer should represent the CRMD, who has no volume and profit targets.

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Credit Appraisal

Credit appraisal guidelines include borrower standards, procedures for analyzing credit
requirements and risk factors, policies on standards for presentation of credit proposals,
financial covenants, rating standards and benchmarks, etc. This brings a uniformity of
approach in credit risk taking activity across the organisation. Credit appraisal guidelines
may include risk monitoring and evaluation of assets at transaction level, pricing of loans,
regulatory/legal compliance, etc.

Prudential Limits

Prudential limits serve the purpose of limiting credit risk. There are several aspects for
which prudential limits may be specified. They may include:

• Prudential limits for financial and profitability ratios such as current ratio, debt
equity and return on capital or return on assets, debt service coverage ratio, etc.
• Prudential limits for credit exposure
• Prudential limits for asset concentration
• Prudential limits for large exposures
• Prudential limit for maturity profile of the loan book.

Prudential limits may have flexibility for deviations. The conditions subject to which
deviations are permitted and the authority thereof should also be clearly spelt out in the
Loan low Policy.

Risk Pricing

The pricing strategy for credit products should move towards risk-based pricing to
generate adequate risk adjusted returns on capital. The Credit Spread should have a
bearing on the expected loss rates and charges on capital.

Credit Control and Monitoring At Portfolio Level

Credit control and monitoring at portfolio level deals with the risk of a given portfolio,
expected losses, requirement of risk capital, and impact of changing the portfolio mix on
risk, expected losses and capital It also deals with the marginal and absolute risk
contribution of a new position and diversification benefits that come out of changing the
mix. It also analyses factors that affect the portfolio's risk profile.

The activities include --

• Identification of portfolio credit weakness in advance - through credit quality migrations.

• Moving from measuring obligor specific risk associated with individual credit exposures to
measuring concentration effects on the portfolio as a whole.

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• Evaluating exposure distribution over rating categories and stipulating quantitative ceilings
on aggregate exposure in specified rating categories.

• Evaluating rating-wise distribution in various industries and setting corresponding

exposure limits to contain concentration risk.

• Moving towards Credit Portfolio Value at Risk Models.

Some measures to maintain the portfolio quality are:

• Quantitative ceiling on aggregate exposure in specified rating categories.

• Evaluation of rating-wise distribution of borrowers in various industries, business
segments, etc.
• Industry-wise and sector-wise monitoring of exposure performance. Where
portfolio exposure to a single industry is badly performing, the banks may increase
the quality standards for that specific industry.
• Target for probable defaults and provisioning requirements as a prudent planning
exercise. For any deviation/s from the expected parameters, an exercise for
restructuring of the portfolio should immediately be undertaken and if necessary,
the entry-level criteria could be enhanced to insulate the portfolio from further
deterioration.
• Undertake rapid portfolio reviews, stress tests and scenario analysis when external
environment undergoes rapid changes (e.g., volatility in the forex market, economic
sanctions, changes in the fiscal/monetary policies, general slowdown of the
economy, market risk events, extreme liquidity conditions, etc.). Based on the
findings of stress test, prudential limits, quality standards, etc., may be revised.
• Introduce discriminatory time schedules for review of borrowers.

Active Credit Portfolio Management

Motivation for active credit portfolio management comes from changing demand of
traditional products and new business opportunities. Change in demand of traditional
products has arisen due to

• Less demand due to disintermediation

• More supply due to capital mobility

• Lower returns and increased importance of risk

The motivation for active credit portfolio management also comes from new
opportunities in the economy, such as:

• Pass through certificates

• Syndicated lending

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• Project/structured finance

Essentially, new products have different types of risks as compared to traditional

products. In addition, banks also have new tools to manage credit portfolio such as:

• Secondary loan trading

• Securitisation

• Credit derivatives

This calls for a business transformation plan - a gradual process with a well-articulated
strategy and with a thorough understanding of markets and supported by

• Necessary infrastructure

• Appropriate policy development

• Human resource training

• Careful system selection

• Continuous testing and refinement

Controlling Credit Risk Through Loan Review Mechanism

(LRM)
LRM is also called as Credit Audit. LRM an effective tool for constantly evaluating the
quality of loan book and to bring about qualitative improvements in credit administration.
Loan Review Mechanism is used for large value accounts with responsibilities assigned in
various areas such as, evaluating effectiveness of loan administration, maintaining the
integrity of credit grading process, assessing portfolio quality, etc.

The main objectives of LRM are:

• To promptly identify loans, which develop credit weaknesses and initiate timely corrective
action.

• To evaluate portfolio quality and isolate potential problem areas.

• To provide information for determining adequacy of loan loss provision.

• To assess the adequacy of and adherence to, loan policies and procedures, and to monitor
compliance with relevant laws and regulations.

• To provide top management with information on credit administration, including credit

sanction process, risk evaluation and post-sanction follow up.

Qualification and Independence

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The Loan Review Officers should have sound knowledge in credit appraisal, lending
practices and loan policies of the bank. They should also be well-versed in the relevant
laws/regulations that affect lending activities. The independence of Loan Review Officers
should be ensured and the findings of the reviews should also be reported directly to the
Board or Committee of the Board.

Frequency and Scope of Reviews

The Loan Reviews are designed to provide feedback on effectiveness of credit sanction
and to identify incipient deterioration in portfolio quality. Reviews of high value loans
should be undertaken usually within three months of sanction/renewal or more frequently
when factors indicate a potential for deterioration in the credit quality.

Depth of Reviews

The loan reviews should focus on:

• Approval process

• Accuracy and timeliness of credit ratings assigned by loan officers

• Adherence to internal policies and procedures, and applicable laws/regulations

• Compliance with loan covenants

• Post-sanction follow up

• Sufficiency of loan documentation

• Portfolio quality

• Recommendations for improving portfolio quality

Credit Risk Mitigation

Credit risk mitigation is an essential part of credit risk management. This refers to the
process through which credit risk is reduced or it is transferred to counterparty. Strategies
for risk reduction at transaction level differ from that at portfolio level.

At transaction level banks use a number of techniques to mitigate the credit risks to which
they are exposed. They are mostly traditional techniques and need no elaboration. They are,
for example, exposures collateralised by first priority claims, either in whole or in part, with
cash or securities, or an exposure guaranteed by a third party. Recent techniques include
buying a credit derivative to offset credit risk at transaction level.

Securitisation
Securitisation refers to a transaction where financial securities are issued against the cash
flow generated from a pool of assets. Cash flows arising out of payment of interest and

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repayment of principal are used to service interest and repayment of financial securities.
Usually an SPV - special purpose vehicle is created for the purpose. Originating bank - that is
the bank which has originated the assets -- transfers the ownership of such assets to the
SPV. The SPV issues financial securities and has the responsibility to service interest and
repayments on such financial instruments.

Credit Derivatives (CDS)

For most banks, particularly Indian banks, the single largest source of earnings and
perhaps earnings volatility also are on account of credit risk. The traditional means to deal
with credit risk include lending policies, credit approval processes, discretionary power
structure, collateral and guarantees, concentration limits (with regard to single or group
borrowers, industries or geographic regions), documentation, etc.

Credit Derivatives Defined

A credit derivative is an over-the-counter bilateral contract between two or more

counterparties that provide for transfer of risks in a credit asset or credit portfolio without
necessarily transferring the underlying asset from the books of the originator.

Generally, credit derivatives transfer risks in a credit asset without transferring the
underlying asset themselves from the books of the originator. Hence, they are off-balance
sheet financial instruments. All credit assets (loans, bonds, account receivable, financial
leases, etc.) are bundles of risk and rewards.

Credit Default Swaps (CDS)

A Credit default swap is a transaction in which a credit hedger (PB) pays a periodic
premium to an investor (PS) in return for protection against a credit event experienced on
a reference obligation, (i.e., the underlying credit that is being hedged).

Credit events are ISDA defined credit events and include six events, namely - bankruptcy,
obligation acceleration, obligation default, failure to pay, repudiation/moratorium and
restructuring.

Total Return Swaps (TRS)

In a total return swap, the PB swaps with the PS, total actual return (coupon capital
appreciation depreciation) on an asset in return for a premium. The premium is arrived at
by adding a spread to a reference rate like LIBOR. Thus, in a TRS, the protection seller is
able to synthetically create an exposure to the reference asset without actually lending to it.

A total return swap represents an off-balance sheet replication of a financial asset such as a
loan or bond Whereas credit default swaps capture only credit risk, total return swaps
involved the transfer of the total economic return of the asset (i.e., both credit and market
risks.)

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Credit Linked Notes (CLN)

Credit default swaps (CDS) are generally off-balance sheet items and are not funded
exposures. Credit linked notes are on-balance sheet equivalents of CDS, which combine
credit derivatives with normal bond instruments and thus convert credit derivatives
(generally an OTC instrument) into capital market instruments.

Credit Spread Options

Credit Spread options enable credit hedgers to acquire protection from an unfavourable
migration or Credit spread risk of an asset, as measured by a widening of its credit spread.
Credit spread options transfer credit spread risk from the credit spread PB to an investor
(PS), in return for an upfront or periodic payment of premium.

Example

Transferring default risks; Imagine that an A-rated oil company is planning to arrange a
fully drawn one-year credit for Rs. 1,600 Crores and has invited few banks into the deal.
The company requested the bank to commit Rs. 600 Crores but the bank's credit portfolio
management team has placed a limit of Rs. 200 Crores as they are concerned about the
bank's significant exposure to the oil company.

Solution: The bank can commit to the request and arrange a credit default swap with
another bank for Rs. 400 Crores. The bank can approach foreign or regional banks that are
at a credit risk origination disadvantage and transfer the credit risk of the credit without
transferring the loan itself.

The advantages of this approach include:

• The bank-client relationship is preserved.

• Alternative strategies, such as sale in the secondary markets or participation, may have
adverse consequences for the bank-client relationship.

• The bank enjoys, the fee-based income associated with the higher level of commitment.

• The hedging bank has significantly diversified its risk, only experiencing a default if both
the oil company and counterparty bank fail jointly and concurrently to perform. This joint
probability of default is likely to be quite low.

• The return on capital of the hedged position can be significantly higher.

Hedging Pitfalls in Practice

Transaction Origination

• Successful credit derivatives dealers endeavour to.

• Establish client/product suitability.

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• Identify and fully appreciate end-user motivations and portfolio.

• Provide end users with useful feedback and help manage expectations about the timing of
transactions.

• Understand that transaction terms are generally indicative and not firm.

• Appreciate that dealers may have limits on their appetite for certain credits.

• Appreciate the limitations and liquidity restraints of the developing credit derivatives
market.

Transactions Structuring

Occurs once a credit derivatives transaction has been originated. The major terms and
conditions/issues to confirm at this stage include:

• All settlement methods are agreed and market disruption clauses have been considered.

• The hedging strategy employed is the most efficient vehicle in terms of funding,
relationship issues and capital treatment.

• If the reference asset and the underlying credit risk are one and the same, no residual
basis risk remains (or, if it does, is identified and priced accordingly). In addition, a thorough
check of the reference asset is required to identify any risk of pre-payment, extension,
sinking fund or call features.

• The assignability of the unvetted underlying assets is established (otherwise alternative

settlement techniques need to be established).

• The parties have a thorough understanding of any materiality tests requirements,

especially in the case of non-investment grade credits.

• If a credit-linked note is being issued by a founder, it must confirm that credit events in
the credit default swap confirmation are mirrored in the credit-linked note pricing
supplement.

• Credit events are appropriate for the situation.

Transactions Documentation

All transaction structuring issues must be resolved prior to documentation. A successful

documentation process includes:

• Presentation by credit derivatives trading to documentation of a transaction term sheet

setting out terms and conditions.

• Good communication between all members of the credit hedging team.

• An appreciation of transaction objectives and goals.

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• Problem-solving approach with the credit derivatives trading desk, the end-users and
other internal partners

• A well thought-out transaction template or use of ISDA-sponsored transaction

confirmation.

Unit 6: Operational Risk and Integrated Risk

Management

Operational Risk

Operational risk is one area of risk that is faced by all organisations. The more complex an
organisation is, the more would be its exposure to operational risk. Operational risk would
arise due to deviations from normal and planned functioning of systems, procedures,
technology and human failures of omission and commission.

Operational Risk - Classification

Before we classify operational risk into various categories, we must understand the nature
of the operational risk. Operational risk arises literally from all the activities undertaken and
consequently it is present everywhere in an organisation. Impact of various forms of
operational risk on the organisation may vary in degree i.e.,

The nature of operational risk may be listed as:

• Operational risk exists almost everywhere in the organisation.

• Operational risks vary in their components. Some are high occurrence low value risks,
while some are low occurrence high value risks.
• Operational risks in the organisation continuously change especially when an
organisation is undergoing changes.

The Second Consultative Paper of Basel II suggested classification of operational risks based
on the 'Causes' and 'Effects'. That is, classifications based on causes that are responsible for
operational risks or classifications based on effects of risks were suggested. Classifications
based on 'Causes' and 'Effects' are listed below.

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Cause-based

• People oriented causes - negligence, incompetence, insufficient training, integrity,

key man.
• Process oriented (Transaction based) causes - business volume fluctuation,
organizational complexity, product complexity, and major changes.
• Process oriented (Operational control based) causes - inadequate segregation of
duties, lack of management supervision, inadequate procedures.
• Technology oriented causes - poor technology and telecom, obsolete applications,
lack of automation, information system complexity, poor design, development and
testing.
• External causes - natural disasters, operational failures of a third party, deteriorated
social or political context.

Effect Based

• Legal liability
• Regulatory, compliance and taxation penalties
• Loss or damage to assets
• Restitution
• Loss of recourse
• Write-downs

Event Based

• Internal Fraud
• External Fraud
• Employment practices and workplace safety
• Clients, products and business practices
• Damage to physical assets
• Business disruption and system failures
• Execution, delivery and process management

Operational Risk Classification By Event Type

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• Internal Fraud: Losses due to acts of a type intended to defraud, misappropriate

property or circumvent regulations, the law or company policy, excluding
diversity/discrimination events, which involve at least one internal party.
• External Fraud: Losses due to acts of a type intended to defraud, misappropriate
property or circumvent the law, by a third party
• Employment Practices and Work Place Safety: Losses arising from acts inconsistent
with employment, health or safety laws or agreements from payment of personal
injury claims, or from diversity/ discrimination events.
• Clients, Products and Business Practices: Losses arising from an unintentional or
negligent failure to meet a professional obligation to specific clients (including
fiduciary and suitability requirements), or from the nature or design of a product.
• Damage to Physical Assets: Losses arising from loss or damage to physical assets
from natural disasters or other events.
• Business Disruption and System Failures: Losses arising from disruption of business
or system failures.
• Execution, Delivery and Process Management: Losses from failed transaction
processing or process management, from relations with trade counterparties and
vendors.

Operational Risk Management Practices

Fundamental principles of operational risk management

Principle 1

The board of directors should take the lead in establishing a strong risk management
culture. The board of directors and senior management should establish a corporate culture
that is guided by strong risk management and that supports and provides appropriate
standards and incentives for professional and responsible behaviour. In this regard, it is the
responsibility of the board of directors to ensure that a strong operational risk management
culture exists throughout the whole organisation.

Principle 2

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Banks should develop, implement and maintain a Framework that is fully integrated into the
bank's overall risk management processes. The Framework for operational risk management
chosen by an individual bank will depend on a range of factors, including its nature, size,
complexity and risk profile.

GOVERNANCE

The Board of Directors

Principle 3

The board of directors should establish, approve and periodically review the Framework.
The board of directors should oversee senior management to ensure that the policies,
processes and systems are implemented effectively at all decision levels.

Principle 4

The board of directors should approve and review a risk appetite and tolerance statement
for operational risk that articulates the nature, types, and levels of operational risk that the
bank is willing to assume.

Senior Management

Principle 5

Senior management should develop for approval by the board of directors a clear, effective
and robust governance structure with well defined, transparent and consistent lines of
responsibility. Senior management is responsible for consistently implementing and
maintaining throughout the organisation policies, processes and systems for managing
operational risk in all of the bank's material products, activities, processes and systems
consistent with the risk appetite and tolerance.

Risk Management Environment

Identification and Assessment

Principle 6

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Senior management should ensure the identification and assessment of the operational risk
inherent in all material products/activities, processes and systems to make sure the inherent
risks and incentives are well understood.

Principle 7

Senior management should ensure that there is an approval process for all new products,
activities, processes and systems that fully assesses operational risk.

Monitoring Reporting

Principles 8

Senior management should implement a process to regularly monitor operational risk

profiles and material exposures to losses. Appropriate reporting mechanisms should be in
place at the board, senior management, and business line levels that support proactive
management of operational risk.

Control and Mitigation

Principle 9

Banks should have a strong control environment that utilises policies, processes and
systems; appropriate internal controls; and appropriate risk mitigation and/or transfer
strategies.

Business Resiliency and Continuity

Principle 10

Banks should have business resiliency and continuity plans in place to ensure an ability to
operate on an ongoing basis and limit losses in the event of severe business disruption.

Principle 11

A bank's public disclosures should allow stakeholders to assess its approach to operational
risk management.

Operational Risk Management Practices should be based on a well laid out policy duly
approved at the board level that describes the processes involved in controlling operational

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risks. It should meet the standards set in terms of the principles mentioned above. In
addition, well laid down procedures in dealing with various products and activities should be
in place. The policies and procedures should also be communicated across the organisation.

The policy should cover

• Operational risk management structure

• Role and responsibilities

• Operational risk management processes

• Operational risk assessment/measurement methodologies

Management Overview and Organisational Structure

• Role of Board: The board of directors takes overall responsibility to manage and
implement the operational risk framework. It should approve bank's ORM
framework and review it periodically. The framework should provide a firm-wide
definition of operational risk and lay down the principles of how operational risk is to
be identified, assessed, monitored, and controlled/mitigated.
• Role of Operational Risk Management Committee: The operational risk
management committee should identify the operational risks to which the bank is
exposed to, formulate policies and procedures for operational risk management, set
clear guidelines on risk assessment/measurement and ensure adequacy of risk
mitigating controls.
• Role of Operational Risk Management Department: The operational risk
management department is the nodal department for identifying, managing and
quantifying operational risks. ORMD, in conjunction with groups, lays down
procedures for management of operational risks.
• Role of Internal Audit/Business Functions: Roles and responsibilities relating to
internal audit business functions in the operational risk processes should be clearly
defined. These should include comprehensive audit of the ORM framework so as to
assess its effectiveness. The internal audit function should be operationally
independent and should not be directly responsible for operational risk
management.

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Processes and Framework

The processes and framework include the following:

• Mapping of Processes and Identification of Risks/Control.

• The key business processes in the bank must be mapped into sub-processes. This should
be a joint exercise between the operational risk group and the business groups.

• Implementation of a Qualitative Approach to Aggregating and Assessing Operational Risks.

• A system to qualitatively analyse the operational risk profile using a scorecard approach
should be implemented. This would involve self-assessment by the business group and
normalization/collation by the operational risk management department.

• Implementation of a Quantitative Approach to Assessing Operational Risks New Product

Processes.

Risk Monitoring and Control Practices

Risk Monitoring and Control Practices encompasses the following:

• Collection of Operational Risk Data (incident reporting framework).

• Regular monitoring and feedback mechanism in place for monitoring any deterioration in
the operational risk profile.

• Collation of incident reporting data to assess frequency and probability of occurrence of

operational risk events.

• Monitoring and control of management of large exposures. The modalities to be

prescribed in the Loan Policy document.

Information System Infrastructure: Information system infrastructure should be responsive

to the ORM framework.

Operational Risk Quantification

This is by far the most difficult of all risk measurements. The behaviour pattern of
operational risk does not follow the statistically normal distribution pattern and that

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makes it difficult to estimate the probability of an event resulting in losses. The historical
loss distribution pattern, which may provide a method to estimate operating losses requires
a data set that has statistically acceptable numbers of loss. Related data may be captured
only over a period. Basel II has recognised the difficulties in measurement of operational
losses. Consequently, it has provided options in the measurement of operational risk for
the purpose of capital allocation purposes. They are:

• The Basic Indicator Approach (BIA)

• The Standardised Approach (TSA)
• Advanced Measurement Approaches (AMA)

Of these, the Basic Indicator and the Standardised Approaches are based on the income
generated. The Advance Measurement Approach is based on operational loss
measurement. A brief description of the Basel II prescriptions under these approaches is
given below. For details, it is advised that Basel II document may be consulted.

The Standardised Approach

In the Standardised Approach, banks' activities are divided into eight business lines:

Corporate finance, trading and sales, retail banking, commercial banking, payment and
settlement, agency services, asset management, and retail brokerage.

Within each business line, gross income is a broad indicator that serves as a proxy for the
scale of business operations and thus the likely scale of operational risk exposure within
each of these business lines. The capital charge for each business line is calculated by
multiplying gross income by a factor (denoted beta assigned to that business line (Beta
Factors).

Business Lines Beta Factors

• Corporate finance - 18%

• Trading and sales - 18%
• Retail banking - 12%
• Commercial banking - 15%
• Payment and settlement - 18%

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• Agency services - 15%

• Asset management - 12%
• Retail brokerage - 12%

Advanced Measurement Approach (AMA)

Under the AMA, the regulatory capital requirement will equal the risk measure generated
by the bank's internal operational risk measurement system using the quantitative and
qualitative criteria for the AMA discussed below. Use of the AMA is subject to supervisory
approval.

A Generic Measurement Approach

The first step in measurement approach is operation profiling. The steps involved OP
Profiling are:

• Identification and quantification of operational risks in terms of its components.

• Prioritisation of operational risks and identification of risk concentrations - hot spots
resulting in lower exposure.
• Formulation of bank's strategy for operational risk management and risk based
audit.

Estimated level of operational risk depends on

• Estimated probability of occurrence

• Estimated potential financial impact
• Estimated impact of internal controls

Estimated Probability of Occurrence

This will be based on historical frequency of occurrence and estimated likelihood of future
occurrence. Probability is mapped on a scale of 5 say where

• Implies negligible risk

• Implies low risk
• Implies medium risk
• Implies high risk
• Implies very high risk

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Estimated Potential Financial Impact

This will be based on severity of historical impact and estimated severity of impact from
unforeseen events. Probability is mapped on a scale of 5 as mentioned above.

Estimated Impact of Internal Controls

This will be based on historical effectiveness of internal controls and estimated impact of
internal control on risks. This is estimated as fraction in relation to total control, which is
valued at 100%.

Estimated level of operational risk = Estimated probability of occurrence impact x Estimated

potential financial x Estimated impact of internal controls

In case of a hypothetical example where

• Probability of occurrence = 2 (Medium)

• Potential financial impact = 4 (very high)
• Impact of internal controls = 50%
• Estimated level of operational risk = [(2 * 4* (1 - 0.50)] ^ 0.5 = 2.00 or 'Low'

Scenario Analysis

Basel II guidelines on scenario analysis are as follows.

• A bank must use scenario analysis based on expert opinion in conjunction with
external data to evaluate its exposure to high-severity events. This approach draws
on the knowledge of experienced business managers and risk management experts
to derive reasoned assessments of plausible severe losses.
• In addition, scenario analysis should be used to assess the impact of deviations
from the correlation assumptions embedded in the bank's operational risk
measurement framework, in particular, to evaluate potential losses arising from
multiple simultaneous operational risk loss events.
• Over time, such assessments need to be validated and re-assessed through
comparison to actual loss experience to ensure their reasonableness.

The Necessity of Integrated Risk Management

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Risk Management is a basic necessity for financial institutions of all sizes, and ultimately
central to their success and survival. It integrates an organisation's internal and external
business processes by applying standard risk terminology, metrics and reporting to facilitate
optimal risk/return decisions. An integrated approach to risk management centralizes the
process of supervising risk exposure so that the organisation can determine how best to
absorb, limit or transfer risk.

When properly implemented, Integrated Risk Management:

• Aligns the strategic aspects of risk with day-to-day operational activities.

• Facilitates greater transparency for investors and regulators.
• Enhances revenue and earnings growth.
• Controls downside risk potential.

Integrated Risk Management: Approach

The Process of Integrated Risk Management Consists of

• Strategy
• Organisation
• Process
• System

Unit 7: Liquidity Risk Management

Liquidity Risk Management - Need & Importance

A bank is said to be solvent if it's net worth is not negative. To put it differently, a bank is
solvent if the total realizable value of its assets is more than its outside liabilities (i.e.,
other than its equity/owned funds). As such, at any point in time, a bank could be (i) both
solvent and liquid or (ii) liquid but not solvent or (iii) solvent but not liquid or (iv) neither
solvent nor liquid. The need to stay both solvent and liquid therefore, makes effective
liquidity management crucial for increasing the profitability as also the long-term

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viability/solvency of a bank. This also highlights the importance of the need of having the
best Liquidity Risk Management practices in place in Banks.

Some Key Considerations in Liquidity Risk Management include:

• Availability of liquid assets,

• Extent of volatility of the deposits,
• Degree of reliance on volatile sources of funding,
• Level of diversification of funding sources,
• Historical trend of stability of deposits,
• Quality of maturing assets,
• Market reputation,
• Availability of undrawn standbys,
• Impact of off balance sheet exposures on the balance sheet, and
• Contingency plans.

Some of the issues that need to be kept in view while managing liquidity include:

• The extent of operational liquidity, reserve liquidity and contingency liquidity that
are required.
• The impact of changes in the market or economic condition on the liquidity needs.
• The availability, accessibility and cost of liquidity.
• The existence of early warning systems to facilitate prompt action prior to surfacing
of the problem and
• The efficacy of the processes in place to ensure successful execution of the solutions
in times of need.

Potential Liquidity Risk Drivers

The internal and external factors in banks that may potentially lead to liquidity risk
problems in Banks are as under:

Internal Banking Factors External Banking Factors

High off-balance sheet exposures Very sensitive financial markets depositors.

The banks rely heavily on the short-term External and internal economic shocks.
corporate deposits

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A negative gap (liability is more than the Low/slow economic performances.

asset) in the maturity dates of assets and
liabilities.
The banks' rapid asset expansions exceed Decreasing depositors' trust on the
the available funds on the liability side. banking sector
Concentration of deposits in the short Non-economic factors
term Tenor
Less allocation in the liquid government Sudden and massive liquidity withdrawals
instruments. from depositors.
Fewer placements of funds in long-term Unplanned termination of government
deposits. deposits.

Types of Liquidity Risk

Banks face the following types of liquidity risk:

• Funding Liquidity Risk - the risk that a bank will not be able to meet efficiently the
expected and unexpected current and future cash flows and collateral needs without
affecting either its daily operations or its financial condition.
• Market liquidity Risk - the risk that a bank cannot easily offset or eliminate a
position at the prevailing market price because of inadequate market depth or
market disruption.

Principles For Sound Liquidity Risk Management

After the global financial crisis, in recognition of the need for banks to improve their
liquidity risk management, the Basel Committee on Banking Supervision (BCBS) published
"Principles for Sound Liquidity Risk Management and Supervision" in September 2008. The
broad principles for sound liquidity risk management by banks as envisaged by BCBS are as
under:

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BCBS's Fundamental principle for the management and supervision of liquidity risk

Principle 1 A bank is responsible for the sound management of liquidity risk.

A bank should establish a robust liquidity risk management
framework that ensures it maintains sufficient liquidity, including
a cushion of unencumbered, high quality liquid assets, to
withstand a range of stress events, including those involving the
loss or impairment of both unsecured and secured funding
sources. Supervisors should assess the adequacy of both a bank's
liquidity risk management framework and its liquidity position
and should take prompt action if a bank is deficient in either area
in order to protect depositors and to limit potential damage to
the financial system.

Governance of liquidity risk management

Principle 2 A bank should clearly articulate a liquidity risk tolerance that is

appropriate for its business strategy and its role in the financial
system.

Principle 3 Senior management should develop a strategy, policies and

practices to manage liquidity risk in accordance with the risk
tolerance and to ensure that the bank maintains sufficient
liquidity. Senior management should continuously review
information on the bank's liquidity developments and report to
the board of directors on a regular basis. A bank's board of
directors should review and approve the strategy, policies and
practices related to the management of liquidity at least annually

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and ensure that senior management manages liquidity risk

effectively.

Principle 4 A bank should incorporate liquidity costs, benefits and risks in

the internal pricing, performance measurement and new product
approval process for all significant business activities (both on-
and off-balance sheet), thereby aligning the risk-taking incentives
of individual business lines with the liquidity risk exposures their
activities create for the bank as a whole.

Measurement and management of liquidity risk

Principle 5 A bank should have a sound process for identifying, measuring,

monitoring and controlling liquidity risk. This process should
include a robust framework for comprehensively projecting cash
flows arising from assets, liabilities and off-balance sheet items
over an appropriate set of time horizons.

Principle 6 A bank should actively monitor and control liquidity risk

exposures and funding needs within and across legal entities,
business lines and currencies, taking into account legal,
regulatory and operational limitations to the transferability of
liquidity.

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Principle 7 A bank should establish a funding strategy that provides effective

diversification in the sources and tenor of funding. It should
maintain an ongoing presence in its chosen funding markets and
strong relationships with funds providers to promote effective
diversification of funding sources. A bank should regularly gauge
its capacity to raise funds quickly from each source. It should
identify the main factors that affect its ability to raise funds and
monitor those factors closely to ensure that estimates of fund
raising capacity remain valid.
Principle 8 A bank should actively manage its intraday liquidity positions and
risks to meet payment and settlement obligations on a timely
basis under both normal and stressed conditions and thus
contribute to the smooth functioning of payment and settlement
systems.
Principle 9 A bank should actively manage its collateral positions,
differentiating between encumbered and unencumbered assets.
A bank should monitor the legal entity and physical location
where collateral is held and how it may be mobilised in a timely
manner.
Principle 10 A bank should conduct stress tests on a regular basis for a variety
of short-term and protracted institution-specific and market-
wide stress scenarios (individually and in combination) to identify
sources of potential liquidity strain and to ensure that current
exposures remain in accordance with a bank's established
liquidity risk tolerance. A bank should use stress test outcomes to
adjust its liquidity risk management strategies, policies, and
positions and to develop effective contingency plans.

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Principle 11 A bank should have a formal contingency funding plan (CFP) that
clearly sets out the strategies for addressing liquidity shortfalls in
emergency situations. A CFP should outline policies to manage a
range of stress environments, establish clear lines of
responsibility, include clear invocation and escalation procedures
and be regularly tested and updated to ensure that it is
operationally robust.
Principle 12 A bank should maintain a cushion of unencumbered, high quality
liquid assets to be held as insurance against a range of liquidity
stress scenarios, including those that involve the loss or
impairment of unsecured and typically available secured funding
sources. There should be no legal, regulatory or operational
impediment to using these assets to obtain funding.

Public disclosure

Principle 13 A bank should publicly disclose information on a regular basis

that enables market participants to make an informed judgment
about the soundness of its liquidity risk management framework
and liquidity position.

Governance of Liquidity Risk Management

The Reserve Bank had issued guidelines on Asset Liability Management (ALM) system,
covering inter alia liquidity risk management system, in February 1999 and October 2007.
Successful implementation of any risk management process has to emanate from the top
management in the bank with the demonstration of its strong commitment to integrate
basic operations and strategic decision making with risk management. Ideally, the
organisational set up for liquidity risk management should be as under:

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• The Board of Directors (BOD): The BoD should have the overall responsibility for
management of liquidity risk. The Board should decide the strategy, policies and
procedures of the bank to manage liquidity risk in accordance with the liquidity risk
tolerance/limits as detailed in paragraph 14. The risk tolerance should be clearly
understood at all levels of management. The Board should also ensure that it
understands the nature of the liquidity
• The Risk Management Committee: The Risk Management Committee, which reports
to the Board, consisting of Chief Executive Officer (CEO) Chairman and Managing
Director (CMD) and heads of credit, market and operational risk management
committee should be responsible for evaluating the overall risks faced by the bank
including liquidity risk. The potential interaction of liquidity risk with other risks
should also be included in the risks addressed by the risk management committee.
• The Asset-Liability Management Committee (ALCO): The Asset-Liability
Management Committee (ALCO) consisting of the bank's top management should be
responsible for ensuring adherence to the risk tolerance/limits set by the Board as
well as implementing the liquidity risk management strategy of the bank in line with
bank's decided risk management objectives and risk tolerance.
• The Asset Liability Management (ALM) Support Group: The ALM Support Group
consisting of operating staff should be responsible for analysing, monitoring and
reporting the liquidity risk profile to the ALCO. The group should also prepare
forecasts (simulations) showing the effect of various possible changes in market
conditions on the bank's liquidity position and recommend action needed to be
taken to maintain the liquidity position/adhere to bank's internal limits.

Liquidity Risk Management Policy

• Liquidity Risk Tolerance: Banks should have an explicit liquidity risk tolerance set
by the Board of Directors. The risk tolerance should define the level of liquidity risk
that the bank is willing to assume, and should reflect the bank's financial condition
and funding capacity. The tolerance should ensure that the bank manages its
liquidity in normal times in such a way that it is able to withstand a prolonged period
of, both institution specific and market wide stress events.

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• Strategy for Managing Liquidity Risk: The strategy for managing liquidity risk
should be appropriate for the nature, scale and complexity of a bank's activities. In
formulating the strategy, banks/banking groups should take into consideration its
legal structures, key business lines, the breadth and diversity of markets, products,
jurisdictions in which they operate and home and host country regulatory
requirements, etc. Strategies should identify primary sources of funding for meeting
daily operating cash outflows, as well as expected and unexpected cash flow
fluctuations.

Management of Liquidity Risk

A bank should have a sound process for identifying, measuring, monitoring and mitigating
liquidity risk as enumerated below:

• Identification: A bank should define and identify the liquidity risk to which it is
exposed for each major on and off balance sheet position, including the effect of
embedded options and other contingent exposures that may affect the bank's
sources and uses of funds and for all currencies in which a bank is active.
• Measurement of Liquidity Risk: There are two simple ways of measuring liquidity;
one is the stock approach and the other, flow approach. The stock approach is the
first step in evaluating liquidity. Under this method, certain ratios, like liquid assets
to short term total liabilities, purchased funds to total assets, core deposits to total
assets, loan to deposit ratio, etc., are calculated and compared to the benchmarks
that a bank has set for itself. While the stock approach helps up in looking at liquidity
from one angle, it does not reveal the intrinsic liquidity profile of a bank.

Ratios In Respect Of Liquidity Risk Management

Certain critical ratios in respect of liquidity risk management and their significance for
banks are given below. Banks may monitor these ratios by putting in place an internally
defined limit approved by the Board for these ratios.

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Sl. Ratio Significance Industry

No. Average (in
%)

1. (Volatile liabilities Measures the extent to which volatile 40

- Temporary money supports bank's basic earning
Assets) (Earning assets. Since the numerator represents
Assets - short-term, interest sensitive funds, a
Temporary Assets) high and positive number implies some
risk of illiquidity.

2. Core Measures the extent to which assets are 50

deposits/Total funded through stable deposit base.
Assets

3. (Loans + Loans including mandatory cash 80

mandatory SLR + reserves and statutory liquidity
mandatory CRR + investments are least liquid and hence a
Fixed high ratio signifies the degree of
Assets)/Total 'illiquidity embedded in the balance
Assets sheet.

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4. (Loans + Measure the extent to which illiquid 150

mandatory SLR + assets are financed out of core deposits.
mandatory CRR +
Fixed Assets)/Core
Deposits

5. Temporary Measures the extent of available liquid 40

Assets/Total assets. A higher ratio could impinge on
Assets the asset utilisation of banking system in
terms of opportunity cost of holding
liquidity.

6. Temporary Measures the cover of liquid 60

Assets/Volatile investments relative to volatile
Liabilities liabilities. A ratio of less than 1 indicates
the possibility of a liquidity problem.

7. Volatile Measures the extent to which volatile 60

Liabilities/Total liabilities fund the balance sheet.
Assets

Volatile Liabilities: (Deposits + borrowings and bills payable up to 1 year). Letters of credit –
full outstanding. Component-wise CCF of other contingent credit and commitments. Swap
funds (buy/sell) up to one year. Current deposits (CA) and Savings deposits (SA) i.e. (CASA)
deposits reported by the hanks as payable within one year (as reported in structural liquidity

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statement) are included under volatile liabilities. Borrowings include from RBI, call, other
institutions and refinance.

Temporary assets = Cash + Excess CRR balances with RBI + Balances with banks + Bills
purchased/ discounted up to 1 year + Investments up to one year + Swap funds (sell/buy) up
to one year.

Earning Assets = Total assets - (Fixed assets + Balances in current accounts with other banks
+ Other assets excluding leasing + Intangible assets).

Core deposits = All deposits (including CASA) above 1 year (as reported in structural liquidity
statement) + net worth.

Stress Testing

Stress testing should form an integral part of the overall governance and liquidity risk
management culture in banks. A bank should conduct stress tests on a regular basis for a
variety of short term and protracted bank specific and market wide stress scenarios
(individually and in combination). In designing liquidity stress scenarios, the nature of the
bank's business, activities and vulnerabilities should be taken into consideration so that the
scenarios incorporate the major funding and market liquidity risks to which the bank is
exposed.

Contingency Funding Plan

A bank should formulate a contingency funding plan (CFP) for responding to severe
disruptions which might affect the bank's ability to fund some or all of its activities in a
timely manner and at a reasonable cost CFPs should prepare the bank to manage a range of
scenarios of severe liquidity stress that include both bank specific and market-wide stress
and should be commensurate with a bank's complexity, risk profile, scope of operations.

Overseas Operations of The Indian Banks’ Branches And

Subsidiaries And Branches Of Foreign Banks In India

A bank's liquidity policy and procedures should also provide detailed procedures and
guidelines for their overseas branches/subsidiaries to manage their operational liquidity on

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an ongoing basis. Similarly, foreign banks operating in India should also be self-reliant with
respect to liquidity maintenance and management.

Broad Norms In Respect Of Liquidity Management

Some of the broad norms in respect of liquidity management are as follows:

(i)Banks should not normally assume voluntary risk exposures extending beyond a period of
ten years

(ii)Banks should endeavour to broaden their base of long-term resources and funding
capabilities consistent with their long term assets and commitments.

(iii)The limits on maturity mismatches shall be established within the following tolerance
levels (a) long term resources should not fall below 70% of long term assets; and (b) long
and medium term resources together should not fall below 80% of the long and medium
term assets. These controls should be undertaken currency-wise, and in respect of all such
currencies which individually constitute 10% or more of a bank's consolidated overseas
balance sheet. Netting of inter-currency positions and maturity gaps is not allowed. For the
purpose of these limits. Short term, medium term and long term are defined as under:

• Short-term: those maturing within 6 months.

• Medium-term: those maturing in 6 months and longer but within 3 years.
• Long-term: those maturing in 3 years and longer.

(iv) The monitoring system should be centralised in the International Division (ID) of the
bank for controlling the mismatch in asset-liability structure of the overseas sector on a
consolidated basis, currency-wise. The ID of each bank may review the structural maturity
mismatch position at quarterly intervals and submit the review/s to the top management of
the bank.

Liquidity Across Currencies

Banks should have a measurement, monitoring and control system for liquidity positions
in the major currencies in which they are active. For assessing the liquidity mismatch in
foreign currencies, as far as domestic operations are concerned, banks are required to
prepare Maturity and Position (MAP) statements according to the extant instructions. A

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bank should also undertake separate analysis of its strategy for each major currency
individually by taking into account the outcome of stress testing.

Management Information System (MIS)

A bank should have a reliable MIS designed to provide timely and forward-looking
information on the liquidity position of the bank and the ALM Group should place this
information periodically to the Board and ALCO, both under normal and stress situations.
The MIS should cover liquidity positions in all currencies in which the bank conducts its
business - both on a subsidiary/branch basis (in all countries in which the bank is active) and
on an aggregate group basis.

Unit 8: Basel II Framework on Liquidity Standards

Objective

• The LCR standard aims to ensure that a bank maintains an adequate level of
unencumbered HQLA, that can be converted into cash to meet its liquidity needs for
a 30 calendar day time horizon under a significantly severe liquidity stress scenario
specified by supervisors. At a minimum, the stock of liquid assets should enable the
bank to survive until day 30 of the stress scenario, by which time it is assumed that
appropriate corrective actions can be taken.

Scope

• To start with, the LCR and monitoring tools would be applicable for Indian banks at
whole bank level only i.e. on a stand-alone basis including overseas operations
through branches. However, banks should endeavour to move over to meeting the
standard at consolidated level also. For foreign banks operating as branches in India,
the framework would be applicable on stand-alone basis (i.e. for Indian operations
only).

LIQUIDITY COVERAGE RATIO (LCR)

The Liquidity Coverage ratio is computed as under:

≥ 100%
Stock of High Quality Liquid Assets (HQLAs)

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Total Net Cash Outflows over the next 30 calendar days

Calculation of LCR

As stated in the definition of LCR, it is a ratio of two factors, viz. the Stock of HQLA and the
Net Cash Outflows over the next 30 calendar days. Therefore, computation of LCR of a
bank will require calculations of the numerator and denominator of the ratio, as detailed in
the RBI Circular.

Liquidity Risk Monitoring Tools

In addition to the two liquidity standards, the Basel III framework also prescribes five
monitoring tools/ metrics for better monitoring a bank's liquidity position. These metrics
along with their objective and the prescribed returns are as under:

(a) Contractual Mismatch Maturity

The contractual maturity mismatch profile identifies the gaps between the contractual
inflows and outflows of liquidity for defined time bands. These maturity gaps indicate how
much liquidity a bank would potentially need to raise in each of these time bands if all
outflows occurred at the earliest possible date. This metric provides insight into the extent
to which the bank relies on maturity transformation under its current contracts.

(b) Concentration of Funding

This metric is meant to identify those sources of funding that are of such significance, the
withdrawal of which could trigger liquidity problems. The metric thus encourages the
diversification of funding sources recommended in the Basel Committee's Sound Principles.
This metrics aims to address the funding concentration of banks by monitoring their funding
from each significant counterparty, each significant product/instrument and each significant
currency.

(c) Available Unencumbered Assets

This metric provides supervisors with data on the quantity and key characteristics of banks'
available unencumbered assets. These assets have the potential to be used as collateral to
raise additional secured funding in secondary markets and/or are eligible at central banks.

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(d) LCR by Significant Currency

While the LCR standard is required to be met in one single currency, in order to better
capture potential currency mismatches, the LCR in each significant currency needs to be
monitored.

(e) Market-related Monitoring Tools

This includes high frequency market data that can serve as early warning indicators in
monitoring potential liquidity difficulties at banks.

Basel III Liquidity Returns

S. No. Name of the Basel III Liquidity Return (BLR) Frequency Time Period by
of which Required
Submission to be Reported
1. Statement on Liquidity Coverage Ratio (LCR)-BLR-1 Monthly within 15 days

2. Statement of Funding Concentration- BLR- Monthly within 15 days

3. Statement of Available Unencumbered Assets - BLR- Quarterly within a month

3
4. LCR by Significant Currency - BLR-4 Monthly within a month

5. Statement on Other Information on Liquidity - BLR-5 Monthly within 15 days

Definition of the Standard Net Stable Funding Ratio

(Available Stable Funding (ASF))/Required Stable Funding (RSF)) x 100 = Should be 100%

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