Professional Certificate Program

‘Risk Management in Banking and Financial Markets’

- Prof. PC Narayan

Special Topics in Risk Management of

Banking and Financial Markets
Week 03 – Summary

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

2008 Global Financial Crisis

Several structured products such as Mortgage Backed Securities (MBS), Credit Default
Swaps (CDS) and Collateralized Debt Obligations (CDO) were fraught with many embedded
and inter-related risks that spiralled out of control resulting in the 2008 global financial
crisis.

What went wrong?

Banks disbursed several thousand mortgage loans, then packaged those loans as Mortgage-
Backed Securities (MBS) and sold them in the financial markets. In many ways, such a ready
market for MBS enabled mortgage lenders (including Banks and Housing finance companies)
to easily offload large portfolio of mortgage loans to the financial markets. This ready
‘conduit’ made mortgage lenders flagrant and adventurous in building their mortgage loan
portfolio, by lending to sub-prime customers, who would otherwise not be eligible for a
loan.

Role of CDS and CDO’s in accentuating the crisis

The investors in the Mortgage-Backed Securities and similar securitization tranches had little
information about the credit-worthiness of the original borrowers (i.e. to whom the
mortgage lender had given the loan). To protect themselves against potential loss that could
arise if the original borrowers failed to repay the loan, the investors in the MBS got the
issuers of the MBS (i.e. the original mortgage lenders) to buy Credit Default Swaps (CDS). A
CDS essentially is an ‘insurance’ underwritten by a third party to make good any default in
loan repayments by the original borrower. In turn, the CDS writer (i.e. the protection seller)
receives a premium upfront for the ‘insurance’ so provided.

Concurrently, Collateralized Debt Obligations (CDO) was another instrument that was
designed to cater to the varying risk appetite of investors in the financial markets. A CDO
manager created multiple investment tranches, say lowest risk tranche (‘A tranche’),
moderate risk tranche (‘B tranche’) and high-risk tranche (‘C tranche’), etc.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

and sold those tranches to different investors, to match their risk appetite. For instance,
pension funds would invest in ‘A tranche’ that offered the lowest return (with the lowest risk)
whereas Hedge Funds would invest in the ‘C tranche’ that offered the highest return (with
the highest risk). The proliferation of CDOs further swelled the volume of mortgage backed
securities traded in the financial markets.

This bulging of financial assets traded in the financial markets continued unabated until a
change in the interest rate policy of the political and economic leadership in the United States
mandated an increase in interest rates instead of the predictable reduction in interest rates
that financial markets had grown used to.

1) With the rise in interest rates, the market value of mortgage backed securities
dropped (in keeping with bond pricing theory).
2) Unbale to pay the higher monthly mortgage due to increase in interest rates, several
borrowers handed back their homes to the mortgage lender and closed the mortgage
loan. This resulted in a fall in the price of homes, with a knock-on adverse impact on
the price of the underlying mortgage backed securities.
3) A reduction in value of MBS and its associated derivatives led to significant mark-to-
market losses for all big investors in the US financial markets, including the large
investment banks and hedge funds, leading to a ‘contagion’ in financial markets
around the world.

If we look back (and this is wisdom in hindsight), it was sheer ‘avarice’ / ‘greed’ among
participants in the financial markets that lead to excessive use of risk transfer instruments
such as MBS, CDS and CDOs, culminating in the 2008 global financial crisis. As a result of the
devastation caused by the 2008 financial crisis, several regulatory changes have been brought
about including the BASEL III guidelines intended to ensure that Banks are better prepared to
handle extreme risk events as witnessed in the 2008 financial crisis.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

BASEL II Guidelines for Capital Adequacy

Under Basel I guidelines, Capital Adequacy Ratio has been defined as:

The numerator in the above equation ‘Capital’ comprises:

The denominator ‘Risk Weighted Assets’ in the Capital Adequacy Ratio involves assigning
‘risk weights’ to the various categories of assets on a scale of 0 to 100%, based on the
underlying risk.

G-Sec / T-Bonds Unsecured Loans Mortgage Loans

Risk Risk Risk

Weight Weight Weight
0% 100% 50%

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Almost ten years after the Basel I guidelines were implemented, Basel II came into being with
a view to ensure that Capital Adequacy norms are more flexible, robust and reflected the
increasing complexity of managing risks in the financial system.

Basel-II rests on three pillars:

BASEL II
NEW BASEL CAPITAL ACCORD
PILLAR I PILLAR II PILLAR III

Minimum Supervisory Market

Capital Review Discipline and
Requirements Process Disclosure

Strengthening and Safeguarding Financial System

1. Pillar – 1: Minimum Capital Requirements

a. When computing capital adequacy, Basel II aligns the minimum capital

requirements more closely to the banks’ actual underlying risks.

b. Capital charge for operational risk has also been mandated under Pillar-1

2. Pillar – 2: Supervisory Review Process

a. Pillar -2 mandates that the Board of Directors and the top management of every
bank will have primary responsibility to ensure that the bank has adequate capital
commensurate with its risk profile.

b. A process should be developed to estimate risks such as liquidity risk, reputation

risk, etc. in addition to credit risk and market risk.

c. It should also covers the Business cycle effects, which represent factors external
to the bank.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

3. Pillar – 3: Market Discipline

a. It supplements regulation in as much as monitoring of the banks and financial

institutions is not merely carried out by the regulators, but equally by the financial
markets and stakeholders in the bank.

Basel II guidelines are admittedly more comprehensive and sophisticated than its
predecessor, thBasel-I guidelines, because the one-size-fits-all idea that prevailed in Basel-I
has been abandoned. Pillar-1 (Minimum capital requirements) under Basel-II addresses this
by providing three distinct approaches for credit and operational risk, thereby offering a high
degree of flexibility, at the same time, maintaining standardization.

Approaches to Credit Risk:

1. Standardized Approach: Capital allocation to be governed by risk weights based on the

nature of the risk and external credit assessments by accredited credit rating agencies

2. Internal Ratings Based (IRB) Approach: Capital adequacy computation is based on

estimating:

a. Probability of default (PD)

b. Loss given default (LGD)

c. Exposure at default (EAD)

d. Maturity (M)

3. In Foundation Internal Ratings Based (FIRB) Approach, Bank provides only the PD, and
the Banking Regulator in the country provides the rest.

4. In Advanced Internal Ratings Based (AIRB) Approach, the bank is required to provide all
the above parameters, to be approved by the Banking Regulator prior to implementation.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Approaches to Operational Risk:

1. Basic Indicator Approach (BIA): A single indicator, say percentage of gross profit, to be
used as the basis for allocating operational risk capital, as specified by the Banking
Regulator.

2. Standard Approach (SA): This approach uses a combination of indicators for each line of
business as the basis for allocating operational risk capital, as specified by the Banking
Regulator.

3. Advanced Measurement Approach: This approach is based on clearly defining the lines
of business and defining the potential loss events in each line of business. For every such
combination based on internal data, determine:

a. Exposure indicator (EI)

b. Probability of that loss event (PE)

c. Likely loss given that event (LGE)

Expected loss will be computed as EI*PE*LGE and capital allocation for operational
risk will be made accordingly.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

BASEL – II.5 Guidelines for Capital Adequacy

Basel II Accord was adopted in 2004 by regulators and implemented by financial institutions
in most countries by 2008.

However, the devastation caused by the 2008 global financial crisis highlighted the need for
a more comprehensive and radical overhaul of the Basel II guidelines. Pending that radical
overhaul (that was implemented as Basel III a few years later), Basel II.5 was implemented
as an interim measure to protect financial institutions particularly against riskier credit
products and risk transfer instruments such as CDS and CDO that had proliferated rapidly
leading up to the 2008 financial crisis.

Major enhancement to Basel II delivered under Basel II.5 include:

1. Stressed Value-at-Risk (SVaR)

It became evident during the 2008 financial crisis that under extremely volatile market
conditions, banks and financial institutions will require more capital than what was captured
in the traditional one-day or ten-day value at risk models at 95% or 99% confidence
level. This led to the introduction of Stressed Value-at-Risk (SVaR)

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

2. Capital charge on securitization

3. Capital charge on correlation risk

4. Incremental Risk Charge (IRC)

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Credit migration risk is a risk that a portfolio's credit quality will deteriorate over-time
without the opportunity to reprice the constituent loans to compensate the lender for the
higher default risk that the lender is expected to absorb because of the deterioration in the
credit quality (i.e. due to the reduction in the credit rating of that portfolio).

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

BASEL – III Guidelines for Capital Adequacy

The global financial crisis of 2008 unearthed several facets that could not be safeguarded
under the Basel II guidelines. These include the following:

1. Credit intermediation outside the traditional banking system (‘shadow banking’ channels)

2. However, the dependence of shadow banking channels on the traditional (regulated)

banking channels to fulfil their payment and settlement obligations

3. The systemic risk further compounded by the exponential growth in structured financial
instruments such as collateralized debt obligations and credit default swap in the years
immediately preceding the 2008 crisis.

4. Massive mark-to-market losses in the financial markets and consequent ‘settlement

defaults’ and a ‘liquidity crisis’ that eventually devolved on the traditional banking system.

Basel III was conceived as an attempt to cope better with such unforeseen eventualities.

Highlights of Basel III guidelines

The Basel Committee on Banking Supervision announced the following changes under Basel
III guidelines in 2009, with implementation commencing from 2013:

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

Perceived downside of Basel III

1. Maintaining higher capital as required under Basel III is the responsibility of only the
regulated banks in that country.

2. Entities in the shadow banking system such as hedge funds and CDOs are not governed
by the Basel III guidelines or by any other norms of capital adequacy.

3. In view of the above, ‘moral hazard’ in the form of ‘regulatory arbitrage’ by the
shadow banking system is bound to aggravate

4. Regulated banks are likely to find their cost of capital going up significantly under Basel
III. As a result, lending rates by Banks are also likely to go up.

5. The ‘Too-Big-To-Fail’ Syndrome would aggravate and Governments will be called

upon to bail out such banks.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

BASEL – IV Guidelines for Capital Adequacy

The Basel – III framework that was implemented starting 2010 focused only on enhancing the
capital requirements i.e., the numerator of the capital adequacy ratio. Very little changes
were effected with respect to the denominator of the Capital adequacy ratio, i.e. the
computation of risk weighted assets.

The ‘Basel III Reforms’ that the Basel Committee on Banking Supervision published in 2017
addressed several enhancements to the computation of risk weighted assets, i.e. the
denominator of the Capital Adequacy Ratio. These changes have popularly come to be known
as Basel – IV.

Please note, the Basel Committee does not recognise the phrase
“Basel – IV”, instead has merely called the changes as ‘Basel – III reforms’.

The major changes implemented in Basel:

1. Enhancing the common equity Tire 1 (CET-1) capital to 4.5% from 2% under Basel II.
2. Inclusion of macro-prudential measures such as, the capital conservation buffer, the counter
cyclical buffer.
3. Maintaining a leverage ratio of 3%.
𝑻𝒊𝒆𝒓 𝑰 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒏𝒔𝒐𝒍𝒊𝒅𝒂𝒕𝒆𝒅 𝒂𝒔𝒔𝒆𝒕𝒔

4. Introducing the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), to
better manage liquidity risk on the balance sheet of banks.

Specific changes to the capital adequacy ratio computation issued under Basel IV:
1. Constraining the use of the internal rating-based approach for credit risk and detailing a more
robust approach to deploy the standardized approach with an intent to avoid banks from
cleverly reducing their capital requirements.
2. Reducing the reliance on credit rating published by accredited credit rating agencies when
computing risk weight particularly on loans given to mid-sized and large corporates.

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])
 Professional Certificate Program
‘Risk Management in Banking and Financial Markets’
- Prof. PC Narayan

3. Significant fine-tuning of Credit Conversion Factor (CCF), to determine the risk weight for off-
balance sheet items such as letters of credit, bank guarantees, derivative contracts, etc.

4. Eliminating the use of the advanced IRB approach to certain asset classes as well as input floor
for parameters such as probability of default, loss given default, etc.
5. Eliminating the use of internal rating-based approach in the computation of CVA and bringing
CVA risk computation in sync with the approach used for the market risk framework.
6. Earlier approaches to computing operational risk have been found insufficient and have been
replaced by a single standardized approach that will be applicable equally to all banks.
7. ‘Leverage Ratio’ has been further tightened with an increase of 1%, i.e. from 3% to 4% for
Global Systemically Important Banks or (G-SIB).
8. A cap has been imposed to disable banks from misusing the internal rating-based approach
by defining an ‘output floor’.

The tentative implementation dates for Basel IV as announced by the Basel Committee in
December 2017 is: 1st January 2022, except for the ‘output floor’ which can be implemented
in a phased manner starting with 50% as of January 2022 and gradually scaling up to 72.5%
by January 2027.
In summary, a gradual and phased implementation of the Basel guidelines from Basel I in
1994 to Basel IV in 2022 have slowly but surely enhanced the management of capital
adequacy by banks and consequently enhance the solvency of the financial system in every
country.
**********

This document has been prepared by PC Narayan, Indian Institute of Management, Bangalore and is made available for use only with the Professional
Certificate Program ‘Risk Management in Banking and Financial Markets’ delivered in the online course format by IIM Bangalore. All rights reserved. No part
of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means— electronic, mechanical, photocopying, recording,
or otherwise—without the permission of the Indian Institute of Management Bangalore ([email protected])