Risk Management and Basel II

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How do banks make money?

By playing term of funds: Long v/s short. By playing risk levels- accept lower risk and

place in higher risk- play safety as a market mantra Dispersed source v/s concentrated use. Trading in the market

Essentially by taking risk

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Risk Definition and features

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

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Generic and Unique risks

Industry Unit/firm/company related Location specific Ownership related Sector specific HRD/Structure related

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Sources of Risk
Decision ,Indecision Business cycles/ Political compulsions Regulations Human resources, skill

Seasonality Economic/Fiscal changes Policy Changes Market movements Events

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sets Competition Technology Non-availability of information

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Types of Risks

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

Safety and soundness of banks. Ensuring a level playing field. Capital Adequacy Ratio (1) own funds (i.e. available capital and reserves) (2) risk-weighted assets (i.e. the amount of money the bank has put at risk in the course of its business)
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How to manage risk

Hedging Exposure limits Reserves and Provisioning

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Basel I
Norms- uniform across institutions,

products and performance Capital adequacy- Uniform across the commercial banking- coop banking will catch up shortly

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Basel II
Primarily for internationally active banks RBI will take view on other banks- It is

safe that all banks comply CRAR @ 8%on risk weight. But weights and loss estimates differBasel II is capital accord. Other risk management norms will happen F.M says Indian Banks will need additional 60,000 Crores in the next few years- to meet with growth needs.
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Three Pillars of Basel II

Minimum Capital Supervisory Review

Market Discipline

Focus on Advanced internal methods for capabilities capital Supervisors to allocation review banks Capital charge internal for operational assessment risk and strategies
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The new Basel Accord is based on Three Pillars

Focus on disclosure

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Basle II. Minimum Capital Requirements-Pillar 1

Sets minimum acceptable capital Capital arrived by enhanced approach with

credit ratings
External or Public rating Internal rating

Explicit treatment to operational risk ALM risk not treated but included in

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Supervisory Review _ Four Principles- Pillar 2

Banks must attain solvency relative to their

risk profile Supervisors should review each banks own risk assessment & capital strategies Banks should maintain excess of minimum capital Regulators would intervene at an early stage Possibility of rewarding banks with better risk management systems. RBI has already taken steps to conduct supervisory review P.A.C.
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Market Discipline- Pillar 3

Improved disclosure of Capital structure Risk measurement and

management practices Risk profile Capital adequacy

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Credit Risk -Approaches

Criteria Standard I. R. B Foundation Internal Function provided by Basel Committee Advanced Internal Function provided by Basel Committee

Rating

External

Risk weight Calibrated on ratings by Basel Committee Probability of default

Implicitly Provided by Provided by provided by bank on own bank on own AN IIM ALUMNI Venture Basel estimates estimates 15 Committee Shaping Careers in Finance

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Credit Risk Approaches

Criteria
Standardized I.R.B

Foundation Advanced
Supervisory Provided by values bank on

Exposure Supervisory at Default values provided by Basel Loss given Implicitly default provided by Basel on external estimates

provided by Basel Implicitly provided by Basel on external estimates

own estimates Provided by bank own estimates

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Credit Risk Approaches

Criteria Standardize I.R.B d Foundation All included in Defined by standardize Regulator. d + Receivables for goods and Services, Other physical Securities subject to criteria Advanced All types of Collaterals if Bank can prove by internal estimation

Risk mitigation

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Computation of Capital
Standardized No change over 1988

Foundation No change over 1988 Market Risk in VaR Advanced No change over 1988 in VaR
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Computation of Capital
Standardized Capital change based on single risk indicator Foundation Operational Capital based on business Risk lines and industry standards Advanced Capital based on business lines and internally calculated standards
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Operational Risk Approaches

Approach Basic Indicator Standardized Gross income per regulatory line as indicator Depending on business line 12, 15 or 18 % of the indictor as capital charge Total capital charge equals sum of charge per business line Advanced Measurement Capital charge equals internally generated measures based on, Internal loss data External loss data Scenario analysis Business environment and internal control factors Recognition of risk mitigation (upto 20%)

Calculation of Average of Capital charge Gross Income for three years as indicator Capital charge equals 15% of the indicator

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Decision areas for Banks

Choice of methodology and convincing the

regulators IT supports needed Software requirements Staff training on compliance Consultancy requirements Risk mitigation opportunities Outsourcing possibilities New jobs creation Implementation cost and time
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BASLE II IS ALL ABOUT A RESPONSIVE AND SOPHESTICATED RISK MANAGEMENT SYSTEM

R = Risk = Function of Uncertainty U U = Function of Quality Information QI QI = Function of Accuracy/ Timeliness/

Relevance/ Adequacy A, T, R, Ad A = Function of IT T = Function of IT R and Ad = Function of IT, Management Science, Modeling amenable to establish mathematical relationship

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Risk Management a data intensive function

Credit Risk Risk
Banks

Market Risk Market Risk

Operational Risk Operational Risk

Transaction Data

Operational CRM Data Analytical CRM Data Risk Management Data Economy & Industry Data 23

Borrower Data Guarantor Data Asset-specific Data Default Data Data on Recoveries External Default Data Data on Rating and Migration Macro & Industry Data Correlation Data

Data on Exchange Rates Data on Interest Rates Data on Security Prices Data on Correlations Data on Instruments (non-linear)

Loss Event Data Causal Data Loss Effect Key Risk Indicators (KRIs) Proxies Risk Inventories Structured Self Assessment AN IIM ALUMNI Venture Data

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Basle Accord and IT

Basle II promises significant business

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

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

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

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