RISK MANAGEMENT PRESENTATION ON CREDIT RISK MARKET RISK AND By S.D.BARGIR, Joint Director, IIBF

Risk may be defined as “ exposure to uncertainty” favourable or unfavourable outcomes aims at mitigating the loss managing risk rather than on eliminating it

Risk management is a four steps process Identifying Measuring ( quantifying) Managing controlling, monitoring and reviewing

Three generic categories of risk Credit risk Market risk Operational risk

Credit Risk credit risk means default of the borrower or deterioration of borrowers’ credit quality.

Market Risk arising from movement in market prices Interest Rate Risk, Exchange Rate Risk, Commodities Price risk Equity Price Risk.

Operational Risk loss resulting from inadequate or failed internal processes People systems or external events.

Credit Risk defaults take various forms Direct Lending:Loan amount (Principal as well as interest) will not be paid Guarantees/ Letter of Credit etc.Funds will not be forthcoming upon crystallization of liability

Credit Risk defaults take various forms Treasury Products payment due from the counter parties either stops or not forthcoming Securities Trading Settlement will not be effected Cross boarder exposure: free transfer of currency is restricted or comes to an end.

credit risk, consists of three risks Default risk Exposure risk Recovery risk

Default risk is the probability of an event of default depends upon credit standing of the counter party. default probability cannot be measured directly. guidance from historical statistics on large sample over long period of time. bank faces difficulty in obtaining accurate historical data.

Exposure risk uncertainty associated with future amounts credit lines- repayment schedule- exposure risk small other lines of credit -OD, project financing , guarantees etc- risk cannot be predicted accurately

Recovery risk: recoveries in the event of default not predictable depend upon type of default availability of collaterals, third party guarantees circumstances surrounding the default.

Expected Losses & Unexpected Losses EL depends upon default probability(PD), Loss given default (LGD)& exposure at risk (EAD) EL = PD x LGD x EAD Unexpected losses (UL) is the uncertainty around EL and it is Standard deviation of EL.

challenges faced by banks in r/o EL aggregation of the risk-related information to assess the PD, LGD and EAD implementation of a risk rating system that can correctly model these parameters which is statistically valid.

BASEL Basel Committee on Banking supervision (BCBS) under the auspices of Bank for International Settlements (BIS) Established in 1975 by group of 10 countries Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

Basel II-Implementation in India with effect from March, 31, 2007 by commercial banks. 90 commercial Banks in India 100 countries

Basel II capital requirements more risk sensitive directly related to the credit rating of each counter-party instead of counter-party category capital for credit and market risk but also for operational risk (OR) where warranted for interest rate risks, credit concentration risks, liquidity risks SME sector

BASEL II RESTS ON THE THREE PILLARS, Pillar I Minimum Capital Requirements Pillar 2 Supervisory Review Process Pillar 3 Market Discipline each pillar is as important as the other one

Pillar 1 – Minimum Capital Requirements menu of approaches for computing capital adequacy freedom to choose the approach minimum, the Standardized Approach for credit risk Basic Indicator Approach for operational risk standardised Approach or Internal Risk Measurement Models approach for market risk

Various Approaches Credit Risk Market Risk Operational Risk Standardized Approach(SA) Basic Indicator Approach Basic-Internal Risk Based(IRB) Internal Risk Measurement Model Advanced IRB The internal measurement approach

Pillar 2- Supervisory Review encourage to adopt better risk management techniques intervene to mandate a higher capital requirement more inclusive –besides CR,MR,OR credit concentration risk Interest rate risk in banking book, Liquidity risk, Business risk, Strategic risk and Reputation risk. Takes into account Business cycle effects too

RISK BASED SUPERVISION (RBS) Business Risk Factors Capital, Credit Risk, Market Risk, Earnings risk, Liquidity Risk, Business Strategy and Environment Risk, Operational Risk Group Risk. Control Risk Factors Internal Controls Risk, Organisation risk, Management Risk Compliance Risk.

Pillar 3- Market Discipline disclosures to enhance market discipline Monitoring by markets- other banks, customers, depositors, subordinated debt instrument holders, analysts & rating agencies disclosure policy approved by Board financial penalty, for non-compliance

INITIATIVES BY RBI each bank has suitable risk management framework and the expected level of capital introduced RBS In 23 banks on a pilot basis encouraged all banks to operationalise CAAP expanded the area of disclosures encouraged some banks to migrate from SA to IRB approaches  

Standardised Approach Different categories of obligors Corporates Sovereign Bank Retail Real Estate Specialized Lending

Issues emerging out of Basel II higher capital requirements improved IT architectures data issues consolidation capacity building external ratings use of national discretion validating the concept of economic capital

Capital requirements for CORPORATES in Basel II credit rating AAA to AA A+ to A- BBB+ to BB- Below BB- Unrated RW Basel I 100% Capital-Basel I 8% RW Basel II 20% 50% 150% Capital-Basel II 1.6% 4% 12%

Capital requirements for SOVEREIGN in Basel II AAA to AA A+ to A- BBB+ to BB- BB to BB- Below BB- Unrated 100% 8% 20% 50% 150% 1.6% 4% 12%

Capital requirements for BANKS in Basel II AAA to AA A+ to A- BBB+ to BB- BB to BB- Below BB- Unrated 100% 8% 20% 50% 150% 1.6% 4% 12%

Capital requirements for BANKS in Basel II AAA to AA A+ to A- BBB+ to BB- BB to BB- Below BB- Unrated 100% 8% 20% 50% 150% 1.6% 4% 12%

Capital requirements for RETAIL in Basel II INDIVIDUAL OR SMALL BUSINESS DEFAULT RW under Basel I 100% RW under Basel II 75% From 150% to 50% Capital under Basel II 6% 4% to 12%

Capital requirements for REAL ESTATE in Basel II RETAIL RW BASEL I RESIDENTIAL 50% COMMERCIAL 100% Capital under Basel I 4% 8% RW under Basel II 35% Capital under Basel II 2.7%

SPECIALISED LENDDING PROJECT FINANCE COMMODITIES,COM. REAL ESTATE RW UNDER BASEL I 100% CAPITAL Basel I 8% RW UNDER BASEL II CAPITAL BASEL II

Assessing exposure customer wise and facility wise Probability of Default (PD) - the probability that a specific customer will default within the next 12 months. Loss Given Default (LGD) - the percentage of each credit facility that will be lost if the customer defaults. Exposure at Default (EAD) - the expected exposure for each credit facility in the event of a default.

MARKET RISK Market risk takes the form of interest rate risk, exchange rate risk, commodity price risk and equity price risk , major risk presently faced by banks in India are interest rate ,exchange rate and liquidity risk.

MARKET RISK-CONTINUED Basel-I focused only on credit risk excluding the market risk Risk brought vide amendments in 1996 usually measured with a Value-at-Risk method and on daily basis capital charge should be either the previous day’s VaR or three times the average of the daily VaR for the preceding 60 working days.

Stipulations of RBI Assign additional risk weight of 2.5% on the entire investment portfolio Assign risk weight of 100% on the open position limit on foreign exchange and gold Build investment fluctuation reserve up to a minimum of 5% of the investment held in ‘Held for Trading’(HFT) and ‘available for sale’(AFS) category in their investment portfolio

Linking risk to capital- single metric Risk measurement focuses on unexpected losses Different business activities lead to various unexpected losses These different risks must be measured individually and aggregated to a single risk metric, both by business line and across the bank as a whole

Overall risk should always be lower than overall economic capital WINNING FORMULA Overall risk should always be lower than overall economic capital

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