Risk Management Module D Capital Management & Profit planning By S.G.Savadatti savadatti@iibf.org.in

Balance Sheet Liabilities or Sources of funds Assets or Usage of funds Capital & Reserves (No due-date, no fixed rate of return & to be paid last in case of winding up). Borrowed funds (Have due-date, fixed rate of return & are paid before share- holders in case of winding-up.) Assets or Usage of funds Cash & bank balances Investments Advances

Principles Liabilities- Taken at book value Assets - The lower of book value or market value Minimum capital should be adequate to absorb the maximum loss that is likely to occur. It means, others money is treated as more sacrosanct. Thus, capital in a business is regarded as a surrogate for the financial strength of the business. What then is minimum capital? To know that, one needs to assess the loss that is likely to occur. This leads us to the concept of risk weights.

Basel-1 Addressed mainly credit risk and defined components of capital assigned risk weights to different types of assets assigned credit conversion factors to off-balance sheet items and bench marked minimum ratio of capital to risk weighted assets Risk weight norms under Basel –1 were of a straightjacket nature. The Basel- II accord addresses this shortcoming by emphasizing on the credit rating methodologies.

The Basel - II Accord 1st Pillar- Minimum capital requirements Replaces existing ’one-size-fits-all’ frame work with several options for banks. 2nd Pillar- Supervisory review process Provides guidelines for supervisors for effective implementation. 3rd Pillar- Market discipline Clamps disclosure norms about risk management practices. The revised accord provides incentives to banks to improve their risk management systems.

Components of Capital Regulatory capital would consist of Tier-I or core capital (paid up capital, free reserves & unallocated surpluses, less specified deductions.) Tier-Il or supplemental capital (subordinated debt > 5yrs., loan loss reserves, revaluation reserves, investment fluctuation reserves, and limited life preference shares ) and Tier- III capital (short term subordinated debt >2yrs & < 5yrs solely for meeting a proportion of market risk.) Tier II capital restricted to 100% of Tier-I capital Long term subordinated debt to be < 50 % of tier-I capital Tier III to be less than 250 %of Tier-I capital assigned to market risk, i.e., a minimum of 28.5 % of market risk must be covered by tier-I

Pillar-1 Minimum Capital Requirements The total capital ratio must not be lower than 8% The scope of risk weighted assets is expanded to include certain additional aspects of market risk and also operational risk. For the first time, operational risk is brought under the ambit of risk- weighted assets Thus, total risk-weighted assets = Risk weighted assets for credit risk + 12.5* Capital for market risk + 12.5 Capital for operational risk Minimum capital requirement is calculated in three steps: Capital for credit risk Capital for market risk and Capital for operational risk

Pillar- I MCR : CAPITA L FOR CREDIT RISK a Standard approach Based on ratings of External Credit Assessment Institutions ( ECAI ), satisfying seven requisite criteria and to be approved by national supervisors. A simplified standard approach (SSA) is also put in place. Internal rating based ( IRB) approaches Based on the bank’s internal assessment of key risk parameters such as, probability of default ( PD), loss given at default ( LGD ), exposure at default ( ED), and effective maturity ( M ) etc. b Foundation approach and c Advanced approach Banks, however, cannot determine all the above four parameters. .In foundation approach, banks estimate PD and supervisors decide the other parameters.In the Advanced approach, banks have more say on all the parameters as well.

Pillar- I MCR : CAPITA L FOR MARKET RISK The risk of losses in on-balance sheet and off-balance sheet positions arising from movements in market prices. Following Market risk positions require capital charge: Interest rate related instruments in trading book Equities in trading book and Forex open positions

Pillar- I MCR : CAPITA L FOR MATKET RISK The minimum capital required comprises two components: Specific charge for each security and General market risk charge towards interest rate risk in the portfolio Capital charge for interest rate related instruments Banks have to follow specific capital charges prescribed by RBI for interest rate related instruments as given on page nos.315 & 316 of the text book. These charges range from 0 % to 9 % for different instruments and for different maturities. As regards general market risk, RBI has prescribed ‘duration ’ method to arrive at the capital charge for market risk ( modified duration ).

Pillar- I MCR : CAPITA L FOR OPERATIONAL RISK There is a general perception that the operational risks are on the rising path The downfall of Barings Bank is mainly attributed to operational risk. Operational risk would vary with the volume and nature of business. It may be measured as a proportion of gross income. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Contd.

Pillar- I MCR : CAPITA L FOR OPERATIONAL RISK (Contd.) Capital charges for operational risks Basic Indicator Approach Average over the three years of a fixed percentage (denoted v by Alfa, presently 15% ) of positive annual gross income. Standardised Approach Here, bank’s activities are divided into eight business lines such as corporate finance, retail banking, asset management etc. Each business line is assigned a factor say, Beta, which determines the capital requirement for that business line. Average for three years gives capital for operational risks. Advanced Management Approach Here, bank’s internal risk measurement system is used after due vetting by the supervisor. As a minimum five year observation period of internal loss data is required this method may evolve over a period of time.

Prevention and control of operational risks Personnel :Ensure employee integrity, domain knowledge and efficiency through effective selection, training and promotion. Work Culture :A value based ethical business approach Organisational structure: Effective chain of command, compliances and redressal mechanism Audit and Internal Control: Effective audits, mix of continuity and surprise checks. System Reviews and Revision: Periodical reviews in the light of changing environment, legal frame work, experience etc. are essential.

Pillar- II : Supervisory Review Process Transparency and objectivity : Hall marks of the process Two objectives : Ensuring adequate capital of banks Encouraging banks to develop and implement better risk management practices (ICAAP- Internal Capital Adequacy Assessment Process ). The supervisory duties are guided by four principles

Supervisory Review Process :Four Principles 1. Banks should have rigorous processes to ensure adequate capital 2 Supervisors should review and evaluate risk management systems and strategies and take appropriate action whenever warranted. 3 Supervisors should expect banks to operate above the minimum regulatory capital levels to cover the uncertainties related to the system and bank specific uncertainties. 4 Supervisors should intervene and take immediate remedial action whenever a bank’s capital is sliding below the minimum regulatory capital. .

Pillar- II : Supervisory Review Process The supervisory review process would invariably involve some amount of discretionary elements. Supervisors, must therefore take care to carryout their obligations in a transparent and accountable manner.

Pillar- III : Market Discipline Disclosure norms to enable the market to assess a bank’s position Market discipline contributes to a safe and sound banking environment. Disclosures under pillar-III have been ensured not to conflict with those required under accounting standards Information given under pillar-III to be consistent with that given in the audited statements. Banks to give all information in one place Disclosures to be on a semi-annual basis. However, critical information needs to be published on a quarterly basis. Contd.

Pillar- III : Market Discipline (Contd.) Proprietary and confidential information need not be disclosed However, the bank must draw attention to the information that it has not disclosed and must state the reasons for the non-disclosure. The bank must, however, part with more general information on that subject matter. Banks should have a formal disclosure policy approved by the board Pillar-III prescribes qualitative and quantitative disclosures in this regard.

Asset Classification and Provisioning norms An account is considered non-performing when interest / instalments remain unpaid for 90 days. Income recognition of non-performing assets to be on receipt basis and not on accrual basis. Assets to be classified as: - Standard assets -Substandard assets -Doubtful assets and -Loss assets First stage of NPA is sub-standard category. Progressive deterioration drags it through the next classifications.

Provisioning Norms NPA causes two fold impact on profitability. Firstly, asset ceases to earn interest, and secondly, provisions are to be created against the NPA based upon the asset classification and value of security if any. Depending on the age of the NPA, the classification changes. With the passage of time, recovery probability diminishes and provisioning requirement goes up. A non-performing asset backed with no security moves from sub-standard category to loss category. Provisioning requirements for Doubtful-III category and for loss category are the same i.e. at 100%.

Profit Planning Profitability is a function of six variables, viz. 1 Interest income 4 Interest expenses 2 Fee based income 5 Staff expenses 3 Trading income 6 Other operating expenses Maximising the first three and minimising the others would boost profitability. Contd.

Profit Planning (Contd.) Banks have to optimise the allocation of funds amongst securities credit portfolios forex / bullion positions to achieve best possible results in terms of profitability and capital adeqacy. Fee-based income areas may have to be reworked with the introduction of new products and phasing out of out dated ones.

GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY FRAMEWORK APRIL, 2007. BASEL II FINAL GUIDELINES All commercial banks ( excluding local area banks and RRBs )shall adopt Standardised approach for credit risk and Basic Indicator Approach for operational risk. Banks shall continue to apply standardised duration approach for market risk.

Effective dates for migration GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY FRAMEWORK APRIL, 2007. BASEL II FINAL GUIDELINES Effective dates for migration Foreign banks in India and Indian banks with operational presence outside India to migrate to above selected approaches w.e.f. 31st March, 2008. All other commercial banks are encouraged to migrate to these approaches not later than 31st March, 2009.

Useful Reference Materials RBI GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY FRAMEWORK APRIL, 2007. BASEL II FINAL GUIDELINES India’s Preparedness for Basel II Implementation By V.Leeladhar, Dy. Governor Basel II and Credit Risk Management ( The above two articles appear in the RBI Monthly Bulletin of October, 2007 from page no.1669 to 1683)