CAIIB BFM MODULE B Risk Mangement

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CAIIB BFM MODULE B Risk Mangement


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Presentation Transcript Presentation Transcript

MUDOLE - B : MUDOLE - B Risk Management in Banks 1

WHAT IS RISK : WHAT IS RISK EVERY ACTION HAS A REACTION IF REACTION IS FOR OUR BEENFIT; NO WORRY AND NO RISK IF IT IS AGAINST OUR INTEREST ONLY WE ARE WORRIED AND THAT IS RISK RISK IS THEREFORE POSSIBILITY OF A NEGATIVE RESULT FOR OUR ACTIONS COULD BE DUE TO US OR BEYOND OUR CONTROL 2

Contd…… : Contd …… RISK IS SUPPOSED TO BE “DARE” DARING IS TO TAKE STEPS RECOGNISING THE POTENTIAL FOR LOSS EXTENT OF THIS BEHAVIOUR IS “TAKER” SPECIFIC MORE RISK IS TAKEN IN VIEW OF POTENTIAL FOR HIGHER YIELD 3

Contd…… : Contd …… DUE TO RISK EITHER , PROFITS AND CAPITAL MAY GROW MULTIFOLD OR BUSINESS MAY BE WIPED OUT NEVERTHLESS WE CANNOT BE RISK FREE/AVERSE BANKER LIKE A SHIP IN A PORT UNCERTAINTIES RESULTING IN ADVERSE OUTCOME, IN RELATION TO PLANNED OBJECTIVE OR EXPECTATIONS. 4

Contd…… : Contd …… FINANCIAL RISKS ARE UNCERTAINTIES RESULTING IN ADVERSE VARIATION OF PROFITABILITY OR OUTRIGHT LOSSES. UNCERTAINTIES WHICH IMPACT THE NET CASH FLOW OF BUSINESS UNFAVORABLE IS “RISK”. ZERO RISK WOULD IMPLY NO VARIATION IN NET CASH FLOW. 5

Contd…… : Contd …… RISK IS RELATED TO AMOUNT OF CAPITAL THAT THE FIRM REQUIRES TO ACHIEVE A SUFFICIENT LEVEL OF PROTECTION AGAINST ADVERSE CIRCUMSTANCES. RISK IS USED TO ADJUST THE RETURNS FROM BUSINESS ACTIVITIES TO DETERMINE WHETHER ACTIVITIES ARE ADDING VALUE TO BUSINESS. FINALLY “RISK IS PROBABILITY THAT REALISED RETURN WOULD DIFFERENT FROM THE ANTICIPATED / EXPECTED RETURN ON INVESTMENT.”   6

Contd…… : Contd …… RETURN THEREFORE SHOUL BE RELATED TO RISK BUSINESSES IS TO BE MANAGED BY ENHANCEMENT IN RISK ADJUSTED RETURN ON CAPITAL (RAROC). HIGHER THE RISK IN A BUSINESS, GREATER WOULD BE THE CAPITAL REQUIREMENT AND RETURN EXPECTATIONS. 7

WHY RISK MANAGEMENT : WHY RISK MANAGEMENT CONTROLLING THE LEVEL OF RISK (CAPACITY TO BEAR RISK) IN A BUSINESS IS THE ESSENCE OF RISK MANAGEMENT AND IT REQUIRES NOT ONLY IDENTIFICATION OF RISK BUT ALSO MEASUREMENT, CONTROL, MITIGATION AND ESTIMATING THE COST OF RISK 8

RISK MANAGEMENT : RISK MANAGEMENT 9 Risk Management is the process of measuring or assessing the actual or potential dangers of a particular situation.

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK ORGANISATION FOR RSIK MANAGEMENT: Board of Directors Risk Management Committee of Board Committee of Senior Level Officers Risk Management Support Group 10

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK RISK IDENTIFICATION : All transaction have one or more risk. Risk identification from various risk associated with the risk taking at the transaction level and examining its impact on the protfolio and on capital requirement. 11

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK RISK MEASUREMENT : Capture variations in earnings, market value, losses due to default etc. arising due to various risk elements. Quantitative measure risk are : Based on Sansitivity Based on Volatily Based on Downside Potential 12

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK RISK PRICING : Factoring Risk into pricing through capital charge & loss probabilities so pricing should take into account the following : Cost of Deployable Funds Operating Expenses Loss Probabilities Capital Charge 13

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK RISK MONITORING & CONTROL : Strong MIS Well laidout procedures, effective control & reporting framework Policy Guidelines for all activities Periodical review by Board or Sr. Management on a regular basis for bank’s risk profile & capital needs. 14

RISK MGMT FRAMEWORK : RISK MGMT FRAMEWORK MITIGATION : By adopting strategies that eliminate or reduce uncertainties of risk elements. Reduce downside variability in net cash flow with reducing upside potential simultaneously Through diversification 15

RISKS IN BANKING : RISKS IN BANKING Banking business is broadly grouped under following major heads from Risk Management point of view: The Banking Book The Trading Book Off-Balance-sheet Exposures 16

The Banking Book : The Banking Book All assets & liabilities in ‘banking book’ have following characteristics: 1. They are normally held until maturity 2. Accrual system of accounting is applied Since assets & liabilities are held till maturity, their mismatch may land the bank in either excess cash in-flow or shortage of cash on a particular time. This commonly known as ‘ Liquidity Risk’. 17

The Banking Book : The Banking Book Due to change in interest rates, assets and liabilities are subjected to interest rate risk on their maturities/re-pricing. Further, the assets side of the banking book generates credit risk arising from defaults in payment of interest and or installments by the borrowers. In addition to all these risk, banking book also suffers from ‘Operational Risk’. 18

The Trading Book : The Trading Book The trading book includes all the assets that are held with intention of trading that are marketable. They are normally held for a short duration and positions are liquidated in the market. Trading Book assets include investment held under ‘Held for Trading’ category. 19

Off-Balance-Sheet Exposure : Off-Balance-Sheet Exposure Off-balance sheet exposure is contingent in nature- Guarantees, LCs, Committed or back up credit lines etc. A contingent exposure may become a fund-based exposure in Banking book or trading book. Therefore, Off-balance sheet exposures may have liquidity risk, interest rate risk, market risk, credit or default risk and operational risk 20

TYPES OF RISKS IN BANKING : TYPES OF RISKS IN BANKING Risk is inherent in Banking Banking is not avoiding risks but managing it Risks in banking can be of Broadly 3 types: Credit Risk Market Risk Operational Risk 21

Slide22 : Anatomy of Bank Risk Non-Financial Risk Financial Risk Business Risk Strategic Risk Delivery (of Financial Services) Risk Balance Sheet Risk Operational Risk Legal Risk Reputational Risk

Slide23 : Balance Sheet Risk Credit Risk Concentration Risk Intrinsic Risk (High value lower return) Market Risk Interest Rate Risk Liquidity Risk Currency Risk Commodity Risk

Slide24 : Interest Rate Risk Price Risk Reinvestment Risk Yield Curve Risk Basis Risk Gap Risk

RISKS IN BANKING : RISKS IN BANKING Other Risk are : 1. Liquidity Risk : Funding of long term assets by short term sources. Inability to obtain funds to meet cash flow obligations at a reasonable rate. Types : Funding – Due to withdrawal/non renewal of deposits. Time – Performing Assets turning into NPA. Call – Due to crystallization of contingent liabilities. 25

RISKS IN BANKING : RISKS IN BANKING 2 . Interest Rate Risk : Gap or Mismatch Risk- Asset maturing in 2 years funded by Liability of 6 month Basis Risk = Spot price of hedged asset – Futures price of contract Yield Curve Risk – An asset linked to 364 day T Bill is funded by 91 day T Bill. 26

RISKS IN BANKING : RISKS IN BANKING Embedded Option Risk – Prepayment of loans & premature withdrawal of TDs. Reinvestment Risk – Uncertainty regarding ROI at which future cash flows could be reinvested. Net Interest Position Risk – Any change in market interest rates may adversely effect bank’s position. 27

RISK MANAGEMENT : RISK MANAGEMENT 28 Main Types of Risk Operational Market Credit

OPERATIONAL RISK : OPERATIONAL RISK 29 The risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This includes legal risk but excludes strategic & reputational risk.

OPERATIONAL RISK : OPERATIONAL RISK 30 Internal Fraud. Unauthorized Activity. Transactions not reported. Transaction type unauthorized. Mismarking of position. Theft and Fraud. Fraud/credit fraud/worthless deposits. Theft/extortion/embezzlement/robbery. Misappropriation of assets. Account take-over/impersonation. Bribes/kickbacks. Money laundering. Willful blindness.

OPERATIONAL RISK : OPERATIONAL RISK 31 2. External Fraud. Theft and Fraud. Theft / Robbery. Forgery. Check kiting (Chq a/c A-B no balance) Elder financial abuse (old age) Systems Security. Hacking damage. Theft of information (with monetary loss).

OPERATIONAL RISK : OPERATIONAL RISK 32 3. Employment Practices and Workplace Safety : Employee Relations. Compensation, benefit, termination issues. Organized labor issues. Safe Environment. General liability Employee health and safety rules. Workers’ compensation. Diversity and Discrimination. All discrimination types. Harassment. Equal Employment Opportunity (EEO).

OPERATIONAL RISK : OPERATIONAL RISK 33 4.Clients,Products & Business Practices : Suitability, Disclosure and Fiduciary. Fiduciary breaches/guideline violations. Suitability/disclosure issues. Retail consumer disclosure violations. Breach of privacy/Lender liability. Inadequate product offerings. Misuse of confidential information. Improper Business or Market Practices . Improper trade /market practice. Market manipulation. Insider trading (on firm’s account). Unlicensed activity/Money laundering.

OPERATIONAL RISK : OPERATIONAL RISK 34 4.Clients,Products & Business Practices Contd… Selection, Sponsorship and Exposure. Failure to investigate client as per guidelines. Exceeding client exposure limits. Advisory Activities. Disputes over performance or advisory activities.

OPERATIONAL RISK : OPERATIONAL RISK 35 5. Damage to Physical Assets : Disasters and Other Events . Natural disaster losses. Human losses from external sources (terrorism, vandalism). 6.Business Disruption and System Failures Systems. Hardware. Software. Telecommunications. Utility outage/disruptions(Power/Water/Gas).

OPERATIONAL RISK : OPERATIONAL RISK Transaction Capture, Execution and Maintenance. Miscommunication/Delivery Failure Data entry, maintenance or loading errors. Missed deadline or responsibility. Accounting error Record retention. Documentation maintenance. Collateral management failure. Reference data maintenance. contd …. 36 7. Execution, Delivery and Process Management.

OPERATIONAL RISK : OPERATIONAL RISK 37 Monitoring and Reporting. Failed mandatory reporting obligations. Inaccurate external loss (loss incurred). Customer Intake and Documentation. Unapproved access given to accounts. Incorrect client records (loss incurred). Negligent loss or damage of client assets. Trade Counterparties. Non-client counterparty misperformance. Vendors and Suppliers. Outsourcing. Vendor disputes.

OPERATIONAL RISK : OPERATIONAL RISK STEPS TO BE TAKEN BY BANKS : To minimize operational risk & strengthen internal control, the objective of the Bank is to develop an appropriate policy, procedures, strategy, framework, and risk culture by adopting best practices to achieve the goal set by the Bank. To find out the extent of Bank’s Operational Risk exposure and to allocate capital for operational risk. 38

OPERATIONAL RISK : OPERATIONAL RISK STEPS TO BE TAKEN BY BANKS : Appropriate policies and procedures Efforts to identify and measure operational risk Effective monitoring and reporting A sound system of internal controls, and Appropriate testing and verification of the Operational Risk Framework 39

Concept of Gross Income : Concept of Gross Income BCBS : All national supervisor to define gross income. RBI defines gross income as follows, Gross income = Net profit (+) Provisions & Contingencies (+) operating expenses (Schedule 16) (-) profit on sale of HTM investments (-) income from insurance (-) extraordinary / irregular income (+) loss on sale of HTM investments 40

OPERATIONAL RISK : OPERATIONAL RISK NCAF - 3 methods : ( i ) the Basic Indicator Approach (BIA) - Under this Approach, banks must hold capital for operational risk equal to the average over previous three years of a fixed percentage (presently 15%) of positive annual gross income ). K BIA = GI x a GI = average annual gross income(three years, negative/zero income be excluded from numerator & denominator both ) α = 15% 41

OPERATIONAL RISK : OPERATIONAL RISK (ii) the Standardised Approach (TSA) : B anking activities have been mapped into 8 business lines: (on average % of gross income of last 3 yrs) Business lines % of gross income Corporate finance (β1) 18 Trading & sales (β2) 18 Retail Banking (β3) 12 Commercial Banking (β4) 15 Payment & Settlement (β5) 18 Agency Services (β6) 15 Asset Management (β7) 12 Retail Brokerage (β8) 12

OPERATIONAL RISK - TSA : OPERATIONAL RISK - TSA 43 GI 1-8 = average annual gross income from business line from one to eight ( three years, negative/zero income be excluded from numerator & denominator both ) β = A fixed percentage set by the Committee

OPERATIONAL RISK : OPERATIONAL RISK (iii ) Advanced Measurement Approaches (AMA) Basel II - Banks can use this approach only subject to approval from their local regulators : 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. Its board of directors and senior management, are actively involved in the oversight of the operational risk management framework; It has sufficient resources for use of approach in major business lines and control & audit areas. (by 31.03.2014) 44

Slide45 : 45

Slide46 : 46

OPERATIONAL RISK : OPERATIONAL RISK Employee training. Close management oversight. Segregation of duties. Employee background checks. Procedures and process. Purchase of insurance. Exiting certain businesses. Capitalization of risks. 47 Operational Risk Checklist :

OPERATIONAL RISK – MGMT TASK : OPERATIONAL RISK – MGMT TASK Decision whether control for risk minimization or bear Risk mitigation tools as complementary to control Investment in technology and Information security Outsourcing policy development and adoption Impact of operational break downs and loss within and outside bank Business Continuity plans, testing & reviewing 48

ORGANISATIONAL SET-UP : ORGANISATIONAL SET-UP Board of Directors Risk Management Committee of the Board Operational Risk Management Committee Operational Risk Management Department Operational Risk Managers Support Group for operational risk management 49

MARKET RISK : MARKET RISK Market risk is risk of losses in on-balance sheet and off balance-sheet positions arising from movements in market prices. Takes into account Notional amount and market parameters 50

MARKET RISK : MARKET RISK Market risk is in 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. 51

MARKET RISK : MARKET RISK 52 The risks pertaining to interest rate related instruments and equities in the trading book (ii) Foreign exchange risk (including open position in precious metals) throughout the bank (both banking and trading [Investment/securities] books).

MARKET RISK : MARKET RISK 53 RBI GUIDELINES : Banks are required to manage the market risks in their books on an ongoing basis and ensure that the capital requirements for market risks are being maintained on a continuous basis, i.e. at the close of each business day.

MARKET RISK : MARKET RISK MEASURES : Prudential gap limits are fixed and reviewed periodically for the liquidity and interest rate risk of the bank’s books. The ALM solution would encompass the Global operations of the bank. Behavioral studies shall continue to be done for assessing and apportioning volatile and non-volatile portion of various non-maturity products of both assets and liabilities. 54

MARKET RISK : MARKET RISK 4.Minimum capital requirement be calculated separately for ( i ) Specific Risk - charge for each security which is designed to protect against an adverse movement in the price of an individual security (Capital charge for Capital Market Investments will be 11.25% and Security Receipts 13.5% i.e. 125% & 150% of RWA i.e. higher) (ii)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) in different securities or instruments can be offset.(Starting 2.5% extra for HFT(Held for Trading)/AFS(Available for sale) not now. 55

MARKET RISK : MARKET RISK The bank’s Foreign Exchange Risk position in each currency should be calculated by summing : net spot position, net forward position, Guarantees, Net future income/ expenses (capital charge for foreign exchange risk and gold open position is 9 per cent). 6.Duration gap analysis (measure of the percentage change in the economic value of a position) continue to be carried out at Monthly (since April 2012) intervals to assess the interest rate risk of both banking book and trading book. 56

MARKET RISK : MARKET RISK Foreign Exchange risk be regularly monitored and managed through exposure limits i.e. Day Light Limit, Overnight Limit, Stop Loss limits, Inter Bank Exposure Limits etc. Maturity Position and Interest Sensitivity of Forex Open positions are assessed on monthly basis and put up to ALCO. Bank may enter into Interest Rate Swaps (IRS) & Forward Rate Agreement (FRA) selectively with the objective of hedging actual balance sheet exposures and to meet the requirements of corporate clients. 57

MARKET RISK : MARKET RISK 10.VaR (Value-at-risk) a measure of the worst expected loss over a given time interval under normal market conditions at a given confidence level (say 95% or 99%) shall be computed on the trading book of the Investment Portfolio on daily basis Thus VaR is simply a distribution of probable outcome of future losses that may occur on a portfolio. The actual result will not be known until the event takes place. Till then it is a random variable whose outcome has been estimated. 58

MARKET RISK : MARKET RISK 11.Earnings at risk (EaR) measure the quantity by which net income might change in the event of an adverse change in interest rates. VaR looks at the change in the entire value over the forecast horizon, EaR looks at potential changes in cash flows or earnings. RBI : Banks should identify their major sources of risk and carry out stress tests appropriate to them, may be run daily or weekly, monthly or at quarterly intervals, which would be preparedness for Pillar 2 of the Basel II framework. 59

Stress Testing : Stress Testing To identify events or influences that could greatly impact banks is a key component of a bank’s assessment of its capital position Need to cover factors that can create extraordinary losses or gains in trading portfolios, or make the risk control in those portfolios very difficult Both of a quantitative and qualitative nature, incorporating both market risk and liquidity aspects of market disturbances Stress tests results should be reviewed periodically by senior management and should be reflected in the policies and limits set by management and the board of directors

BACK TESTING : BACK TESTING The process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward, which could take years, a trader can do a simulation of his or her trading strategy on relevant past data in order to gauge the its effectiveness. A theory assumes that what happens in the past will happen in the future, and this assumption can cause potential risks for the strategy.  61

Advanced Risk Measurement Techniques enables Bank to effectively control the amount of market risk it assumes and allocate capital for the same : Time Sophistication Mark to Market Duration Value at Risk Stress Testing Use of Statistical analysis to determine maximum losses Use of ‘What if’ scenarios to determine losses in extreme events Cashflow analysis to measure the sensitivity of fixed income instruments Revaluation of the portfolio to measure notional P/L Time Time Sophistication Mark to Market Duration Value at Risk Stress Testing Use of statistical analysis to determine maximum losses Use of ‘What if’ scenarios to determine losses in extreme events Cashflow analysis to measure the sensitivity of fixed income instruments Revaluation of the portfolio to measure notional P/L Advanced Risk Measurement Techniques enables Bank to effectively control the amount of market risk it assumes and allocate capital for the same Measurement Techniques Marking to Market Duration Price Value of a Basis Point VaR - Forex (Spot & Forward) Stress Testing Scenario Analysis Duration Limits VaR Limits Stop Loss Limits Counterparty Exposure Limits Country Exposure Limits Standardized Model Internal Model ‘Know’ your risks Allocate Capital Control Measures

BASIS POINT VALUE : BASIS POINT VALUE In finance,  basis point value  ( BPV ) denotes the change in the price of a bond given a basis point change in the yield of the bond. Basis Point Value tells us how much money the positions will gain or lose for a 0.01% parallel movement in the yield curve. It is specified for interest rate risk and quantifies the interest rate risk for small changes in interest rates 63

Slide64 : 64

CREDIT RISK : CREDIT RISK Credit Risk is defined as the possibility of losses associated with diminution in the credit quality of borrowers or counter-parties. In a bank’s portfolio, losses stem from: Outright default due to inability or unwillingness of a customer or counter-party to meet commitments in relation to lending, trading, settlement and other financial transactions. Reduction in portfolio value arising from actual or perceived deterioration in credit quality. 65

CREDIT RISK : CREDIT RISK Credit risk incorporates following three risks: - Counterparty Risk : Risk to each party of a contract that other party (or parties) will not live up to their obligations under the contract. In most financial contracts, counterparty risk is default risk i.e. failure to make payments because of bankruptcy. To reduce the potential of counterparty risk, margin is taken in the accounts. Credit Spread Risk : It arises due to changes in the credit quality of the obligor between a rating horizon. Example - If credit quality of a borrower deteriorates after last rating but before next rating becomes due, in that case bank is not compensated for taking additional risk if loan price is not revised. However, if the borrower’s credit quality improves between a rating horizon, it is beneficial for the bank. 66

CREDIT RISK : CREDIT RISK Concentration Risk: Refers to additional portfolio risk by increased exposure to one obligor or groups of correlated obligors (e.g., by industry, by location, etc.). It includes: Significant exposures to an individual counterparty or group of related counterparties; Credit exposures to counterparties in the same economic sector or geographic region; Credit exposures to counterparties whose financial performance is dependent on the same activity or commodity; and Indirect credit exposures arising from a bank’s Credit Risk Mitigation (CRM) activities (e.g. exposure to a single collateral type or to credit protection provided by a single counterparty). 67

CREDIT RISK MANAGEMENT : CREDIT RISK MANAGEMENT Credit risk management enables banks to identify, assess, manage proactively, and optimise their credit risk at the level of individual borrower as well as for Bank as a whole. The quality of the credit risk management function is one of the key drivers of the level of shareholders’ return. 68

Credit Management Vs Credit Risk Management : Credit Management Vs Credit Risk Management 69 Credit Management Credit Risk Management It involves selecting and identifying the borrower/ counter-party. It involves identifying and analyzing risk in a credit transaction. It revolves around examining three Ps of borrowers: People, Purpose & Protection It revolves around measuring, managing and controlling credit risk in the context of an organization's credit philosophy and credit appetite. It is predominantly based on accounting information and Judgment and is subjective in nature. It is data driven, scientific and is more objective in nature.

Tools for Credit Risk Assessment : Tools for Credit Risk Assessment The credit risk rating system and credit scoring system provides a common language and uniform framework across bank for assessing credit risk.  The system enables the bank to evaluate and track risk on individual borrowers on a continuing basis. Risk Rating models are mostly based on the financials of the borrowers whereas credit scoring models are based on the personal attributes of an individual. 70

Advantages of Credit Rating or Credit Scoring : Advantages of Credit Rating or Credit Scoring Credit Selection/Rejection Evaluation of borrower in totality and of any particular exposure /facility Transaction level analysis and credit pricing & tenure. Activity wise/Sector wise portfolio study keeping in view the macro-level position. Fixing outer limits for taking up/maintaining an exposure arising out of risk rating. Monitoring exposure already in the books and deciding exit strategies in appropriate cases. 71

Advantages of Credit Rating (Contd…) : Advantages of Credit Rating ( Contd …) Allocation of risk capital for credit sanctions. Avoiding over concentration of exposure in specific risk grades, which may not be major concern at a particular point of time, but may in the future pose problems if the concentration continues. Clarity and consistency, together with transparency in rating a particular borrower/exposure, enabling a proper control mechanism to check risks associated in the exposure. 72

Credit Risk Rating System : Credit Risk Rating System In order to create and stabilize robust credit risk management system, bank has been continuously monitoring the ratings and their migration. To provide a standard definition and benchmarks under the credit risk rating system, seven rating grades for performing loans have been specified. To ensure the quality and consistency of credit risk ratings, vetting of the rating is also done. The credit risk rating of a borrower becomes due for updation after the expiry of 12 months from the month of previous rating. Thus fresh rating in the accounts is conducted annually. Out of the seven rating grades, B and above are treated as Investment Grade. The average annual default rates in these rating grades is under 2% 73

Slide74 : 74 Adoption of Credit Risk Management under Basel II

Approaches to Credit Risk Management under Basel II : Approaches to Credit Risk Management under Basel II 75 INCREASED SOPHISTICATION REDUCED CAPITAL REQUIREMENT STANDARDISED APPROACH Risk weights are assigned in slabs according to the asset class or are based on assessment by external credit assessment institutions FOUNDATION INTERNAL RATING BASED APPROACH Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized. ADVANCED INTERNAL RATING BASED APPROACH Banks internal estimations of Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (EM) to calculate risk weights for exposure classes

BASEL-II: IRB APPROACH : BASEL-II: IRB APPROACH Two Approaches IRB Foundation Approach IRB Advanced Approach Bank’s estimated potential future loss – Main elements Risk Component Risk Weight Minimum Requirement 76

BASEL-II: IRB APPROACH : BASEL-II: IRB APPROACH Risk Component Probability of Default (PD) Loss given Default (LGD) Exposure at Default (EAD) Maturity (M) Risk Weight : Dependent on PD, LGD, and effective maturity (M). Minimum Requirements: Credit Rating System for all categories. Track record of using internal ratings for min. 3 yrs. Risk quantification i.e. EAD and LGD covering one economic cycle. Validation of internal estimates. Stress testing process for assessment of capital adequacy. Disclosure requirements. 77

RISK COMPONENTS : RISK COMPONENTS PROBABILITY OF DEFAULT (PD) Probability of default measures the likelihood that the borrower will default over a given time-horizon i.e. What is the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon, such as a year? Calculated for a one-year horizon, this may be called the expected default frequency. 78

RISK COMPONENTS : RISK COMPONENTS LOSS GIVEN DEFAULT (LGD)) Loss Given Default is the credit loss incurred if an obligor of the bank defaults. LGD = 1 – Recovery Rate where, Recovery = Present Value of { Cash flows received from borrower after the date of default - Costs incurred by the bank on recovery } Recovery rate = Recovery (as calculated above)/ Exposure on the date of default 79

RISK COMPONENTS : RISK COMPONENTS EXPOSURE AT DEFAULT (EAD) EXPOSURE AT TIME OF DEFAULT (EAD) IS THE TOTAL BANK'S MONEY AT RISK 80

RISK COMPONENTS : Maturity (M) : RISK COMPONENTS : Maturity (M) It measures the remaining economic maturity of the exposure. Determines framework for comparing different exposures. 81

IRB Foundation Approach : IRB Foundation Approach Under the foundation approach, banks, which comply with certain minimum requirements viz. comprehensive credit rating system with capability to quantify Probability of Default (PD) could assign preferential risk weights, with the data on Loss Given Default (LGD) and Exposure at Default (EAD) provided by the national supervisors . 82 IRB Advanced Approach Banks need to estimate all three risk inputs i.e PD,EAD, & LGD internally. This will help the bank to calculate the expected and unexpected loss. Based on unexpected loss, capital is allocated.

Expected Loss (EL) : Expected Loss (EL) Expected Loss is the bank’s cost of doing business. Expected Loss has to be provided for. The Expected Loss (in currency amounts) EL = PD * EAD * LGD If expressed as a percentage figure of the EAD EL = PD * LGD. The bank should also proactively incorporate an expected loss rate in the estimation of the total spread to be charged on the loan. Expected loss is not a measure of risk as it is anticipated. 83

Unexpected Loss (UL) : Unexpected Loss (UL) Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations. 84

Foundation IRB Vs Advanced IRB Approach : Foundation IRB Vs Advanced IRB Approach 85 Foundation IRB Approach Advanced IRB Approach Values for Loss Given Default (LGD) and exposure at default (EAD) are provided by the regulatory authority. Values for Loss Given Default (LGD) and exposure at default (EAD) are determined by each bank through internal modeling with a data of 5-7 years. Assessment of values of credit mitigants is done by the regulatory authority. Banks may assess the value of its credit mitigants. For retail exposure, there is no foundation IRB (only advanced IRB where besides PD, the bank concerned will have to estimate LGD & EAD.) Advanced IRB is applicable to retail exposure also.

Implementing Foundation IRB approach in PNB : 86 All eligible credit exposures beyond a threshold limit are individually risk rated through internal credit risk rating models. Default Rates for large corporate model generated for last six years. The default rates are satisfactory and comparable with international standards. Migration of ratings analysed since last five years. Implementing Foundation IRB approach in PNB 86

Slide87 : 87 Gaps in the existing systems for adoption of advanced IRB approach are being identified. Data collection for estimation of LGD started and model is being prepared for computation of the same. Data requirements as well as application tools for Risk Management finalized and shall be implemented alongwith the data warehouse project. Establishment of Enterprise wide Data Warehouse and application tools for Credit Risk, Operational Risk, Market Risk, ALM and FTP (Fund Transfer Price) are under process. Implementing Advanced IRB approach

Slide88 : 88 RBI has prescribed list of eligible financial collaterals, method of valuation of these collaterals and haircut thereon etc., which would help the bank in reducing the exposure amount by permitting offset of such collaterals against the exposure. Exposure may be collateralized in whole or in part by cash or securities, deposits from the same party, guarantee of a third party etc. Use of CRM technique reduces or transfers credit risk, it simultaneously may increase other risks such as residual risks Credit Risk Mitigation Techniques(CRM)-TSA

Slide89 : 89 Eligible collaterals for CRM : Cash, Certificate of Deposit/Instruments issued by lending Bank, deposit with banks, Gold, Central/State Govt. Securities, KVPs/NSCs, LIPs(SV) and Debt Securities : i. Rated (BBB-Issued by PSEs & A-3 for Short Term Debt Instruments). ii. Non Rated : a) issued by a bank; and b) listed on a recognised exchange c) classified as senior debt and Units of Mutual Funds (Regulated) : Price of units is publicly quoted daily (daily NAV available) Mutual fund is limited to investing in the listed instruments. CRM - Under Standardized Approach (TSA):

Slide90 : 90 BENEFITS AND DRIVERS OF CREDIT RISK MANAGEMENT

Benefits and drivers of Credit Risk Management : Benefits and drivers of Credit Risk Management Helps in establishing a system for measuring, monitoring and managing risk scientifically. Introduction of rating framework for improved selection of clients according to their risk profile Improved pricing of products Reduces Concentration risk Optimized allocation of economic capital Supports portfolio optimization (Minimising ratio of risk to return) Assuming that we have capital of Rs. 13.50 with a option of lending to BB rated assets or AAA rated assets…… 91 91

The position works out as under: : The position works out as under: Particulars BB AAA Maximum Exposure 100 750 Total Interest Income @11% for BB & 9.75% for AAA 11.00 73.10 Cost: Cost of Funds (assumed) 4.5% 4.50 33.75 Cost of Operations (Estimated) 1.00 2.00 Risk Premium (assuming 1% EL for BB and 0.1% for AAA) 1.00 0.75 Capital Charge @10% 1.35 1.35 Total Cost 7.85 37.10 Return on Capital 3.15 36.00 It can be inferred from the above that lending to AAA assets at 9.75% would be more remunerative vis-à-vis lending to BB at 11%. Our natural choice for selection of borrowers would shift from BB & upwards under Basel I to AAA & downwards under Basel II (SA). In case sufficient number of AAA assets are not available at lease our order of preference would be AA, A and then BB.

Inherent Risk in Different Activities : Inherent Risk in Different Activities Manufacturing Trading Lending Unlimited Up Side Limited Up Side Very Limited Up Side Unlimited Down Side Limited Down Side Unlimited Down Side

What is Credit Risk Rating? : What is Credit Risk Rating? Credit risk rating is a rating assigned to borrowers, based on detailed analysis of their ability and willingness to repay the debt taken from the bank. Credit risk ratings help a bank to assign a probability of default for borrower according to its risk category. The probability of default increases in an exponential manner as the credit risk rating deteriorates.

BENEFITS OF CREDIT RISK ASSESSMENT : BENEFITS OF CREDIT RISK ASSESSMENT It is an important tool for taking credit decisions, i.e. whether to lend to a Borrower or not. Assessing Bank’s Risk Bearing Capacity. Quantification of Estimated Loan Loss. Better Provisioning Risk based Pricing (ROI) of Loans. Product Mix (switching one facility to another). Level (Authority) of decision Making. Frequency of Renewal / Monitoring.

Unexpected Loss (UL): : Unexpected Loss (UL): Regardless of how prudent a bank is in managing its day-to-day business activities, there are market conditions that can cause uncertainty in the amount of loss in portfolio value. This uncertainty, or more appropriately the volatility of loss, is the unexpected loss. Unexpected losses are triggered by the occurrence of higher default rates as a result of unexpected credit migrations. Mathematically, Unexpected Loss is the standard deviation of the change in the asset value at the end of the horizon. This implies that unexpected loss is the estimated volatility of potential loss in portfolio value around the expected loss.

GENERAL GUIDELINES : GENERAL GUIDELINES Latest Audited Financial Statements only (not more than 1 Yr old). Each parameter to be evaluated and no parameter should be left un-assessed. Careful analysis & evaluation of each parameter. Subjective parameters need qualitative evaluation and continuous updating knowledge about the business & industry. To improve information base about management and conduct of the accounts - through regular visit of the industry, interaction – valuable insight beyond financial data.

GENERAL GUIDELINES Contd… : GENERAL GUIDELINES Contd… Information about borrower to be collected from all possible sources. Data used to assign rating should be annualized and comparable. Financials of the Co. should be made comparable with peers in case of change in accounting policies, merger, de-merger, acquisition, sell-off etc. For multi-divisional Co. more than one activity/ product/ industry – Business parameters to be evaluated separately for each of 3 major activities. The complete rating sheet, justification, financial ratios (if computed manually) and other relevant information must be sent to vetting authority for each rating.

GENERAL GUIDELINES Contd… : GENERAL GUIDELINES Contd… Record of rating exercise & history of ratings should be kept on record for further reference, uses, audit etc. Final/ approved rating to be informed to the original rating office after vetting by competent authority. The credit risk rating along with date of approval & date of B/sheet to be mentioned in all references made to competent authority for taking credit decisions. Other guidelines mentioned in manuals of individual credit rating models to be followed strictly. Maintaining utmost secrecy of the rating mechanism and to prevent its misuse.

Basel I : Basel I Rating Exposure ROI RISK WEIGHT Capital Charge AAA 100 9% 100% 9 BB 100 11% 100% 9 Both the above assets are investment grade. As a prudent banker our natural choice is for BB asset vis-à-vis AAA asset because BB is more remunerative.

Basel II (Standardised Approach) : Basel II (Standardised Approach) Rating Exposure ROI RISK WEIGHT Capital Charge AAA 100 9% 20% 1.8 BB 100 11% 150% 13.5 Risk weights under Standardised Approach are more Risk Sensitive. Because of the risk weights are more risk sensitive, we can do 7.5 times more business for AAA assets vis-à-vis BB assets, which will be more remunerative.

Results : : Results : It can be inferred from the above that lending to AAA assets at 9% would be more remunerative vis-à-vis lending to BB at 11%. Our natural choice for selection of borrowers would shift from BB & upwards under Basel I to AAA & downwards under Basel II (SA). In case sufficient number of AAA assets are not available at lease our order of preference would be AA, A and then BB.

Slide103 : Thank You

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