CAIIB- Risk ManagementModule D

Capital Management&

Profit planning

by Shri Amar J.Nayyar

Balance Sheet

Assets or Usage of funds

• Cash & bank balances

• Investments

• Advances

Liabilities or Sources 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.)

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 CapitalRegulatory 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 capitalTier 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 ApproachAverage over the three years of a fixed percentage (denoted v by Alfa,

presently 15% ) of positive annual gross income.

Standardised ApproachHere, 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 ApproachHere, 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.whenever warranted.

• 3 3 Supervisors should expect banks to operate above Supervisors should expect banks to operate above the minimum regulatory capital levels to cover the the minimum regulatory capital levels to cover the uncertainties related to the system and bank specific uncertainties related to the system and bank specific uncertainties.uncertainties.

• 4 4 Supervisors should intervene and take immediate Supervisors should intervene and take immediate remedial action whenever a bank’s capital is sliding remedial action whenever a bank’s capital is sliding below the minimum regulatory capital.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.

GUIDELINES FOR IMPLEMENTATION OF THE NEW CAPITAL ADEQUACY FRAMEWORKAPRIL, 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.

contact no.:9322670458

email: nayyar@pnbrscmbi.com