Description
This is a presentation about shortcomings of Basel 1 and explains architecture and framework of Basel 2
BASEL II – AN OVERVIEW
MBA (Finance)
Group II
WHY BASEL?
?
Risk and uncertainties form an integral part and parcel of Banking
?
Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the bank’s capital and earnings Risk is to be borne by the bank itself and hence is to be taken care of by the requisite capital
So the need for suitable capital structure and sufficient Capital Adequacy Ratio is felt
?
?
BCBS
?
Bankers for International Settlement (BIS) meet at Basel,
situated at Switzerland, to address the common issues
concerning bankers all over the world.
?
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries
?
It has been developing standards and establishment of a framework for bank supervision towards strengthening stability of financial institutions and banks
ACCORD HISTORY – BASEL I
BIS came out with its first Accord in 1988 with emphasis on Capital Adequacy, it was internationally hailed as a milestone in Banking Regulation ? It was the first attempt to prescribe rule based Capital Adequacy norms for all the international banks so as to ensure a level playing field for them ? The Accord attempted to apply state of the art financial modeling techniques for capital adequacy requirements ? The Accord was implemented by more than 100 countries and was implemented in India in 1991 during the economic liberalization and globalization
?
SHORTFALLS
I.
IN
BASEL I
II.
III.
IV.
Only four risk weights such as 0%, 20%, 50% and 100% resulted in inadequate differentiation of credit risk The risk weights applied to AAA rated borrower and that of lower rated borrower are same though the risk profile of the borrowers may vary substantially relatively. There was no relief of capital to the banks holding relatively less risky assets in their books. The accord did not recognize the portfolio diversification effect for credit risk, though such a treatment was given in respect of market risk. The availability of certain credit risk mitigation techniques such as cash margin, collateral security, etc was not recognized.
SHORTFALLS
V.
IN
BASEL I
VI.
VII.
Capital charge was same irrespective of the maturity structure of credit exposure and the accord ignored the fact that there is greater risk of default in the longer-term exposure than the one maturing shortly. In respect of investments, general quantum equivalent to 2.5% risk weight for the entire portfolio was provided for and volatility of the market was ignored. There was no capital charge for the operational risk, though it was a very important source of risk and may be, at times, more devastating than credit risk.
BASEL II ?
INTRODUCTION
The New Basel Capital Accord or Basel II Accord, was approved by the Basel Committee on Banking Supervision (BCBS) of Bank for International Settlements on June 26,2004 ? Initially it was suggested that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months ? It was estimated that the Accord would be implemented in over 100 countries, including India.
SCOPE
?
OF APPLICATION OF
BASEL II
The scope of application of Basel II Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group ? Banking and other relevant financial activities (Excluding insurance activities) conducted within a group containing an internationally active bank will be captured through consolidation
SCOPE
OF APPLICATION OF
BASEL II
EFFECTIVE DATE
?
FOR IMPLEMENTATION IN
INDIA
Foreign banks operating in India and Indian banks having operational presence outside India should migrate to the above selected approaches under the Revised Framework with effect from March 31, 2008.
?
All other commercial banks (except Local Area Banks and Regional Rural Banks) are encouraged to migrate to these approaches under the Revised Framework in alignment with them but in any case not later than March 31,2009.
THREE PILLARS
OF
BASEL II ACCORD
Basel II Capital Accord
Pillar 1 “Quantitative” Minimum Capital Requirements Pillar 2 “Qualitative” Supervisory Review Process Pillar 3 “Market Forces” Market Discipline
• New standards for minimum capital • Enlarges the role of requirements banking supervisors • Methodology for • Power to review the banks’ assigning risk weights on risk management systems the basis of credit risk • Early intervention by and market risk supervisors • Capital requirement for operational risk
Standards and requirements for higher disclosure by banks on the following areas oCapital adequacy oAsset quality oOther risk management processes
PILLAR I – MINIMUM CAPITAL REQUIREMENTS
?
Tier I Capital
Paid up share capital/common stock ? Disclosed reserves
?
?
Tier II Capital ( Maximum 100% of Tier 1 Capital)
Undisclosed reserves ? General provisions/loan loss reserves ? Hybrid (debt/equity) capital instruments ? Subordinated debt
?
PILLAR I – MINIMUM CAPITAL REQUIREMENTS
?
Tier III Capital For short-term subordinated debt to be eligible as tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:
be unsecured, subordinated and fully paid up ? have an original maturity of at least two years ? not be repayable before the agreed repayment date unless the supervisory authority agrees ? be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement
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DEDUCTIONS
FROM
CAPITAL
Deduction from Tier 1 capital elements ? Increase in equity capital resulting from a securitization exposure ? Intangible assets and losses in the current period and those brought forward from previous periods ? Investments in subsidiaries engaged in banking and financial activities which are no consolidated in national systems. ? RBI guidelines’ additional recommendations - DTA associated with accumulated losses - DTA (excluding DTA associated with accumulated losses),net of DTL.
CAPITAL
TO
RISK-WEIGHTED ASSETS RATIO (CRAR)
?
CRAR (Tier 1) = Eligible Tier 1 Capital Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
* RWA = Risk weighted Assets
Banks are encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of at least 6%. Banks which are below this level must achieve this ratio on or before March 31, 2010. ? Banks are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9 percent on an ongoing basis.
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CREDIT RISK
Standardized Approach
Internal Ratings Approach
Measure credit risk in a standardized manner as recommended by Central Bank
Banks to use their internal rating systems for credit risk
Banks may use assessments by external credit assessment institutions
Subject to the explicit approval of the bank’s supervisor
STANDARDIZED APPROACH -RISK
WEIGHTS
Standardized approach provides risk weights for the following individual claim:1. Claims on sovereigns - Claims on sovereigns and their central banks
RBI guidelines says Both fund based and non fund based claims on the central government will attract a zero risk weight. Central Government guaranteed claims will attract a zero risk weight.
STANDARDIZED APPROACH -RISK
2.
WEIGHTS
Claims on non-central government public sector entities (PSEs)
- Risk weighted in a manner similar to claims on Corporates
3.
Claims on multilateral development banks (MDBs) – 20
% Risk weight for all organizations
4.
Claims on banks
Scheduled Banks – 20 % Risk weight Non Scheduled Banks – 100 % Risk weight
5.
Claims on securities firms
- Risk weighted in a manner similar to claims on Corporates
STANDARDIZED APPROACH -RISK
6.
WEIGHTS
Claims on Corporates
7.
Claims included in the regulatory retail portfolios
- Claims included in this portfolio shall be assigned a risk-weight of 75 %
Four Criteria for inclusion in retail portfolio –
•Orientation criterion •Product criterion •Granularity criterion •Low value of individual exposures
STANDARDIZED APPROACH -RISK
8.
WEIGHTS
Claims secured by residential property
Loan to Value ( LTV) ratio below 75%
- Up to Rs. 20 lacs – 50 % Risk weight - Rs. 20 lacs and above – 75 % Risk weight
Loan to Value ( LTV) ratio below 75% - Risk weight of 100%
9.
Claims secured by commercial real estate
- Risk weight of 150 per cent
10.
Non-performing assets (NPAs)
• 150% risk weight when specific provisions are less than 20% • 100% risk weight when specific provisions are at least 20% • 50% risk weight when specific provisions are at least 50% of the outstanding amount of the NPA.
The unsecured portion of NPA
EXTERNAL CREDIT ASSESSMENT
?
Banks can use ratings by eligible credit rating agencies for assigning risk weights for credit risk Basel II Accord recommends the following six criteria for eligible credit rating agency
• • • • • •
?
Objectivity Independence International access/Transparency Disclosure Resources Credibility
EXTERNAL CREDIT AGENCIES
IN INDIA
Reserve Bank of India has decided that banks may use ratings of the following credit rating agencies : Domestic
• •
•
•
CRISIL Limited Fitch India Credit Analysis and Research Limited ICRA Limited
International
• • •
Moody’s Fitch Standard & Poor’s
CREDIT RISK MITIGATION
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Collateralised transactions
A collateralised transaction is one in which: • Banks have a credit exposure or potential credit exposure; and • Credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.
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Simple approach
Comprehensive approach
Substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure
?
Allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral
CREDIT RISK MITIGATION
?
On-balance sheet netting
Banks may calculate capital requirements on the basis of net credit exposures where they have legally enforceable netting arrangements for loans and deposits.
?
Guarantees and credit derivatives
Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and banks fulfill certain minimum operational conditions relating to risk management processes ;Banks are allowed such credit protection in calculating capital requirements.
CREDIT RISK – INTERNAL RATINGS BASED APPROACH
?
Banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include the following measures
• • • •
?
Probability of default (PD), Loss given default (LGD) Exposure at default (EAD) Effective maturity (M)
?
RBI Guidelines for Basel II Implementation does not include this approach
MARKET RISK
?
Market risk is defined as the risk of losses in on and offbalance-sheet positions arising from movements in market prices
The risks subject to this requirement are:
•
•
The risks pertaining to interest rate related instruments and equities in the trading book Foreign exchange risk and commodities risk throughout the bank
MARKET RISK – TRADING BOOK
o 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. o Trading book for the purpose of capital adequacy includes
• Securities included under the Held for Trading category
• Securities included under the Available for Sale category • Open gold position limits
• Open foreign exchange position limits
• Trading positions in derivatives, and • Derivatives entered into for hedging trading book exposures.
MARKET RISK
Market Risk
Interest Rate Risk Equity Risk Currency Risk Commodity Risk
MARKET RISK COMPONENTS
Equity Risk
Trading Risk
“Specific Risk” General Market Risk
Market Risk
Interest Rate Risk Gap Risk Currency Risk
Credit Risk Commodity Risk
Operational Risk
Financial Risks
Reputational Risk
Business and strategic risks
INTEREST RATE RISK
The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap). ? Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa.
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CURRENCY RISK
A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. ? For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would realize no gain.
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COMMODITY RISK
The risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. ? A Commodity enterprise needs to deal with the following kinds of risks:
?
?
? ?
?
Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices) Quantity risk Cost risk (Input price risk) Political risk
32
MARKET RISK - Group II
January 28, 2013
GAP RISK
The risk that an investment's price will change from one level to another with no trading in between ? Usually such movements occur when there are adverse news announcements, which can cause a stock price to drop substantially from the previous day's closing price ? For example, gap risk is the chance that a stock's price closes at $50 and opens the following trading day at $40 - even though no trades happen between these two times
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SPECIFIC RISK
Risk that affects a very small number of assets. This is sometimes referred to as "unsystematic risk" ? An example would be news that is specific to either one stock or a small number of stocks, such as a sudden strike by the employees of a company you have shares in or a new governmental regulation affecting a particular group of companies ? Unlike systematic risk or market risk, specific risk can be diversified away
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GENERAL MARKET RISK
The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or “systematic risk“ ? Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged. ? Even a portfolio of well-diversified assets cannot escape all risk.
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PROVISIONS
?
FOR
MARKET RISK
Banks must Mark to Market as much possible ? Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. This are normally generally excepted models or models developed internally by the institution ? Independent Pricing is price verification when department other than dealing room evaluates the price once in month ? Banks must establish and maintain procedures for considering valuation adjustments or reserves.
PROVISIONS
?
FOR
MARKET RISK
The alternative methodology allows banks to use risk measures derived from their own internal risk management models, subject to seven sets of conditions :
• •
•
• •
•
Qualitative standards for internal oversight of the use of models, notably by management Guidelines for specifying an appropriate set of market risk factors (i.e. the market rates and prices that affect the value of banks’ positions) Quantitative standards setting out the use of common minimum statistical parameters for measuring risk Guidelines for stress testing Validation procedures for external oversight of the use of models Rules for banks which use a mixture of models and the standardised approach
37
PROVISIONS
?
FOR
MARKET RISK
?
?
All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into. Although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis, i.e. at the close of each business day. Banks will also, of course, be expected to maintain strict risk management systems to ensure that intra-day exposures are not excessive. If a bank fails to meet the capital requirements, the national authority shall ensure that the bank takes immediate measures to rectify the situation
38
PROVISIONS
?
FOR
MARKET RISK
Banks will be required to calculate the counterparty credit risk charge for OTC derivatives, repo-style and other transactions booked in the trading book, separate from the capital charge for general market risk and specific risk. For counterparties included in portfolios where the IRB approach is being used the IRB risk weights will have to be applied. ? Calculate minimum capital requirement for credit and operational risk and then the remaining Tier I and II capital is left for market risk. ? Tier III Capital will be eligible for market risk under conditions specified in 49 (xxi) and (xxii)
39
METHODS
?
TO
ASSESS MARKET RISK
Two Methods
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Standardized Method
?
Employs Constant Factors determined by the BIS for various Instruments Based on the Proprietary Models of Individual Banks and the Probability Distributions for changes in the values of claims
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Internal Model Approach
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THE STANDARDIZED APPROACH
“Building Block” Methodology ? Capital Charge for each Risk Category, i.e., Interest Rates, Equities, Foreign Exchange & Commodities- first determined separately ? Four Measures are added together to obtain global capital charge
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MATURITY METHOD
Allocate marked-to-market value of the positions to each band ? Positions in each maturity are risk-weighted according to their sensitivity ? Calculate Capital Requirements for General Market Risk
?
Vertical Disallowance to account for basis risk ? Horizontal Disallowance to account for the risks caused by possible twists in the yield curve ? Account for risk associated with parallel shift in the yield curve
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RISK WEIGHTS
Coupon 3% or more
1 month or less 1 to 3 months 3 to 6 months 6 to 12 months 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years 5 to 7 years 7 to 10 years 10 to 15 years 15 to 20 years over 20years
FOR
MATURITY METHODS
Risk weight
0.00% 0.20% 0.40% 0.70% 1.25% 1.75% 2.25% 2.75% 3.25% 3.75% 4.50% 5.25% 6.00% 8.00% 12.50%
Coupon less than 3%
1 month or less 1 to 3 months 3 to 6 months 6 to 12 months 1.0 to 1.9 years 1.9 to 2.8 years 2.8 to 3.6 years 3.6 to 4.3 years 4.3 to 5.7 years 5.7 to 7.3 years 7.3 to 9.3 years 9.3 to 10.6 years 10.6 to 12 years 12 to 20 years over 20 years
Assumed changes in yield
1.00 1.00 1.00 1.00 0.90 0.80 0.75 0.75 0.70 0.65 0.60 0.60 0.60 0.60 0.60
THE INTERNAL MODELS APPROACH
?
Model Risk: Risk of Proprietary Models developed, to be wrong or wrongly implemented
?
Regulators require institutions to scale up their VaR number from internal model by factor of 3 : “Multiplier”
?
?
Multiplier insurance against other risk
Also safety factor that guards against “non-normal”
QUANTITATIVE & MODELING REQUIREMENTS
?
Market Risk Capital Charge (t) = Max{VaRt-1, k VaR}
?
Internal Model Captures:
? ?
Linear Risk
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Delta Risk
Non Linear Risk
Convexity Risk (gamma) ? Volatility Risk (Vega)
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OPERATION RISK - DEFINITION
“The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”
– –
Excludes reputational and strategic risks Includes legal risks
EVENT TYPE CATEGORIES
Internal Fraud ? External Fraud ? Employee Practices ? Clients, Products & Business practices ? Physical assets damage ? Business disruption and system failures ? Execution, delivery & process management
?
EXAMPLE
In 1995 Barings PLC, Britain’s oldest merchant bank, suffered a $1.3 billion loss due to the actions of a rogue trader who was able to hide substantial losses through the use of a segregated account that he controlled and that was not subject to review by superiors. ? Societe Generale: suffered losses of $7.4 billion because of the unsecured long position taken by the employee. (Jerome Kerviel) ? Terrorist attacks on USA on September 11th 2001 would be classified as Operational Risk Loss under “External Events.”
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Some of the major drivers to the Operational risk initiative. ? Basel II Regulations ? Return on Investment (ROI ? Operational Cost ? Complexity of Operations and Risk Management ? Demanding Customers ? Shareholder Expectations ? Other Regulatory Guidelines
BUSINESS ARCHITECTURE FRAMEWORK OF OPERATIONAL RISK
METHODS OF OR MANAGEMENT
BASIC INDICATOR APPROACH (649)
•
•
•
Recommended for banks without significant international operations. Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.
BASIC INDICATOR APPROACH (649)
?
K(BIA) = [? (GI of n yrs * ?)] / n
Where, K= capital GI = gross income ? = 15% set by Basel Committee n = number of years
SECTION 650 & 651
Section 650 Gross income=Net Interest Income + Net non-interest income (as per national accounting standards) It is intended that this measure should:
?
(i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers;101 (iii) exclude realised profits/losses from the sale of securities in the banking book (iv) exclude extraordinary or irregular items as well as income derived from insurance.
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Section 651
?
No specific criteria for use of the Basic Indicator Approach are set out in this Framework.
STANDARD APPROACH
Recommended for banks which must satisfy its regulator that, at a minimum Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework. It has an operational risk management system that is conceptually sound and is implemented with integrity. It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
•
•
•
ADDITIONAL
?
CRITERIA FOR
ACTIVE BANKS
INTERNATIONALLY
The bank must have an operational risk management system with clear responsibilities assigned to an operational risk management function ? The bank must systematically track relevant operational risk data including material losses by business line ? Regular reporting of operational risk exposures ? System must be well documented ? System must be subject to validation and regular independent review ? Regular review by external auditors and/or supervisors.
BUSINESS AREAS
Banks activities are divided 8 into business lines. • Corporate finance • Trading & sales • Retail banking, • Commercial banking • Payment & settlement • Agency services • Asset management, • Retail brokerage
For every business line an indicative measure called beta is calculated. ? Beta serves as a proxy for the industry wide relationship between the operational risk loss for a given business line and the aggregate level of gross income for that business line.
?
Gross income serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. ? For each business line average of last 3 years gross income is calculated and multiplied by corresponding beta. ? The reserved capital under this approach is calculated as the sum of individual business line calculated as above. ? If there is negative or zero gross income its not neglected in this approach.
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ALTERNATIVE STANDARDISED APPROACH(ASA)
Allowed at national supervisory discretion ? Cannot revert back without supervisor’s permission ? Same methodology as Standardised Approach except retail and commercial banking
?
?
where KRB is the capital charge for the retail banking business line ?RB is the beta for the retail banking business line LARB is total outstanding retail loans and advances (nonrisk weighted and gross of provisions), averaged over the past three years m is 0.035
Banks may aggregate retail and commercial banking (if they wish to) using a beta of 15%. ? Similarly, those banks that are unable to disaggregate their gross income into the other six business lines can aggregate the total gross income for these six business lines using a beta of 18%, ? Total capital charge for the ASA = SUM(regulatory capital charges across each of the eight business lines.)
?
ADVANCED MEASUREMENT APPROACH
According to section 664 of original Basel Accord, In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum:
•
Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework • It has an operational risk management system that is conceptually sound and is implemented with integrity. • It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
Banks are allowed to develop their own empirical model to quantify required capital for operational risk. ? Banks can use this approach only subject to approval from their local regulators.
?
INTERNAL MEASUREMENT APPROACH
EI = Exposure Indicator ? PE= Probability of Event ? LGE = Loss due to Given Event ? EL (expected loss) = EI * PE * LGE ? Gamma term is supplied by supervisor for each business line which translates the EL in to the capital reserves.
?
The use of AMA provides the following benefits compared to the other approaches detailed earlier. ? Risk Sensitivity – The capital allocated reflects the size and scope of bank’s activities. ? Flexibility – Banks could choose supportive methodologies reflective of their business. Capital allocation can be integrated into scorecards, risk indicators, warning systems and audit scores used to measure and monitor operational risk. ? Reward better control environments – Actions that reduce loss experience, reduce the likelihood or severity of extreme events can reduce capital. ? Appropriate allocation of capital - As the industry improves the measuring, modeling, monitoring, and mitigation of operational risk, the capital allocation becomes more refined.
The AMA approach poses following challenges to the risk management community ? Greater complexity / resource commitment than the other approaches. ? Numerous modeling issues / decisions need to be made by bank – including Incorporation of external data, scenario analysis. ? Combining quantitative techniques and qualitative factors into a comprehensive integrated methodology.
The implementation of the Operational Risk system have benefits that can be classified into “Tangible” and “Intangible” benefits. ? The Tangible benefits directly affect the banks financial performance, while the intangible benefits indirectly aid the bank getting new business, capital and competitive edge.
?
? ?
First, it omits altogether basic business risk: the risk of loss attributable to the institution’s inability to reduce costs as quickly as revenues decline. Second, it excludes the Basel Committee’s earlier attempt to include indirect costs and reputational risk.
The Basel Committee has stated a goal of setting capital charges for operational risk in conjunction with an anticipated reduction in the capital charge for credit risk, so that overall capital charges will remain the same on average. Not a profit enhancing risk cover but a cost effective measure Amount of capital set aside for operational risk under BIA and SA is unjustified Losses due to some incidents are too huge to be covered under operational risk eg. Rogue trading, terrorist attacks Effective means of reducing operational risk are sound policies, practices and procedures, and insurance
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• • • •
THE SECOND PILLAR
Discuss key principles
?
Supervisory review
?
Risk management guidance
Supervisory transparency Accountability
?
?
Including guidance to……
?
Treatment of interest rate risk in banking book Credit risk
?
?
Operational risk
Securitization
?
IMPORTANCE OF SUPERVISORY REVIEW
?
Ensure enough capital Encourage better risk management
?
?
Evaluate banks in assessing capital needs relative to risk
Intervene
?
AREAS SUITED TO TREATMENT
?
Risks not fully covered under pillar 1 Factors external to bank
?
?
Assessment of compliance for more advanced methods
KEY PRINCIPLES
First principle
?
Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
WHY IT NEEDED…..
?
Able to demonstrate chosen internal capital targets are well founded Targets consistent with risk and operating environment Particular stage of business cycle
?
?
FEATURES OF RIGOROUS PROCESS
ADOPTED
?
Board and senior management oversight Sound capital assessment
?
?
Comprehensive assessment of risks
Monitoring and reporting Internal control review.
?
?
BOARD AND SENIOR MANAGEMENT
OVERSIGHT
?
Responsible for understanding the nature and level of risk being taken by the bank Risk related to adequate capital levels Sophistication of the risk management processes Analysis of a bank’s current and future capital requirements Setting the bank’s tolerance for risks
?
?
?
?
SOUND CAPITAL ASSESSMENT
?
Policies and procedures designed to ensure that the bank identifies, measures, and reports all material risks A process that relates capital to the level of risk
?
?
A process that states capital adequacy goals with respect to risk, taking account of the bank’s strategic focus and business plan
A process of internal controls, reviews and audit to ensure the integrity of the overall management process.
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COMPREHENSIVE ASSESSMENT OF RISKS
Not all risks can be measured precisely, a process should be developed estimate risks.
? Credit
Risk ? Market Risk ? Operational Risk ? Liquidity Risk ? Interest Rate Risk ? Reputational Risk ? Strategic Risk
MONITORING AND REPORT
Management receive reports on the bank’s risk profile and capital needs on regular basis.
?
Evaluate the sensitivity and reasonableness of key assumptions used in the capital assessment measurement system Determine that the bank holds sufficient capital against the various risks and is in compliance with established capital adequacy goals Assess its future capital requirements based on the bank’s reported risk profile make necessary adjustments to the bank’s strategic plan accordingly
?
?
INTERNAL CONTROL REVIEW
?
Independent Review Involvement of external/internal auditors
?
?
Verify system of internal controls
Second Principle
Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Periodic review includes
?
On-site examinations or inspections Off-site review Discussions with bank management Review of work done by external auditors
?
?
?
?
Periodic reporting
Third Principle Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
BUFFER IS MAINTAINED BECAUSE…
? Level ? Type
of creditworthiness
and volume of activities will change causing fluctuations in the overall capital ratio for banks to raise additional capital when market conditions are unfavorable risks which may not be covered in
? Costly
? Other
Pillar I
Fourth Principle
Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restor.ed
RANGE OF OPTIONS TO INTERVENE…
?
Intensifying the monitoring of the bank Restricting the payment of dividends
?
?
Requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan
Requiring the bank to raise additional capital immediately
?
SPECIFIC ISSUES TO BE ADDRESSED….
These issues include some key risks which are not directly addressed under Pillar 1 and important assessments that supervisors should make to ensure the proper functioning of certain aspects of Pillar 1
?
Interest rate risk in the banking book To facilitate supervisors’ monitoring of interest rate risk exposures across institutions, banks would have to provide the results of their internal measurement systems.
?
Credit Risk
?
Stress tests under the IRB approaches
Definition of default Residual risk Credit concentration risk Counterparty credit risk
?
?
?
?
?
Operational Risk The supervisor should consider whether the capital requirement generated by the Pillar 1 calculation gives a consistent picture of the individual bank’s operational risk exposure, for example in comparison with other banks of similar size and with similar operations.
?
Market Risk
?
Valuation Specific risk modeling under the internal models approach
?
?
Stress testing under the internal models approach
OTHER ASPECTS
?
Supervisory transparency and accountability Enhanced cross-border communication and cooperation
?
THE THIRD PILLAR
? ? ? ? ?
Disclosure requirements Guiding principles Achieving appropriate disclosure Interaction with accounting disclosures Materiality
?
?
Frequency
Proprietary and confidential information
?
Guiding Principles Aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution Banks’ disclosures should be consistent with how senior management and the board of directors assess and manage the risks of the bank
?
?
?
Achieving appropriate disclosure
?
Supervisors have the authority to require banks to provide information in regulatory reports
Could make some or all of the information in these reports publicly available Moral suasion through dialogue with the bank’s management, to reprimands or financial penalties
?
?
? Interaction
with accounting disclosures
?
Recognizes the need for a Pillar 3 disclosure framework that does not conflict with requirements under accounting standards, which are broader in scope
Committee intends to maintain an ongoing relationship with the accounting authorities
?
MATERIALITY
?
Information would be regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions
FREQUENCY
? The
disclosures set out in Pillar 3 should be made on a semi-annual basis, subject to the following exceptions
Qualitative disclosures that provide a general summary of a bank’s risk management objectives and policies, reporting system and definitions may be published on an annual basis Large internationally active banks and other significant banks must disclose their Tier 1 and total capital adequacy ratios, and their components, on a quarterly basis In all cases, banks should publish material information as soon as practicable and not later than deadlines set by like requirements in national laws
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?
?
THANK YOU
doc_441971054.ppt
This is a presentation about shortcomings of Basel 1 and explains architecture and framework of Basel 2
BASEL II – AN OVERVIEW
MBA (Finance)
Group II
WHY BASEL?
?
Risk and uncertainties form an integral part and parcel of Banking
?
Risk is the potentiality that both the expected and unexpected events may have an adverse impact on the bank’s capital and earnings Risk is to be borne by the bank itself and hence is to be taken care of by the requisite capital
So the need for suitable capital structure and sufficient Capital Adequacy Ratio is felt
?
?
BCBS
?
Bankers for International Settlement (BIS) meet at Basel,
situated at Switzerland, to address the common issues
concerning bankers all over the world.
?
The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries
?
It has been developing standards and establishment of a framework for bank supervision towards strengthening stability of financial institutions and banks
ACCORD HISTORY – BASEL I
BIS came out with its first Accord in 1988 with emphasis on Capital Adequacy, it was internationally hailed as a milestone in Banking Regulation ? It was the first attempt to prescribe rule based Capital Adequacy norms for all the international banks so as to ensure a level playing field for them ? The Accord attempted to apply state of the art financial modeling techniques for capital adequacy requirements ? The Accord was implemented by more than 100 countries and was implemented in India in 1991 during the economic liberalization and globalization
?
SHORTFALLS
I.
IN
BASEL I
II.
III.
IV.
Only four risk weights such as 0%, 20%, 50% and 100% resulted in inadequate differentiation of credit risk The risk weights applied to AAA rated borrower and that of lower rated borrower are same though the risk profile of the borrowers may vary substantially relatively. There was no relief of capital to the banks holding relatively less risky assets in their books. The accord did not recognize the portfolio diversification effect for credit risk, though such a treatment was given in respect of market risk. The availability of certain credit risk mitigation techniques such as cash margin, collateral security, etc was not recognized.
SHORTFALLS
V.
IN
BASEL I
VI.
VII.
Capital charge was same irrespective of the maturity structure of credit exposure and the accord ignored the fact that there is greater risk of default in the longer-term exposure than the one maturing shortly. In respect of investments, general quantum equivalent to 2.5% risk weight for the entire portfolio was provided for and volatility of the market was ignored. There was no capital charge for the operational risk, though it was a very important source of risk and may be, at times, more devastating than credit risk.
BASEL II ?
INTRODUCTION
The New Basel Capital Accord or Basel II Accord, was approved by the Basel Committee on Banking Supervision (BCBS) of Bank for International Settlements on June 26,2004 ? Initially it was suggested that banks and supervisors implement it by beginning 2007, providing a transition time of 30 months ? It was estimated that the Accord would be implemented in over 100 countries, including India.
SCOPE
?
OF APPLICATION OF
BASEL II
The scope of application of Basel II Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group ? Banking and other relevant financial activities (Excluding insurance activities) conducted within a group containing an internationally active bank will be captured through consolidation
SCOPE
OF APPLICATION OF
BASEL II
EFFECTIVE DATE
?
FOR IMPLEMENTATION IN
INDIA
Foreign banks operating in India and Indian banks having operational presence outside India should migrate to the above selected approaches under the Revised Framework with effect from March 31, 2008.
?
All other commercial banks (except Local Area Banks and Regional Rural Banks) are encouraged to migrate to these approaches under the Revised Framework in alignment with them but in any case not later than March 31,2009.
THREE PILLARS
OF
BASEL II ACCORD
Basel II Capital Accord
Pillar 1 “Quantitative” Minimum Capital Requirements Pillar 2 “Qualitative” Supervisory Review Process Pillar 3 “Market Forces” Market Discipline
• New standards for minimum capital • Enlarges the role of requirements banking supervisors • Methodology for • Power to review the banks’ assigning risk weights on risk management systems the basis of credit risk • Early intervention by and market risk supervisors • Capital requirement for operational risk
Standards and requirements for higher disclosure by banks on the following areas oCapital adequacy oAsset quality oOther risk management processes
PILLAR I – MINIMUM CAPITAL REQUIREMENTS
?
Tier I Capital
Paid up share capital/common stock ? Disclosed reserves
?
?
Tier II Capital ( Maximum 100% of Tier 1 Capital)
Undisclosed reserves ? General provisions/loan loss reserves ? Hybrid (debt/equity) capital instruments ? Subordinated debt
?
PILLAR I – MINIMUM CAPITAL REQUIREMENTS
?
Tier III Capital For short-term subordinated debt to be eligible as tier 3 capital, it needs, if circumstances demand, to be capable of becoming part of a bank's permanent capital and thus be available to absorb losses in the event of insolvency. It must, therefore, at a minimum:
be unsecured, subordinated and fully paid up ? have an original maturity of at least two years ? not be repayable before the agreed repayment date unless the supervisory authority agrees ? be subject to a lock-in clause which stipulates that neither interest nor principal may be paid (even at maturity) if such payment means that the bank falls below or remains below its minimum capital requirement
?
DEDUCTIONS
FROM
CAPITAL
Deduction from Tier 1 capital elements ? Increase in equity capital resulting from a securitization exposure ? Intangible assets and losses in the current period and those brought forward from previous periods ? Investments in subsidiaries engaged in banking and financial activities which are no consolidated in national systems. ? RBI guidelines’ additional recommendations - DTA associated with accumulated losses - DTA (excluding DTA associated with accumulated losses),net of DTL.
CAPITAL
TO
RISK-WEIGHTED ASSETS RATIO (CRAR)
?
CRAR (Tier 1) = Eligible Tier 1 Capital Credit Risk RWA* + Market Risk RWA + Operational Risk RWA
* RWA = Risk weighted Assets
Banks are encouraged to maintain, at both solo and consolidated level, a Tier 1 CRAR of at least 6%. Banks which are below this level must achieve this ratio on or before March 31, 2010. ? Banks are required to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR) of 9 percent on an ongoing basis.
?
CREDIT RISK
Standardized Approach
Internal Ratings Approach
Measure credit risk in a standardized manner as recommended by Central Bank
Banks to use their internal rating systems for credit risk
Banks may use assessments by external credit assessment institutions
Subject to the explicit approval of the bank’s supervisor
STANDARDIZED APPROACH -RISK
WEIGHTS
Standardized approach provides risk weights for the following individual claim:1. Claims on sovereigns - Claims on sovereigns and their central banks
RBI guidelines says Both fund based and non fund based claims on the central government will attract a zero risk weight. Central Government guaranteed claims will attract a zero risk weight.
STANDARDIZED APPROACH -RISK
2.
WEIGHTS
Claims on non-central government public sector entities (PSEs)
- Risk weighted in a manner similar to claims on Corporates
3.
Claims on multilateral development banks (MDBs) – 20
% Risk weight for all organizations
4.
Claims on banks
Scheduled Banks – 20 % Risk weight Non Scheduled Banks – 100 % Risk weight
5.
Claims on securities firms
- Risk weighted in a manner similar to claims on Corporates
STANDARDIZED APPROACH -RISK
6.
WEIGHTS
Claims on Corporates
7.
Claims included in the regulatory retail portfolios
- Claims included in this portfolio shall be assigned a risk-weight of 75 %
Four Criteria for inclusion in retail portfolio –
•Orientation criterion •Product criterion •Granularity criterion •Low value of individual exposures
STANDARDIZED APPROACH -RISK
8.
WEIGHTS
Claims secured by residential property
Loan to Value ( LTV) ratio below 75%
- Up to Rs. 20 lacs – 50 % Risk weight - Rs. 20 lacs and above – 75 % Risk weight
Loan to Value ( LTV) ratio below 75% - Risk weight of 100%
9.
Claims secured by commercial real estate
- Risk weight of 150 per cent
10.
Non-performing assets (NPAs)
• 150% risk weight when specific provisions are less than 20% • 100% risk weight when specific provisions are at least 20% • 50% risk weight when specific provisions are at least 50% of the outstanding amount of the NPA.
The unsecured portion of NPA
EXTERNAL CREDIT ASSESSMENT
?
Banks can use ratings by eligible credit rating agencies for assigning risk weights for credit risk Basel II Accord recommends the following six criteria for eligible credit rating agency
• • • • • •
?
Objectivity Independence International access/Transparency Disclosure Resources Credibility
EXTERNAL CREDIT AGENCIES
IN INDIA
Reserve Bank of India has decided that banks may use ratings of the following credit rating agencies : Domestic
• •
•
•
CRISIL Limited Fitch India Credit Analysis and Research Limited ICRA Limited
International
• • •
Moody’s Fitch Standard & Poor’s
CREDIT RISK MITIGATION
?
Collateralised transactions
A collateralised transaction is one in which: • Banks have a credit exposure or potential credit exposure; and • Credit exposure or potential credit exposure is hedged in whole or in part by collateral posted by a counterparty or by a third party on behalf of the counterparty.
?
Simple approach
Comprehensive approach
Substitutes the risk weighting of the collateral for the risk weighting of the counterparty for the collateralised portion of the exposure
?
Allows fuller offset of collateral against exposures, by effectively reducing the exposure amount by the value ascribed to the collateral
CREDIT RISK MITIGATION
?
On-balance sheet netting
Banks may calculate capital requirements on the basis of net credit exposures where they have legally enforceable netting arrangements for loans and deposits.
?
Guarantees and credit derivatives
Where guarantees or credit derivatives are direct, explicit, irrevocable and unconditional, and banks fulfill certain minimum operational conditions relating to risk management processes ;Banks are allowed such credit protection in calculating capital requirements.
CREDIT RISK – INTERNAL RATINGS BASED APPROACH
?
Banks that have received supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include the following measures
• • • •
?
Probability of default (PD), Loss given default (LGD) Exposure at default (EAD) Effective maturity (M)
?
RBI Guidelines for Basel II Implementation does not include this approach
MARKET RISK
?
Market risk is defined as the risk of losses in on and offbalance-sheet positions arising from movements in market prices
The risks subject to this requirement are:
•
•
The risks pertaining to interest rate related instruments and equities in the trading book Foreign exchange risk and commodities risk throughout the bank
MARKET RISK – TRADING BOOK
o 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. o Trading book for the purpose of capital adequacy includes
• Securities included under the Held for Trading category
• Securities included under the Available for Sale category • Open gold position limits
• Open foreign exchange position limits
• Trading positions in derivatives, and • Derivatives entered into for hedging trading book exposures.
MARKET RISK
Market Risk
Interest Rate Risk Equity Risk Currency Risk Commodity Risk
MARKET RISK COMPONENTS
Equity Risk
Trading Risk
“Specific Risk” General Market Risk
Market Risk
Interest Rate Risk Gap Risk Currency Risk
Credit Risk Commodity Risk
Operational Risk
Financial Risks
Reputational Risk
Business and strategic risks
INTEREST RATE RISK
The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different durations) or hedging (e.g. through an interest rate swap). ? Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa.
?
CURRENCY RISK
A form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged. ? For example if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change of the Canadian dollar against the U.S. dollar. Suppose that you realized a return in the stocks of 15% but if the Canadian dollar depreciated 15% against the U.S. dollar, you would realize no gain.
?
COMMODITY RISK
The risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. These commodities may be grains, metals, gas, electricity etc. ? A Commodity enterprise needs to deal with the following kinds of risks:
?
?
? ?
?
Price risk (Risk arising out of adverse movements in the world prices, exchange rates, basis between local and world prices) Quantity risk Cost risk (Input price risk) Political risk
32
MARKET RISK - Group II
January 28, 2013
GAP RISK
The risk that an investment's price will change from one level to another with no trading in between ? Usually such movements occur when there are adverse news announcements, which can cause a stock price to drop substantially from the previous day's closing price ? For example, gap risk is the chance that a stock's price closes at $50 and opens the following trading day at $40 - even though no trades happen between these two times
?
SPECIFIC RISK
Risk that affects a very small number of assets. This is sometimes referred to as "unsystematic risk" ? An example would be news that is specific to either one stock or a small number of stocks, such as a sudden strike by the employees of a company you have shares in or a new governmental regulation affecting a particular group of companies ? Unlike systematic risk or market risk, specific risk can be diversified away
?
GENERAL MARKET RISK
The risk inherent to the entire market or entire market segment. Also known as "un-diversifiable risk" or “systematic risk“ ? Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged. ? Even a portfolio of well-diversified assets cannot escape all risk.
?
PROVISIONS
?
FOR
MARKET RISK
Banks must Mark to Market as much possible ? Marking-to-model is defined as any valuation which has to be benchmarked, extrapolated or otherwise calculated from a market input. This are normally generally excepted models or models developed internally by the institution ? Independent Pricing is price verification when department other than dealing room evaluates the price once in month ? Banks must establish and maintain procedures for considering valuation adjustments or reserves.
PROVISIONS
?
FOR
MARKET RISK
The alternative methodology allows banks to use risk measures derived from their own internal risk management models, subject to seven sets of conditions :
• •
•
• •
•
Qualitative standards for internal oversight of the use of models, notably by management Guidelines for specifying an appropriate set of market risk factors (i.e. the market rates and prices that affect the value of banks’ positions) Quantitative standards setting out the use of common minimum statistical parameters for measuring risk Guidelines for stress testing Validation procedures for external oversight of the use of models Rules for banks which use a mixture of models and the standardised approach
37
PROVISIONS
?
FOR
MARKET RISK
?
?
All transactions, including forward sales and purchases, shall be included in the calculation of capital requirements as from the date on which they were entered into. Although regular reporting will in principle take place only at intervals (in most countries quarterly), banks are expected to manage the market risk in their trading book in such a way that the capital requirements are being met on a continuous basis, i.e. at the close of each business day. Banks will also, of course, be expected to maintain strict risk management systems to ensure that intra-day exposures are not excessive. If a bank fails to meet the capital requirements, the national authority shall ensure that the bank takes immediate measures to rectify the situation
38
PROVISIONS
?
FOR
MARKET RISK
Banks will be required to calculate the counterparty credit risk charge for OTC derivatives, repo-style and other transactions booked in the trading book, separate from the capital charge for general market risk and specific risk. For counterparties included in portfolios where the IRB approach is being used the IRB risk weights will have to be applied. ? Calculate minimum capital requirement for credit and operational risk and then the remaining Tier I and II capital is left for market risk. ? Tier III Capital will be eligible for market risk under conditions specified in 49 (xxi) and (xxii)
39
METHODS
?
TO
ASSESS MARKET RISK
Two Methods
?
Standardized Method
?
Employs Constant Factors determined by the BIS for various Instruments Based on the Proprietary Models of Individual Banks and the Probability Distributions for changes in the values of claims
?
Internal Model Approach
?
THE STANDARDIZED APPROACH
“Building Block” Methodology ? Capital Charge for each Risk Category, i.e., Interest Rates, Equities, Foreign Exchange & Commodities- first determined separately ? Four Measures are added together to obtain global capital charge
?
MATURITY METHOD
Allocate marked-to-market value of the positions to each band ? Positions in each maturity are risk-weighted according to their sensitivity ? Calculate Capital Requirements for General Market Risk
?
Vertical Disallowance to account for basis risk ? Horizontal Disallowance to account for the risks caused by possible twists in the yield curve ? Account for risk associated with parallel shift in the yield curve
?
RISK WEIGHTS
Coupon 3% or more
1 month or less 1 to 3 months 3 to 6 months 6 to 12 months 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years 5 to 7 years 7 to 10 years 10 to 15 years 15 to 20 years over 20years
FOR
MATURITY METHODS
Risk weight
0.00% 0.20% 0.40% 0.70% 1.25% 1.75% 2.25% 2.75% 3.25% 3.75% 4.50% 5.25% 6.00% 8.00% 12.50%
Coupon less than 3%
1 month or less 1 to 3 months 3 to 6 months 6 to 12 months 1.0 to 1.9 years 1.9 to 2.8 years 2.8 to 3.6 years 3.6 to 4.3 years 4.3 to 5.7 years 5.7 to 7.3 years 7.3 to 9.3 years 9.3 to 10.6 years 10.6 to 12 years 12 to 20 years over 20 years
Assumed changes in yield
1.00 1.00 1.00 1.00 0.90 0.80 0.75 0.75 0.70 0.65 0.60 0.60 0.60 0.60 0.60
THE INTERNAL MODELS APPROACH
?
Model Risk: Risk of Proprietary Models developed, to be wrong or wrongly implemented
?
Regulators require institutions to scale up their VaR number from internal model by factor of 3 : “Multiplier”
?
?
Multiplier insurance against other risk
Also safety factor that guards against “non-normal”
QUANTITATIVE & MODELING REQUIREMENTS
?
Market Risk Capital Charge (t) = Max{VaRt-1, k VaR}
?
Internal Model Captures:
? ?
Linear Risk
?
Delta Risk
Non Linear Risk
Convexity Risk (gamma) ? Volatility Risk (Vega)
?
OPERATION RISK - DEFINITION
“The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events.”
– –
Excludes reputational and strategic risks Includes legal risks
EVENT TYPE CATEGORIES
Internal Fraud ? External Fraud ? Employee Practices ? Clients, Products & Business practices ? Physical assets damage ? Business disruption and system failures ? Execution, delivery & process management
?
EXAMPLE
In 1995 Barings PLC, Britain’s oldest merchant bank, suffered a $1.3 billion loss due to the actions of a rogue trader who was able to hide substantial losses through the use of a segregated account that he controlled and that was not subject to review by superiors. ? Societe Generale: suffered losses of $7.4 billion because of the unsecured long position taken by the employee. (Jerome Kerviel) ? Terrorist attacks on USA on September 11th 2001 would be classified as Operational Risk Loss under “External Events.”
?
Some of the major drivers to the Operational risk initiative. ? Basel II Regulations ? Return on Investment (ROI ? Operational Cost ? Complexity of Operations and Risk Management ? Demanding Customers ? Shareholder Expectations ? Other Regulatory Guidelines
BUSINESS ARCHITECTURE FRAMEWORK OF OPERATIONAL RISK
METHODS OF OR MANAGEMENT
BASIC INDICATOR APPROACH (649)
•
•
•
Recommended for banks without significant international operations. Approach must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income. Figures for any year in which annual gross income is negative or zero should be excluded from both the numerator and denominator when calculating the average.
BASIC INDICATOR APPROACH (649)
?
K(BIA) = [? (GI of n yrs * ?)] / n
Where, K= capital GI = gross income ? = 15% set by Basel Committee n = number of years
SECTION 650 & 651
Section 650 Gross income=Net Interest Income + Net non-interest income (as per national accounting standards) It is intended that this measure should:
?
(i) be gross of any provisions (e.g. for unpaid interest); (ii) be gross of operating expenses, including fees paid to outsourcing service providers;101 (iii) exclude realised profits/losses from the sale of securities in the banking book (iv) exclude extraordinary or irregular items as well as income derived from insurance.
?
Section 651
?
No specific criteria for use of the Basic Indicator Approach are set out in this Framework.
STANDARD APPROACH
Recommended for banks which must satisfy its regulator that, at a minimum Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework. It has an operational risk management system that is conceptually sound and is implemented with integrity. It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
•
•
•
ADDITIONAL
?
CRITERIA FOR
ACTIVE BANKS
INTERNATIONALLY
The bank must have an operational risk management system with clear responsibilities assigned to an operational risk management function ? The bank must systematically track relevant operational risk data including material losses by business line ? Regular reporting of operational risk exposures ? System must be well documented ? System must be subject to validation and regular independent review ? Regular review by external auditors and/or supervisors.
BUSINESS AREAS
Banks activities are divided 8 into business lines. • Corporate finance • Trading & sales • Retail banking, • Commercial banking • Payment & settlement • Agency services • Asset management, • Retail brokerage
For every business line an indicative measure called beta is calculated. ? Beta serves as a proxy for the industry wide relationship between the operational risk loss for a given business line and the aggregate level of gross income for that business line.
?
Gross income serves as a proxy for the scale of business operations and thus the likely scale of operational risk exposure within each of these business lines. ? For each business line average of last 3 years gross income is calculated and multiplied by corresponding beta. ? The reserved capital under this approach is calculated as the sum of individual business line calculated as above. ? If there is negative or zero gross income its not neglected in this approach.
?
ALTERNATIVE STANDARDISED APPROACH(ASA)
Allowed at national supervisory discretion ? Cannot revert back without supervisor’s permission ? Same methodology as Standardised Approach except retail and commercial banking
?
?
where KRB is the capital charge for the retail banking business line ?RB is the beta for the retail banking business line LARB is total outstanding retail loans and advances (nonrisk weighted and gross of provisions), averaged over the past three years m is 0.035
Banks may aggregate retail and commercial banking (if they wish to) using a beta of 15%. ? Similarly, those banks that are unable to disaggregate their gross income into the other six business lines can aggregate the total gross income for these six business lines using a beta of 18%, ? Total capital charge for the ASA = SUM(regulatory capital charges across each of the eight business lines.)
?
ADVANCED MEASUREMENT APPROACH
According to section 664 of original Basel Accord, In order to qualify for use of the AMA a bank must satisfy its supervisor that, at a minimum:
•
Its board of directors and senior management, as appropriate, are actively involved in the oversight of the operational risk management framework • It has an operational risk management system that is conceptually sound and is implemented with integrity. • It has sufficient resources in the use of the approach in the major business lines as well as the control and audit areas.
Banks are allowed to develop their own empirical model to quantify required capital for operational risk. ? Banks can use this approach only subject to approval from their local regulators.
?
INTERNAL MEASUREMENT APPROACH
EI = Exposure Indicator ? PE= Probability of Event ? LGE = Loss due to Given Event ? EL (expected loss) = EI * PE * LGE ? Gamma term is supplied by supervisor for each business line which translates the EL in to the capital reserves.
?
The use of AMA provides the following benefits compared to the other approaches detailed earlier. ? Risk Sensitivity – The capital allocated reflects the size and scope of bank’s activities. ? Flexibility – Banks could choose supportive methodologies reflective of their business. Capital allocation can be integrated into scorecards, risk indicators, warning systems and audit scores used to measure and monitor operational risk. ? Reward better control environments – Actions that reduce loss experience, reduce the likelihood or severity of extreme events can reduce capital. ? Appropriate allocation of capital - As the industry improves the measuring, modeling, monitoring, and mitigation of operational risk, the capital allocation becomes more refined.
The AMA approach poses following challenges to the risk management community ? Greater complexity / resource commitment than the other approaches. ? Numerous modeling issues / decisions need to be made by bank – including Incorporation of external data, scenario analysis. ? Combining quantitative techniques and qualitative factors into a comprehensive integrated methodology.
The implementation of the Operational Risk system have benefits that can be classified into “Tangible” and “Intangible” benefits. ? The Tangible benefits directly affect the banks financial performance, while the intangible benefits indirectly aid the bank getting new business, capital and competitive edge.
?
? ?
First, it omits altogether basic business risk: the risk of loss attributable to the institution’s inability to reduce costs as quickly as revenues decline. Second, it excludes the Basel Committee’s earlier attempt to include indirect costs and reputational risk.
The Basel Committee has stated a goal of setting capital charges for operational risk in conjunction with an anticipated reduction in the capital charge for credit risk, so that overall capital charges will remain the same on average. Not a profit enhancing risk cover but a cost effective measure Amount of capital set aside for operational risk under BIA and SA is unjustified Losses due to some incidents are too huge to be covered under operational risk eg. Rogue trading, terrorist attacks Effective means of reducing operational risk are sound policies, practices and procedures, and insurance
?
• • • •
THE SECOND PILLAR
Discuss key principles
?
Supervisory review
?
Risk management guidance
Supervisory transparency Accountability
?
?
Including guidance to……
?
Treatment of interest rate risk in banking book Credit risk
?
?
Operational risk
Securitization
?
IMPORTANCE OF SUPERVISORY REVIEW
?
Ensure enough capital Encourage better risk management
?
?
Evaluate banks in assessing capital needs relative to risk
Intervene
?
AREAS SUITED TO TREATMENT
?
Risks not fully covered under pillar 1 Factors external to bank
?
?
Assessment of compliance for more advanced methods
KEY PRINCIPLES
First principle
?
Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.
WHY IT NEEDED…..
?
Able to demonstrate chosen internal capital targets are well founded Targets consistent with risk and operating environment Particular stage of business cycle
?
?
FEATURES OF RIGOROUS PROCESS
ADOPTED
?
Board and senior management oversight Sound capital assessment
?
?
Comprehensive assessment of risks
Monitoring and reporting Internal control review.
?
?
BOARD AND SENIOR MANAGEMENT
OVERSIGHT
?
Responsible for understanding the nature and level of risk being taken by the bank Risk related to adequate capital levels Sophistication of the risk management processes Analysis of a bank’s current and future capital requirements Setting the bank’s tolerance for risks
?
?
?
?
SOUND CAPITAL ASSESSMENT
?
Policies and procedures designed to ensure that the bank identifies, measures, and reports all material risks A process that relates capital to the level of risk
?
?
A process that states capital adequacy goals with respect to risk, taking account of the bank’s strategic focus and business plan
A process of internal controls, reviews and audit to ensure the integrity of the overall management process.
?
COMPREHENSIVE ASSESSMENT OF RISKS
Not all risks can be measured precisely, a process should be developed estimate risks.
? Credit
Risk ? Market Risk ? Operational Risk ? Liquidity Risk ? Interest Rate Risk ? Reputational Risk ? Strategic Risk
MONITORING AND REPORT
Management receive reports on the bank’s risk profile and capital needs on regular basis.
?
Evaluate the sensitivity and reasonableness of key assumptions used in the capital assessment measurement system Determine that the bank holds sufficient capital against the various risks and is in compliance with established capital adequacy goals Assess its future capital requirements based on the bank’s reported risk profile make necessary adjustments to the bank’s strategic plan accordingly
?
?
INTERNAL CONTROL REVIEW
?
Independent Review Involvement of external/internal auditors
?
?
Verify system of internal controls
Second Principle
Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.
Periodic review includes
?
On-site examinations or inspections Off-site review Discussions with bank management Review of work done by external auditors
?
?
?
?
Periodic reporting
Third Principle Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.
BUFFER IS MAINTAINED BECAUSE…
? Level ? Type
of creditworthiness
and volume of activities will change causing fluctuations in the overall capital ratio for banks to raise additional capital when market conditions are unfavorable risks which may not be covered in
? Costly
? Other
Pillar I
Fourth Principle
Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restor.ed
RANGE OF OPTIONS TO INTERVENE…
?
Intensifying the monitoring of the bank Restricting the payment of dividends
?
?
Requiring the bank to prepare and implement a satisfactory capital adequacy restoration plan
Requiring the bank to raise additional capital immediately
?
SPECIFIC ISSUES TO BE ADDRESSED….
These issues include some key risks which are not directly addressed under Pillar 1 and important assessments that supervisors should make to ensure the proper functioning of certain aspects of Pillar 1
?
Interest rate risk in the banking book To facilitate supervisors’ monitoring of interest rate risk exposures across institutions, banks would have to provide the results of their internal measurement systems.
?
Credit Risk
?
Stress tests under the IRB approaches
Definition of default Residual risk Credit concentration risk Counterparty credit risk
?
?
?
?
?
Operational Risk The supervisor should consider whether the capital requirement generated by the Pillar 1 calculation gives a consistent picture of the individual bank’s operational risk exposure, for example in comparison with other banks of similar size and with similar operations.
?
Market Risk
?
Valuation Specific risk modeling under the internal models approach
?
?
Stress testing under the internal models approach
OTHER ASPECTS
?
Supervisory transparency and accountability Enhanced cross-border communication and cooperation
?
THE THIRD PILLAR
? ? ? ? ?
Disclosure requirements Guiding principles Achieving appropriate disclosure Interaction with accounting disclosures Materiality
?
?
Frequency
Proprietary and confidential information
?
Guiding Principles Aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution Banks’ disclosures should be consistent with how senior management and the board of directors assess and manage the risks of the bank
?
?
?
Achieving appropriate disclosure
?
Supervisors have the authority to require banks to provide information in regulatory reports
Could make some or all of the information in these reports publicly available Moral suasion through dialogue with the bank’s management, to reprimands or financial penalties
?
?
? Interaction
with accounting disclosures
?
Recognizes the need for a Pillar 3 disclosure framework that does not conflict with requirements under accounting standards, which are broader in scope
Committee intends to maintain an ongoing relationship with the accounting authorities
?
MATERIALITY
?
Information would be regarded as material if its omission or misstatement could change or influence the assessment or decision of a user relying on that information for the purpose of making economic decisions
FREQUENCY
? The
disclosures set out in Pillar 3 should be made on a semi-annual basis, subject to the following exceptions
Qualitative disclosures that provide a general summary of a bank’s risk management objectives and policies, reporting system and definitions may be published on an annual basis Large internationally active banks and other significant banks must disclose their Tier 1 and total capital adequacy ratios, and their components, on a quarterly basis In all cases, banks should publish material information as soon as practicable and not later than deadlines set by like requirements in national laws
?
?
?
THANK YOU
doc_441971054.ppt