CAPITAL ADEQUACY

Prof. B.B.Bhattacharyya

The Capital Accord

The objective of the Basel Committee was to smoothen out competitive differences among international banks which were subject to different capital regulations by national regulators. In 1987, the Basel Committee issued its consultative paper on capital adequacy of internationally active banks.

Scope of Application of Accord

The Basel Accord applies to banks on a consolidated basis including subsidiaries of the bank. The risk covered by the accord are credit and market risks. In addition to credit risk, the accord also covers counterparty risk. The market value of the transaction varies with time and can be positive or negative to either counterparty to the transaction.

Minimum Capital
Should be enough to absorb maximum losses 1996 amendment to include market risk

Capital for Credit Risk

Standardised Approach IRB Foundation Approach IRB Advanced Approach

Capital for Market Risk

Standardised Approach (Maturity) Standardised Approach (Duration) Internal Model

Capital for Operational risk

Basic Indicator Approach Standardised Approach Advanced Measurement Approach

 Basel I Capital
Minimum Capital Ratio (8%) * (Credit Risk + Market Risk)

Basel II Capital
Minimum Capital Ratio (8%) * (Credit Risk + Market Risk + Operational Risk)

IRB Approach
Banks internal assessment of the risk parameters serve as primary inputs to capital calculation.

IRB
1) P.D. Likelihood that the borrower will default over a given time period. 2) L.G.D. Proportion of the exposure that will be lost, should default occurs 3) E.A.D. Amount likely to be drawn in the event of a default 4) M Residual Maturity of the exposure

 Operational Risk BIA 15% of average gross income over three years

Three Pillars of Basel II

The Basel II accord rests on three pillars : 1) Pillar 1 :- Minimum Capital Requirement 2) Pillar 2 :- Supervisory Review Process 3) Pillar 3 :- Market Discipline

Pillar 1 Minimum Capital Requirements

It prescribes a risk sensitive calculation of capital requirements explicitly includes operational risk in addition to market and credit risk. The Basel I accord provided global standards for minimum capital requirements for banks. Capital requirement is based on the value and nature of assets. Limitations in the accord were noticed over a period of time. The total capital ratio must not be lower than 8%. Supplementary capital comprises subordinated debt of more than five years maturity, loan loss reserves etc.

Pillar 2 Supervisory Review Process

It envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority. Basel II document of the Basel Committee lays down the following four principals in regard to the Supervisory Review Process (SRP): Principle 1 :- 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.

 Principle 2 :- Supervisors should review and evaluate the banks internal capital adequacy assessments and strategies. Principle 3 :- Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require the banks to hold capital in excess of the minimum. Principle 4 :- Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels.

Rationale for Basel II over Basel I

PARAMETER Approach to capital adequacy BASEL I One size fits all Standardized capital charge regardless of rating Covered credit risk and market risk No distinct classification of exposure BASEL II Encourages risk sensitivity Differential capital across exposure classes and rating grades Also covers operational risk Exposure classification in Credit Risk (8)- Corporate, Retail, Sovereign, Inter-bank, Asset Management etc

Classification of exposure

Prescription for disclosures and regulatory oversight

No specific recommendation

Specific guidelines provided Disclosure requirements pertaining to risk information made more stringent
Overall parameters specified Detailed implementation schedule to be stipulated for each bank

Implementation approach
6/26/2013

Details of implementation schedule left to the regulator

Basel II @ Welingkar Education, Mumbai

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Basel II - The Three Pillars

Basel II Framework

Pillar 1 Minimum Capital Requirements

Pillar 2Supervisory Review Process

Pillar 3 Market Discipline

6/26/2013

Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.

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Types of Risk and approaches

Different Risk under Basel II

Credit Risk

Market Risk

Operational Risk

Standardized Approach

Internal Ratings Based

Basic Indicator Approach

Standardized

Advanced Measurement

Foundation
6/26/2013

Advanced

Specific Risk

General Market Risk

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Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.

Other Risks

Business Strategy Risk Environment Risk Group Risk Control Risk Liquidity Risk Reputation Risk

6/26/2013

Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.

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RBI Norms for Basel II..contd

Risk weights for exposure to corporates
Credit rating by domestic rating agencies

AAA

AA

BBB and below 150%

Unrated

Risk weight

20%

50%

100%

100%

Risk weights for exposure to retail exposures Secured by mortgages on residential property linked to loan to value ratio (LTV)
LTV of less than or equal to 80% Risk weight of 75% LTV of more than 80% - Risk weight of 100% Other retail exposures 75%

6/26/2013

Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.

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Ground Realities to Basel II Challenges at home

Costly Database Creation and Maintenance Process Paucity of Credit Rating Agencies Additional Capital Requirement Relative Advantage to Large Banks

Risk Sensitivity
IT infrastructure Communication gap Cross Border Issues for Foreign Banks
6/26/2013

Presented By Archana Purohit & Bhavesh Jajoo @ Welingkar Education, Mumbai.

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 ICAAP and SREP are the two important components of Pillar 2. The ICAAP comprises a banks procedure and measures designed to ensure the following :(a) An appropriate identification and measurement of risks. (b) An appropriate level of internal capital in relation to the banks risk profile. (c) Application and further development of suitable risk management systems in the bank.

 The SREP consists of :

a review and evaluation process adopted by the supervisor. These include the review and evaluation of the banks ICAAP, conducting an independent assessment of the banks risk profile.

ICAAP To Be A Forward-Looking Process

The ICAAP should be forward looking in nature. It should take into account the expected / estimated future developments. The banks shall have an explicit, board approved capital plan. The plan shall outline : - the banks capital needs - the banks anticipated capital utilization - the banks desired level of capital - limits related to capital - a general contingency plan for dealing with divergences and unexpected events.

ICAAP To Be A Risk-Based Process

Banks shall set their capital targets, which are consistent with their risk profile and operating environment. A Bank shall have in place a sound ICAAP, which shall include all material risk exposures incurred by the bank. Banks ICAAP document shall clearly indicate for which risks a quantitative measure is considered warranted and for which risks a qualitative measure is considered to be the correct approach.

Pillar 3 Market Discipline

It seeks to achieve increased transparency through expanded disclosure requirements for banks. Market Discipline is to compliment the Pillar 1 and Pillar 2. It provides disclosure requirements for banks using Basel-II framework.

Qualitative & Quantitative Disclosures

1. 2. 3. 4. 5. Scope of application Capital structure Capital adequacy Credit Risk general disclosures Credit Risk disclosures for portfolios, under standardized approach 6. Credit Risk disclosures for portfolios, under IRB approaches

Qualitative & Quantitative Disclosures

7. Credit Risk mitigation disclosures for standardized & IRB approaches 8. Securitization disclosures for standardized & IRB approaches 9. Market Risk disclosures under standardized approach 10.Market Risk disclosures under internal models approach 11.Operational Risk 12.Equities disclosures for banking book positions 13.Internal Rate Risk in the banking book

Constituents Of Capital
Tier I Capital Tier II Capital Tier III Capital

Tier I Capital
Consists of superior quality instruments and is the mainstay of the capital of a bank. Innovative instruments like perpetual debt can also form a part of Tier I capital.

Tier I Capital - Constituents

Permanent shareholders equity (paid up capital) Statutory reserves and Disclosed free Reserves Innovative Tier I capital

Tier II Capital
Consists of revaluation reserves, general reserves, hybrid debt capital and subordinated term debt and investment reserve. It can be considered for purposes of capital adequacy only upto an amount equal to the Tier I capital of a bank.

Tier II Capital - Constituents

Revaluation Reserves General Provisions / general Reserves Hybrid debt capital instruments Subordinated debt

loan-loss

Tier II Capital - Constituents

Revaluation Reserves General Provisions / general Reserves Hybrid debt capital instruments Subordinated debt

loan-loss

Tier III Capital

It can be considered solely for the purpose of supporting market risk. It cannot be used to support credit and counterparty risks. Tier II and Tier III capital, either together or individually, cannot alone support market risk. It can include only short term subordinated debt.

Tier III Capital - Constituents

Tier III capital can include short-term subordinated debt with a minimum original term to maturity of two years. It can be used as a cushion against market risk only. Trading portfolios tend to be highly volatile and change rapidly over time.

On-Balance Sheet Assets

The Basel Accord recommends that onbalance sheet assets of banks be weighted by risk weights designed to reflect their level of credit risk. The committee has used just five weights to quantify the credit risk level of an exposure, i.e. 0%, 10%, 20%, 50% and 100%. The risk weight assigned to an asset takes account the following characteristics of the assets.
Country type Counterparty type Instrument type

Off-Balance Sheet Items

Basel Accord includes off-balance sheet items for the purpose of risk weighted assets calculation. Off-balance sheet items are bifurcated into following two categories for the purpose of calculating capital requirements : 1) Comprises Instruments 2) Comprises Derivatives

Treatment of Market Risks

The capital requirements for market risk are subdivided into following two subcomponents of market risk:Specific Risk defined as the risk of loss caused by an adverse price movement of a security due principally to factors related to the issuer of the security. It includes the risk that an individual debt or equity security moves by more or less than the general market in day-to-day trading and event risk. It exists for both long and short positions, as it is essentially price risk.

 General Market risk defined as the risk of loss caused by an adverse market movement unrelated to any specific security or issuer. Both general market and specific risks cause changes in the market price of an instruments.

BASEL III
BASEL III requirements will be phased in gradually from 1 January 2013. Liquidity Coverage Ratio (LCR)
Stock of high quality liquid assets = > 100% Net Cash Outflows over a 30-day period

Net Stable Funding Ratio (NSFR)

Available amount of stable funding
Required amount of stable funding

= > 100%

BASEL III CAPITAL RATIOS

2011 2012 201 3 201 4 201 5 2016 2017 2018 2019
SUPERVISORY MONITORING PARALLEL RUN PHASE (PUBLIC DISCLOSURE AS OF Jan 2015) EFFECTIVE JAN 2018

MIN TIER 1 CAPITAL MIN TOTAL CAPITAL MIN TOTAL CAPITAL PLUS CAPITAL CONVERSIO N BUFFER

4.0% 8.0% 8.0%

4.0% 8.0% 8.0%

4.5% 5.5% 6.0% 6.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.625 %

6.0% 8.0% 9.25%

6.0% 8.0%

6.0% 8.0%

9.875% 10.5%

BASEL - III
A set and reform measures developed by BCBS to strengthen the regulation, supervision and risk management of banking sector. The measures focus on : - improving ability of the Banking sector to absorb shocks arising from financial and economic stress. - improve risk management and governance - strengthen transparency and disclosures of banks -Micro prudential and macro prudential supervision.

BASEL - III
Seeks to address four key aspects identified as the main cause of global crisis. - Quality and composition of capital (Enhancing Tier I capital requirement and introduction of capital buffers, strict definition of capital). - Liquidity crunch due to borrowing short and lending long (Introduction of ratios to stress testing of a financial institutions ability to withstand liquidity pressures).

BASEL - III
Balance sheet leveraging (Introduction of Leverage ratios to improve balance sheet structure). Inconsistencies in Accounting and valuation practices (Computation of capital charges based on covered international accounting standards).

Credit Risk Management

Chance that a debtor or financial instrument issuer will not be able to pay interest or repay the principal in terms of the credit agreement. - Inherent part of banking. - Can cause cash flow problems and adversely affect banks liquidity. - Still a major single reason of bank failures.

Types of Credit Risks

Personal or consumer risk; Corporate of company risk; Sovereign or country risk.

Credit Risk Management

1. 2. 3. 4. 5. 6. 7. 8. Credit portfolio management Lending function and operations Credit portfolio quality review Non-performing loan portfolio Credit risk management policies Policies to limit or reduce credit risk Asset classification Loan loss provisioning policy

1. Credit Portfolio Management

Considerations which form the basis for sound lending policies. Limit on total loans in relation to deposits, capital or assets Geographic limits - Awareness about the market Credit concentrations - Concentration limits usually refer to the maximum permitted exposure to a single client, connected group, and/or sector of economic activity i.e. agriculture, steel or textiles etc. A lending policy should also require that all concentrations be reviewed and reported on a frequent basis.

 Distribution by Category - Policies related to such limitations should allow for deviations that are approved by the board. Type of Loans - A lending policy should specify the types of loans and other credit instruments that the bank intends to offer to clients and should provide guidelines for specific loans.

 Maturities - A lending policy should establish the maximum maturity for each type of credit, and loans should be granted with a realistic repayment schedule. Loan pricing - Rates on various loan types must be sufficient to cover the costs of funds, loan supervision, administration (including general overhead), and probable losses. At the same time, they should provide a reasonable margin of profit.

 Lending authority determined by the size of a bank. Appraisal process - A lending policy should outline where the responsibility for appraisals lies and should define standard appraisal procedures. Maximum ratio of loan amount to the market value of pledged securities - A lending policy should set forth margin requirements for all types of securities which are accepted as collateral.

 Impairment - A bank should identify and recognize the impairment of a loan or a collectively assessed group of loans. Collections - A lending policy should define delinquent obligations of all types and specify the appropriate reports to be submitted to the board. Financial information - The safe extension of credit depends on complete and accurate information regarding every detail of the borrowers credit standing.

2. Lending functions and operations

Fundamental Objectives : a) Loans should be granted on a sound and collectible basis; b) Funds should be invested profitably for the benefit of shareholders and protection of depositors; c) The legitimate credit needs of economic agents and/or households should be satisfied.

 Lending process review - The integrity and credibility of the lending process depend on objective credit decisions that ensure an acceptable risk level in relation to the expected return. Human resources analysis - Staff organization, skills, and qualifications should be analyzed. Information flows - A bank must have efficient systems for monitoring adherence to established guidelines.

3. Credit portfolio quality review

All loans to borrowers with aggregate exposure larger than x% of the banks capital; All loans to shareholders and connected parties; All loans for which the interest or repayment terms have been rescheduled while granting of the loan. All loans for which cash payment of interest and/or principal is more than x days past due. All loans classified as substandard, doubtful or loss.

 Interbank Deposits - The most important category of assets for which a bank carries the credit risk. Off-balance-sheet commitments

4. Nonperforming Loan Portfolio

Nonperforming assets are those not generating income. The analysis of a non-performing loan portfolio should cover a number of aspects as follows : Aging of past-due loans Reasons for the deterioration of the loan portfolio quality A list of nonperforming loans should be assessed on a caseby-case basis. Provision levels should be considered. The impact on profit and loss accounts should be considered.

5. Credit Risk Management Policies

Specific credit risk management measures three kinds of policies. 1) Limit or reduce credit risk 2) Asset classification 3) Loss provisioning Workout procedure - An assessment of work-out procedures should consider the organization of this function, including departments and responsible staff.

 Public-disclosure requirements - Disclosure principles related to sound credit risk should be mandated by regulatory authorities as recommended by the Basel Committee on Bank Supervision.

6. Policies to Limit or Reduce Credit Risk

Large exposures - Bank supervisors monitor both the banking sector and an individual banks credit exposure in order to protect depositors interests and to be able to prevent situations that may put a banking system at risk.

 Related-party lending - Lending to connected parties is viewed adversely towards credit risk exposure. It includes banks parent, major shareholders, subsidiaries, affiliate companies, directors and executive officers. Overexposure to geographical areas or economic sectors - Another dimension of risk concentration is the exposure of a bank to a single sector of the economy or a narrow geographical region.

 Renegotiated Debt - This refers to loans that have been restructured to provide a reduction of either interest or principal payments because of the borrowers deteriorated financial position.

7. Asset Classification
Asset classification is a process whereby an asset is assigned a credit risk grade, which is determined by the likelihood that debt obligations will be serviced and debt liquidated according to contract terms. All assets for which a bank is taking a risk should be classified. It is a key risk management tool. Assets are classified at the time of origination and then reviewed and reclassified as necessary

8. Loan Loss Provisioning Policy

Asset classification provides a basis for determining an adequate level of provisions for possible loan losses. Such provisions are counted as tier 2 capital and are not assigned to specific assets. Policies on loan-loss provisioning range from mandated to discretionary, depending on the banking system. Two main approaches exist for dealing with loss assets : 1) to retain loss assets on the books until all remedies for collection have been exhausted and 2) all loss assets be promptly written off against the reserve i.e. removed from the books.

Liquidity Risk Management

Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. It lies at the heart of confidence in the banking system. It addresses market liquidity rather than statutory liquidity. The implication of liquidity risk is that a bank may have insufficient funds on hand to meet its obligations.

Liquidity Management Policies

The Liquidity management policies of a bank normally comprise : - a decision-making structure, - an approach to funding and liquidity operations, - a set of limits to liquidity risk exposure, - a set of procedures for liquidity planning under alternative scenarios

 Foreign currencies aspects . - The liquidity strategy for each currency, should be a central concern of the bank. - A bank should have a management system for its liquidity positions in all major currencies in which it is active.

The Structure of Funding : Deposits and Market Borrowing

Deposits - Funding structure is a key aspect of management. - Product range - Deposit concentration - Deposit administration liquidity

Financial market borrowing - The marginal cost of liquidity is of paramount importance in evaluating the sources of liquidity.

Maturity Structure and Funding Mismatches

Maturity mismatches are an intrinsic feature of banking. An increased mismatch could be due to problems in obtaining long-term funding for the bank. Once the contractual mismatch has been calculated, it is important to determine the expected cash flow that can be produced by the banks asset-liability management. While it is apparent that the maturity structure of deposits for the observed bank has changed, the reasons are not straightforward or easy to determine.

Deposit Concentration and Volatility of Funding

Most banks monitor their funding mix and the concentration of depositors very closely, to prevent excessive dependence on any particular source. The increasing volatility of funding is indicative of the changes in the structure and sources of funding that the banking sector is undergoing. To assess the general volatility of funding, a bank usually classifies its liabilities that are likely to stay with the bank under any circumstances.

Liquidity Risk Management Techniques

The liquidity risk management has three aspects : 1. measuring and managing net funding requirements, 2. market access, and 3. contingency planning

Liquidity risk management involve various scenarios : - The going-concern scenario : This is ordinarily applied to the management of a banks use of deposits. - A second scenario relates to a banks liquidity in a crisis situation when a significant part of its liabilities can not be rolled over or replaced. - A third scenario refers to general market crisis, wherein liquidity is affected in the entire banking system.

Risks associated with market funding-based liquidity management

Purchased funds may not always be available when needed. Over-reliance on liability management may cause a tendency to minimize the holding of short-term securities. During the period of tight money, this tendency could squeeze earnings and give rise to illiquid conditions. A bank may incur relatively high costs when obtaining funds, due to rate competition in the money market.

 If a bank purchases liabilities to support assets that are already on its books, the high cost of purchased funds may result in a negative yield spread. When national monetary tightness occurs, interest rate discrimination may develop, making the cost of purchased funds prohibitive to all but a limited number of large banks. Preoccupation with lowest possible cost and with insufficient regard to maturity distribution can greatly intensify a banks exposure to the risk of interest rate fluctuations.

Market Risk Management

Risk that a bank may experience loss due to unfavorable movements in market prices. Sources of market risk - Market risk results from changes in the prices of equity instruments, commodities, money and currencies. Major components like, equity position risk, commodities risk, interest rate risk and currency risk includes a general market risk aspect and a specific risk aspect that originates in the portfolio structure of a bank.

 Volatility Volatility prevails in mature markets, though it is much higher in new or illiquid markets.
Proprietary trading versus stable investment portfolio management liquidity

Proprietary trading is aimed at exploiting market opportunities with leveraged funding whereas the stable liquidity investment portfolio is held and traded as a buffer. Both the investment portfolios are subject to market risk.

 Value at risk (VAR) VAR is a modeling technique that typically measures a banks aggregate market risk exposure. The risks covered by the model should include all interest, currency, equity and commodity for both on-and-off balance sheet positions. The VAR amount may be calculated by using the following methodologies: - Historical simulation approach - Delta-normal or variance/covariance - Monte Carlo simulation Risk capital The Basel Committee amended the 1988 Capital Accord in January 1996 by adding specific capital charges for market risk.

Portfolio Risk Management Policies

While policies related to market risk management may vary among banks, there are certain types of policies present in all banks. Marking to market : - It is considered prudent for a bank to evaluate and re-price positions related to its stable liquidity investment portfolio on at least a monthly basis.

 Position limits:- A market risk management policy should provide for limits on positions, bearing in mind the liquidity risk that could arise on execution of unrealized transactions. Such position limits should be related to the capital available to cover market risk. Stop-loss provisions:- The stop-loss exposure limit should be determined with regard to a banks capital structure and earning trends, as well as to its overall risk profile.

 Limits to new market presence:- Limits related to a new market presence should be frequently reviewed and adjusted. Once a market becomes established and sufficiently liquid, a bank should readjust the limits to levels applicable to mature markets.

Trading Book and Management of Trading Activities

A banks trading book should include positions arising from brokering or market making, as well as certain instruments taken to hedge the risk exposures inherent in some trading activities. In most banks, Trading activities are carried out in organizational units that are held separate from standard banking activities. Trading activities require highly skilled analytical support to gauge market movements and opportunities.

Market Risk Management

Equity Risk - relates to taking or holding trading book positions in equities that display equitylike behavior and their derivatives. - it is calculated for the specific risk of holding a security (beta).

 Commodity risk - refers to holding or taking positions in exchange-traded commodities, futures, and other derivatives.
another operational aspect of this risk relates to delivery risk and the necessity to close out positions before delivery.

 Currency risk - refers to proprietary trading positions in currencies and gold.

- risk is based on probabilistic events, and is apparent that no single measurement tool can capture the multifaceted nature of market risk.

Stress Testing
The purpose of stress testing is to identify events or influences that may result in a loss. It should be both qualitative and quantitative in nature. The stress test scenarios and the testing results normally are subject to supervisory attention. The complexity of stress tests normally reflects the complexities of a banks market risk exposures and respective market environments. It is virtually impossible to develop a standard stress test scenario that has a consistent impact on all banks.

Interest Rate Risk Management

When interest rates fluctuate, a banks earnings and expenses change, as do the economic value of its assets, liabilities and offbalance-sheet positions. It comprises the various policies, actions, and techniques that a bank can use to reduce the risk rates.

 Repricing risk The most common type of interest rate risk arises from timing differences in the maturity of fixed rates and the repricing of the floating rates of bank assets, liabilities, and off-balancesheet positions. Yield curve risk Yield curve risk materializes when yield curve shifts adversely affect a banks income or underlying economic value.

 Basic risk - Also described as Spread risk. - It arises when assets and liabilities are priced off different yield curves and the spread between these curves shifts. - It derives from unexpected change in the spread between the two index rates. Optionality An important source of interest rate risk stems from the options embedded in many bank assets and liabilities or they may be embedded within otherwise standard instruments.

 Assessing interest rate risk exposure Since interest rate risk can have adverse effects on both a banks earnings and its economic value, two separate but complementary approaches exist for assessing risk exposure.

Risk Management Responsibilities

The Banks board of directors has ultimate responsibility for the management of interest rate risk. The board should systematically review risk, in such a way as to fully understand the level of risk exposure and to assess the performance of management in monitoring and controlling risks in compliance with board policies. Senior management must ensure that the structure of a banks business and the level of interest rate risk it assumes are effectively dealt with, that appropriate policies and procedures are established to control and limit risk.

 A banks risk monitoring and control functions should be sufficiently independent from its risk-taking functions. Bank should have an adequate system of internal controls to oversee the interest rate risk management process. The design of the system of limits should ensure that positions which exceed assigned limits are promptly addressed by management.

Models for the Management of Interest Rate Risk

Static gap model - It was common practice for financial institutions to analyze their exposure to interest rate risk, using the gap approach. - In a gap model, the components of the balance sheet are separated into items that are sensitive to interest rates and those that are not.

 Repricing gap model - Repricing gap is a static measure and does not give the complete picture.
Repricing gap models nonetheless are a useful starting point for the assessment of interest rate exposure.

Currency Risk Management

Currency risk results from changes in exchange rates between a banks domestic currency and other currencies. It arises from a mismatch between the value of assets and liabilities denominated in different currencies. It is of a speculative nature and can result in a gain or a loss.

Currency risk comprises the following : - Transaction risk - Economic or business risk - Revaluation risk or translation risk
There are other types of risks also which accompany currency risk are : counterparty risk, settlement risk, liquidity risk and currencyrelated interest rate risk.

Policies for Currency Risk Management

Policy-setting responsibilities - The policy guidelines should be periodically reviewed and updated to match the banks risk profile with risk management system and staff skills. - It should also reflect circumstances in domestic and international currency markets & should accommodate possible changes in the currency system. - Policy should specify the frequency of revaluation of foreign currency positions for accounting and risk management purposes.

 Risk exposure limit - Banks should have written policies to govern their activities in foreign currencies and to limit their exposure to currency risk. Limits may be applicable in various timeframes depending on the dynamics of the particular activity.

 The net open position limit - It is an aggregate limit of a banks currency risk exposure.
It normally represents a proxy for the maximum loss that a bank might incur due to currency risk. The prudential limit to the net open position is frequently set at 10 15% of a banks qualifying capital.

 Currency position limits - It can apply to balance sheet revaluation points, overnight positions, or intraday positions.
- It can be adjusted on a case-by-case basis depending on the banks expectations of shifts in the exchange rate between the domestic and foreign currency.

 Other position limits - If engaged in currency dealings, a bank should normally maintain limits on spot positions in each currency. - If a bank is engaged in business with derivatives, it should establish limits on the size of mismatches in the foreign exchange book. - These limits are expressed as the maximum aggregate value of all contracts that may be outstanding for a particular maturity.

 Stop loss provisions It should be determined based on a banks overall risk profile, capital structure and earning trends. When losses reach their respective stop-loss limits, open positions should automatically be covered. Concentration limit High concentration always increases risk. Therefore, banks should establish limits on the maximum face value of a contract.

 Settlement risk - While settlement risk can be mitigated by a request for collateral, a bank should also establish specific limits on exposure to settlement risk. These limits should be related to the total outstanding amount and subject to settlement risk on any given day.

 Counterparty risk - All transactions involving foreign contracts or currency receivables also involve counterparty risk. - Such risk may be due to circumstances in the country in which the counterparty conducts business. - This risk is particularly pronounced in countries that lack external convertibility and where the government imposes restrictions on access to the foreign exchange market.

 Revaluation (or Translation) Revaluation is essentially the same as marking to market, except that it pertains to changes in the domestic currency value of assets, liabilities and off-balance sheet instruments that are denominated in foreign currencies. It is an important risk management tool.

 Liquidity risk concerns Currency risk management should incorporate an additional liquidity risk-related aspect. Foreign currency transactions may introduce cash flow imbalances and may require the management of foreign currency liquidity.

 The accounting treatment Accounting treatment may vary among countries, depending on the purpose of revaluation. An analyst should be familiar with the rules applicable on the accounting treatment of gains or losses arising from currency risk. The analyst should also be familiar with the accounting rules used by a bank under review for risk and internal management reporting purposes.

Currency Risk Exposure and Business Strategy

Banks, those operating in countries with unstable currencies, are keenly aware of the risks associated with foreign currency business. The degree of currency risk exposure is a matter of business orientation and is related to a banks size. Smaller and new banks are exposed to currency risk for very short periods of time and to a limited extent, and do not need elaborate currency risk management.

 Recognition of the increased risk and of the needed technical skills associated with the foreign exchange business has prompted regulators in almost all countries that do not maintain external convertibility to introduce two types of bank licenses. Banks averse to risk may avoid dealing in forward contracts altogether and instead engage in currency swaps. A currency swap avoids a net open currency position but still has to be marked to market. In a dynamic trading environment it is virtually impossible for a bank active in currency markets to maintain covered positions in all currencies at all times.

Currency Risk Management and Capital Adequacy

A key aspect of currency risk management review is the assessment of whether or not a bank has the capacity to adequately handle its level of operations in foreign exchange. Currency risk management can be based on gap or mismatch analysis using the same principles as liquidity risk and interest rate risk management. The maturity structure of loans funded by deposits should fully correspond to the deposit maturity structure.

 Currency risk exposure implies certain capital charges which are added to the charge calculated for market risk. According to various countries, the net open foreign currency position established by bank should not exceed 10 15% of qualifying capital and reserves. By using shorthand method, capital adequacy is calculated as 8% of the overall net open position. Adequate procedures and internal controls should be in place for all other key functions related to foreign exchange operations.

 Line management should be responsible for overseeing foreign currency transactions and ensuring compliance with risk limits. A bank with a high volume of foreign exchange operations must have proper information support if it is to develop strategies for trading operations and executing specific transactions.

THANK YOU !!