Basel Regulations

Banking Risk: An Overview

 Credit risk
 Risk arising due to default or deterioration of
the credit quality of the obligor/borrower
 Market risk
 Risk arising due to market movement of
different benchmark rates.
 Operational risk
 Loss resulting due to errors instructing
payments or setting transactions.
 Credit Risk Component
 Arises at two levels
 Transaction level
 At the sanction level – issues of appraisal,
credit worthiness of the obligor etc.
 Portfolio level
 How to manage risk once the bank has built up
its portfolio – does the individual obligor
default? – if so, what is the probability of
default? – in the event of default what is the
expected and unexpected loss? – any cushion
required?
 Market Risk Component
 Can arise due to movement of rates
(e.g. interest rate, stock prices,
exchange rate etc.) in different markets.
 Bank may have exposure to different
markets such as equity, foreign exchange,
commodity etc.
 By far, interest rate risk is the most
prominent component because
 Most of the banks’ assets are benchmarked to
interest rates which are deregulated.
Market Risk Contd..
 Investment portfolio of banks consists of a
substantial investment on treasury bonds (G-
secs) which are interest rate sensitive.
 Reasonable exposure to international
benchmark interest rate such as LIBOR (London
Interbank Offer Rate)
 Operational Risk Component
 Operational risk is the risk of loss resulting from
inadequate or failed internal processes, people
and systems or from external events.
 Internal fraud

 External fraud

 Employment practices & workplace safety

 Clients, products & business practices

 Damage to physical assets

 Business disruption & system failures

 Execution and delivery

 Risk Based Capital Standard
 Why do banks need to hold capital in order to
do business?
 Provides a cushion against unexpected loss that may
arise due to credit/market/operational risk.
 Capital that needs to be maintained as a proportion
of risk based assets is termed as risk based capital –
otherwise termed as capital adequacy ratio (CAR).
 e.g., bank does not maintain any capital towards
credit risk component of GoI bonds as it is non-
existent.
 Evolution of Capital Standard
 Originated in July 1988 under the auspices of
Bank for International Settlement (BIS) in
Basle, Switzerland – popularly termed as Basle
Committee.
 Basel I defines a common measure of solvency,
called the Cooke ratio which covers only credit risk –
one size fits all policy.
 Specifies 8% (9% in India) capital charge on all
exposures.
 Exposures being defined by respective risk weights
 1988 accord is termed as Basel – I.
 Evolution of Capital Standard

June Jan Sept

1999 2001 2001
1988 1992 1996 1998

1988 Basel Introduction of 1st Consultative Working Paper on

Accord capital charge Document: Operational Risk
Capital Charge for Market Risk A New Capital Adequacy
for Credit Risk Framework
Proposed new framework
to
replace existing Accord and
introduced capital charge
Implementation Discussion for operational risk.2nd Consultative
of 1998 Accord Paper: Package:
Operational Risk The New Basel Capital
Accord including capital
charge for Operational
Risks
Risk Weights and Capital Allocation
Risk weight (%) Asset Category (On-balance sheet)

0 Cash and gold held in bank/Obligation on

OECD government and US treasuries

20 Claims on OECD banks/securities issued

by US government agencies/Claims on
municipalities
50 Residential mortgages

100 All other claims such as corporate

debt/Claims on non-OECD banks/Less
developed countries’ debt etc.
 Risk Weights and Capital Allocation
Risk weight (%) Asset Category (Off-balance sheet)

0 OECD governments

20 OECD banks and public sector entities

50 Corporate and other counterparties

Note: OBSIs include undrawn portion of the loans,

Letters of credit, guarantees, derivatives etc.
 A Closer Look into Basel I
 Capital in regulatory context
 Tier 1 Capital
 Shareholders’ equity and disclosed reserves
 Tier 2 Capital (Supplementary)
 Perpetual securities, unrealized gains on investment
securities, hybrid capital instruments, long term
subordinated debt.
 Total of tier 2 capital is limited to a maximum of
100% of the total tier 1 capital.
 Basel I requires tier 1 and tie 2 capital to be at least
8% of the total risk weighted assets.
 1996 Amendment to Incorporate
Market Risk
 1996 amendment treats trading positions in
bonds, equity, foreign exchange and
commodity in the market risk framework.
 Provides explicit capital charges on bank’s open
position in each instrument
 Provides scope for BIS ‘standardized approach’
and ‘internal models approach’.
 Banks can either choose BIS prescribed model or
their own internal model (e.g. Value at Risk) to
assess market risk subject to supervisory
compliance.
 1996 Amendment Contd..
 Capital charge is to be made on the
following
 Held for trading (HFT) category
 Available for sale (AFS)
 Foreign exchange positions
 Trading positions on derivatives

Note: Any position which is marked to the market

carries a capital charge.
 1996 Amendment Contd..
 Allows banks to use new ‘Tier 3’ capital
 Includes short term subordinated debt to
meet the market risk.
 Tier 3 capital being restricted only to market
risk.
 No such capital can be repaid if that
payment results in a bank’s overall capital
being lower than a minimum capital
requirement.
 Basel I in India
 Basel I was implemented in India by 1996 (Process got
started in 1992-93 and was spread over 3/4 years).
 However, capital charges for market risk under Basel I got
implemented in June 2004.
 Banks in India are statutorily required to maintain capital
for credit risk and market risk.
 In India, Capital adequacy ratio, termed as Capital to risk
assets ratio (CRAR) is set at 9%.
 However, banks are not allowed, at present, to use Tier III
capital towards market risk capital charge.
 CRAR of Indian Public Sector Banks
CRAR of Public Sector Banks in India
(1995-1996 to 2004-2005)
(Percent)
1995- 1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004-
Banks 96 97 98 99 0 1 2 3 4 5
Nationalized Banks 10.2 10.9 12.2 13.1 13.2
Andhra Bank 5.07 12.05 12.37 11.02 13.36 13.4 12.59 13.62 13.71 12.11
Bank of Baroda 11.19 11.8 12.05 13.3 12.1 12.8 11.32 12.65 13.91 12.61
Bank of India 8.44 10.26 9.11 10.55 10.57 12.23 10.68 12.02 13.01 11.52
Bank of Maharashtra 8.49 9.07 10.9 9.76 11.66 10.64 11.16 12.05 11.88 12.68
Central Bank of India 2.63 9.41 10.4 11.88 11.18 10.02 9.58 10.51 12.43 12.15
Corporation Bank 11.3 11.3 16.9 13.2 12.8 13.3 17.9 18.5 20.12 16.23
Dena Bank 8.27 10.81 11.88 11.14 11.63 7.73 7.64 6.02 9.48 11.91
Indian Bank Neg. -18.81 1.41 Neg. Neg Negative 1.7 10.85 12.82 14.14
Indian Overseas Bank 5.95 10.07 9.34 10.15 9.15 10.24 10.82 11.3 12.49 14.2
Oriental Bank of Commerce 16.99 17.53 15.28 14.1 12.72 11.81 10.99 14.04 14.47 9.21
Punjab National Bank 8.23 9.15 8.81 10.79 10.31 10.24 10.7 12.02 13.1 14.78
Syndicate Bank 8.42 8.8 10.49 9.57 11.45 11.72 12.12 11.03 11.49 10.7
Union Bank of India 9.5 10.53 10.86 10.09 11.42 10.86 11.07 12.41 12.32 12.09
State Bank Group 12.7 13.3 13.4 13.4 12.4
Public Sector Banks 11.2 11.8 12.6 13.2 12.9
 Problems with Basel I
 Does not distinguish among different
credit exposures
 Both AAA and BBB assets attract the same
capital charge.
 No capital charges for short term
instruments.
 Does not allow any capital charge for
operational risk.
 Basel II
 Will replace 1988 Basel Accord.
 Based on the consultative paper issued by
Basel Committee on Banking Supervision
(BCBS).
 Based on three mutually enforcing pillars.
 Specific reference to operational risk in
banking.
 Implementation scheduled for 2005 (By 2007
in India).
 The New Basel Capital Accord
PILLAR I PILLAR II PILLAR III
Minimum capital Supervisory Market
requirements Review Discipline
Credit risk Review of the

Market risk institution’s Enhancing

Operational risk capital adequacy transparency
Review of the through
rigorous
internal disclosure
assessment norms.
process
The New Basel Capital Accord
Total Capital
= Capital Ratio (minimum 8%)
Credit + Market +
Operational
Risk Risk Risk

Revised Unchanged New

The new Accord focuses on revising only the denominator (risk-

weighted assets), the definition and requirements for capital are
unchanged from the original Accord.
 The New Basel Capital Accord
 Credit Risk
 Standardized approach
 Internal Rating Based (IRB) approach
 Foundation vs. Advanced
 Operational Risk
 Basic indicator approach
 Standardized approach
 Advanced measurement approach
 Credit Risk and Standardized
Approach
 Risk weights of sovereigns

AAA to A+ to BBB+ to BB+ to B- Belo Unrated

AA- A- BBB- w B-

Risk 0 20 50 100 150 100

weights
(%)
 Credit Risk and Standardized
Approach
 Risk weights of corporates

AAA to AA- A+ to BBB+ to Below Unrated

A- BB- BB-

Risk weights 20 50 100 150 100

(%)
 Credit Risk and IRB Approach
 IRB approach determines the economic capital
whereby banks are allowed to use an approach
for determining capital requirement for a given
exposure that is based on their own internal
assessment.
 Exclusively driven by Internal credit rating
system (best examples are PNB, SBI, OBC and
a number of new generation private sector
banks in India).
 Provides separate schemes for retail banking,
project finance etc.
 Operational Risk
 Basic indicator approach
 Sets the charge for operational risk as a
percentage of gross income, defined to
include net interest income and net non-
interest income, but excludes extraordinary
or irregular items.
 Links to the risk of an expected loss due to
internal or external events.
 Operational Risk
 Basic indicator approach
KBIA = EI*α
Where
KBIA = the capital charge under the Basic Indicator
Approach
EI = the level of an exposure indicator for the whole
institution, provisionally gross income
α = a fixed percentage, set by the Committee, relating
the industry-wide level of required capital to the
industry-wide level of the indicator
 Operational Risk
 Standardized approach
 Requires that the institution partition its
operation into different lines of business.
The capital charge is estimated as an
exposure indicator for each line of business
multiplied by a coefficient.
 Provisionally, the Basel committee intends to
use gross income for this purpose.
 Operational Risk
 Advanced measurement approach (AMA)
 Capital requirement is based on bank’s
internal operational risk measurement
system.
 Focuses on both measurement and
management of operational risk.
 Requires supervisory approval based on
qualitative and quantitative standards.
 Supervisory Review Process
 Four basic principles
 Banks should have a process for assessing
their overall capital
 Supervisory review of bank’s internal capital
adequacy and compliance
 Supervisor must expect the banks to
operate above the minimum capital
requirements.
 Appropriate intervention on behalf of the
supervisor before it gets too late!
 Market Discipline
 Comprehensive disclosure is essential for
market participants to understand the
relationship between risk profile and
capital of an institution.
 Includes the disclosure of capital
structure, capital adequacy, risk
exposure such as market, credit and
operational etc.
 Basel II in India
 Reserve Bank of India circular on ‘Prudential guidelines on capital
adequacy – Implementation of new capital adequacy framework’.
 The banks are required to adopt new Basel II norms by March
31, 2007.
 Basel II compliance is expected to increase the capital
requirement as it captures operational risk.
 The cushion available in the system, which at present has a
Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides
for some comfort (as a survey made by FICCI shows).
 However, keeping in mind a sustainable requirement of capital,
the Reserve Bank has, for its part, issued policy guidelines
enabling issuance of several instruments by the banks -
innovative perpetual debt instruments, perpetual non-cumulative
preference shares, redeemable cumulative preference shares and
hybrid debt instruments.
 Basel II Norms in India: An
Overview
 Credit risk
 Adopts standardized approach
 Operational risk
 Adopts the basic indicator approach
 Market risk
 Banks are allowed to use their internal models to
assess the market risk (i.e., status quo has been
maintained in this respect).
 However, RBI’s guideline on Basel II remains silent
on the issue of Tier III capital in Indian context.