Class Notes

Financial Risk MANAGEMENT

(session-V & VI; Jun-Jul-2019)

FOR

PGDM
INSTITUTE OF MANAGEMENT TECHNOLOGY

What is Sub Prime Crisis & How it Occurred

Prime credit means giving loans to creditworthy customers. A creditworthy customer
is one with a sound financial position and good cash flows which ensure timely
repayment of credit facilities availed.
Whereas, Sub prime credit refers to the credit exposure to customers who are not
creditworthy and may have a weak financial position and unreliable cash flows.
The main driver for sub-prime lending is social factors or government policy. There is
normal tendencies in my countries to facilitate the flow of credit to the
underprivileged sectors in the society, through several schemes sponsored or
promoted by the government.
In 2002 the U.S. President issued ‘ America’s Homeownership challenge to the real
estate and mortgage finance industries to join to their efforts to provide more housing
to deprived section of U.S. Society. From 2000 onwards, the U.S. Fed reduced the
interest rates sharply to stimulate the economy. The U.S. Fed rate was just 1 % in in
2003.Many large investors such as pension funds who traditional invested in gilt
edged securities searched for alternative sources given the low interest yield on
treasury securities. Realizing the huge potential for high yield bonds and securities ,
the investment banks focused on securitizing mortgages and marketed products
such as CDOs and similar asset backed securities to the investors.
As the supply of prime mortgages was insufficient, the focus shifted to sub-prime
assets, which also had relatively high yield. Gradually sub-prime mortgages
increasingly formed part of CDOs. Sub-prime mortgages which constituted less than
5% of the CDOs in 1999 exceeded 20% by 2006. Given the demand for securitized
assets from the yield hungry investors in the low interest rate regime , the investment
and other mortgage backed mainly sub prime loans into CDOs securities. They
mixed prime and sub prime assets and created tranches based on risk profile.
Prime and sub prime lending increased the demand for housing during the bubble
formation years. The US ownership rates inceased rapidly from late 1990s to
2004/2005. This demand fueled a sharp rise in housing prices between 1997 to
2006. In other words , easy availability of cheap mortgages propelled housing
demand which drove house prices up.The demand for houses was derived from
various sources. People bought houses to live in, for renting out,for investment
purposesor as a vacation or as second or third homes.
The US house prices reached unrealistic levels measured by price to rent ratio or
any other prudent measure and, accordingly, incremental led demand was tapering
away from 2006 onwards. Around the same time US interest rates were hiked by
the Fed, partially to curtail the massive credit availability in system. US Fed rates
touched 5.25% in June 2006 from the low of 1 % few years back. Higher interest
rates had their impact. They reduced the mortgage off take as the cost of mortgage
shot up. Most of mortgages were based on flexible interest rates and as such
borrowing cost s on existing mortgages increased. Sub prime borrowers were hard
hit resulting into fore closures.
The down turn in the housing market prompted a collapse of the US sub prime
mortgage industry, which offered loans to individuals with poor credit, no cash for a
down payment. By September 2008, average US housing prices declined by more
than 20% from 2006 levels. Households with negativity equity on their homes
increased. During this situation , even prime borrowers had an incentive to walk
away from their mortgages and leave their homes for creditors to reposses. And
other mortgage

Consequences
The housing crisis deepened with defaults on both sub-prime and prime mortgages.
The default rate of subprime borrowers exceeded 20% and their level of substantial
default impacted the mortgage portfolio and, consequently, the structured products
created out of them. Foreclosures increased sharply with the default from both prime
and sub prime borrowers. Cash flows into the CDO and other mortgage backed
securities reduced sharply. In fact, the custodians held the unsold inventory of
houses.

Due to non receipt of timely payment by these structured products , valuation

dropped sharply in the secondary market and in some cases no buyers were left for
such products in the market. As a result of the panic, even the good structured
products were affected with liquidity implications. As a result, a number of Financial
Institutions faced mark to market losses.
Around 25 sub prime lending firms declared bankruptcy during early 2007.These
bankruptcies shook the financial markets. At the end of 2007, Citigroup and Merrill
Lyanch reported losses of $18.1 billion and $ 11.5 billion respectively. In Europe
UBS also reported substantial losses.. During Feb.2008, the UK government
nationalized Northern Rock while in March 2008 Bear Stearns , facing losses and a
liquidity crisis , was taken over by JP Morgan in Fed initiated deal. In sept 2008, the
US government took over US Federal mortgage insurers Fannie Mae and Freddie
Mac. Lehman filed for bankruptcy , triggering a chain reaction in financial system.

What is Securitisation ?
Securitization refers to the act of aggregation of several discrete credit assets into a
pool managed by a separate trust , which issues bonds and securities with
appropriate documentation linking the underlying pool of credit assets or loans to
bonds or securities issued
The basic idea is that .loan origination is decoupled from holding of credit assets and
consequent risks . Major incentives to bank in such arrangement is :-
1) It brings liquidity to otherwise illiquid credit assets of the bank
2) It transfers risk to the investors and leads to lower capital adequacy
3) It helps to match maturity mis-match
What is Asset Based Securities?
When a bank grants several loans to different retail borrowers and once the loan
become sizeable, bank pools them together and sells to a Special Purpose Vehicle
( SPV) or to a trust ,to recover the funds deployed for providing loans. The SPV then
issues a series of bonds based on the underlying loan/credit assets. Usually rating
agencies are asked to rate the bonds. These bonds are assigned rating and
according to the rating ,they are priced. Lower the rating higher is the price and
higher the rating lower is the price. Investor in the market ,according to their risk
appetite invest in such bonds. Every month recovery received from the borrowers is
distributed first to AAA rated and then balance amount to lower rated bond holders.

What is CDOs- Collateralized Debt Obligations ?

CDO is a structured security where the credit asset pool is segmented to different
tranches with a different risk/return matrix and sold to investors with appropriate risk
appetite. The senior tranches are considered the safest securities with junior
tranches carry high risk .Interest and principal payment are made in order of seniority
and as such senior tranches are carrying low coupon rate and junior tranches carry
high coupon rates.

Lesson from Sub-Prime Crisis & Introduction of Basel III

One of the main reasons the economic and financial crisis, which began in 2007,
became so severe was that the banking sectors of many countries had built up
excessive on and off-balance sheet leverage. This was accompanied by a gradual
erosion of the level and quality of the capital base. At the same time, many banks
were holding insufficient liquidity buffers. The banking system therefore was not able
to absorb the resulting systemic trading and credit losses nor could it cope with the
reintermediation of large off-balance sheet exposures that had built up in the shadow
banking system. The crisis was further amplified by a procyclical deleveraging
process and by the interconnectedness of systemic institutions through an array of
complex transactions. During the most severe episode of the crisis, the market lost
confidence in the solvency and liquidity of many banking institutions. The
weaknesses in the banking sector were rapidly transmitted to the rest of the financial
system and the real economy, resulting in a massive contraction of liquidity and
credit availability.
Ultimately the public sector had to step in with unprecedented injections of liquidity,
capital
support and guarantees, exposing taxpayers to large losses
Lessons can be summarised as under:-
1) Avoid too much leverage
2) Avoid too much reliance on external agencies
3) Never let a financial institution become too big to fail
4) Give more importance to liquidity
5) Strengthen regulatory oversight
6) In-depth Credit risk evaluation is needed even for traded credit assets.
Key Building Blocks of Basel III

With above development in place BCBS issued guidelines on capital in December ,

2010 & then revised it in June 2011June as “ Basel III : A Global Regulatory
framework for more Resilient Banks and Banking System ” and another guidelines
on liquidity as “Basel III: International framework for liquidity risk measurement,
standards and monitoring” .The objective of both these guidelines is to improve the
banking sector’s ability to absorb shocks arising from financial and economic stress,
whatever the source, thus reducing the risk of spill over from the financial sector to
the real economy . To address the market failures revealed by the crisis, the
Committee introduced a number of fundamental reforms to the international
regulatory framework. The reforms strengthen bank-level, or micro prudential,
regulation, which will help raise the resilience of individual banking institutions to
periods of stress .

The key features of these guidelines are :-

 Increased Quantity /Quality of Capital

 Conservation of Capital Buffer
 Countercyclical Buffer
 Additional requirement of Global and Domestic Systemic Banks
 Global Liquidity Standards
 Leverage Ratio

Increased Quantity /Quality of Capital

Under Basel III, a bank’s total capital consists of :
1) Tier 1 equity capital (also known as CET 1 i.e. Core Equity Tier 1)
2) Additional Tier 1 Capital i.e. IPDI & PNCPS
3) Tier 2 capital
Under Basel II also components of the capital as stated above are same but
minimum requirement of each component is different. The table below shows the
comparative picture of capital requirement under Basel II & Basel III:-
As a percentage of RWA
Sr. No. Capital Component Basel II Basel III as on
Jan. 1, 2019
A=(B+D Minimum Total Capital 8.0 8.0
)
B Minimum Tier 1 Capital 4.0 6.0
C Of B , Minimum CET 1 Capital 2.0 4.5
D Maximum Tier 2 Capital ( Within Total 4.0 2.0
Capital )
E Capital Conservation Buffer NIL 2.5
F= C+E Minimum Common Equity Tier 1 + CCB 2.0 7.0
 G=A+E Minimum Total Capital + CCB 8.0 10.5

The component wise comparison as per above table clearly shows that core equity
requirement under Basel III has increased sustainably from 2 % to 7 %. Beside,
Total minimum capital requirement under pillar- I has also increased from 8 % to
10.5 %.
As regards quality of capital, loss absorbing components under Basel II were only
core capital in Tier I and provisions in Tier II whereas under Basel III, Tier I & Tier II
bonds are also having the feature of loss absorbency which means at the point of
non-viability these bonds either can be considered to adjust the losses or can be
converted into equity.

Capital Conservation Buffer

In addition to Core Equity Capital of 4.5 %, Basel III requires a capital conservation
buffer in normal times consisting of a further amount of core Tier I equity capital
equal to 2.5 % of risk weighted assets. This provision is designed to ensure that
banks build up capital during normal times so that it can be run down when losses
are incurred during period of financial difficulties. It is presumed that raising capital
during normal circumstances is easier than raising capital during stressed market
conditions. There are certain dividend restrictions imposed as per following table:-
Tier I Equity Capital Ratio in % Minimum Percentage of Earnings
Retained in %
4.00 to 5.125 100
5.125 to 5.750 80
5.750 to 6.375 60
6.375 to 7.000 40
>7 0

The capital conservation buffer means that the Tier I equity capital required to be
kept in normal times is 7 % of RWA; total Tier Capital is to be 8.5 % of RWA and
Total CRAR is required to be 10.5 % of RWA and in India, requirement is 11.5 %
RWA.
This requirement of additional Capital of 2.5 % was phased out in four equal
tranches of .625 each starting from Jan 1, 2016 to Jan 1, 2019. In India it started
from 1st April 2016 up to 1st April 2019 . Last tranch of .625 has been deffered up to
1st April, 2020.

Counter Cyclic Buffer

Losses incurred in the banking sector can be extremely large when a downturn is
preceded by a period of excess credit growth. These losses can destabilise the
banking
sector and spark a vicious circle, whereby problems in the financial system can
contribute to
a downturn in the real economy that then feeds back on to the banking sector. These
interactions highlight the particular importance of the banking sector building up
additional
capital defences in periods where the risks of system-wide stress are growing
markedly.
Another Capital requirement specified under Basel III is Countercyclical buffer. This
similar to Capital conservation buffer , but the extent to which it is implemented in a
particular country is left to the discretion of national authorities. The buffer is
intended to provide protection for the cyclicality of bank earnings. The buffer can be
set to between 0 % to 2.5 % of total risk weighted assets and must be met with Tier I
equity capital..
National authorities will monitor credit growth and other indicators that may signal a
build up of system-wide risk and make assessments of whether credit growth is
excessive and is leading to the build up of system-wide risk. Based on this
assessment they will put in place a countercyclical buffer requirement when
circumstances warrant. This requirement will be released when system-wide risk
crystallises or dissipates.

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Global Liquidity Standards
Liquidity is a bank’s capacity to fund increase in assets and meet both expected and
unexpected cash and collateral obligations at a reasonable cost. Liquidity risk is the
inability of a bank to meet such obligations as they become due, without adversely
affecting the bank’s financial condition. Effective liquidity risk management helps
ensure a bank’s ability to meet its obligations as they fall due and reduces the
probability of an adverse situation developing. This assumes significance on account
of the fact that liquidity crisis, even at a single institution can have systemic
implications.

Liquidity risk for banks mainly manifests on account of the following:

(i) Funding Liquidity Risk – the risk that a bank will not be able to meet efficiently
the expected and unexpected current and future cash flows and collateral needs
without affecting either its daily operations or its financial condition.

(ii) Market Liquidity Risk – the risk that a bank cannot easily offset or eliminate a
position at the prevailing market price because of inadequate market depth or market
disruption.
The Basel Committee on banking supervision had published its report on Basel III
rules text on Liquidity- “Basel III International Framework for liquidity risk
measurement, standards and monitoring in 2010”
This committee had suggested two standards namely
(1) Liquidity Coverage Ratio (LCR) and (2) Net Stable Funding Ration (NSFR) to
ensure adequate liquidity with banks and to take care of funding risk.
These two ratios are a key components of the Basel III Framework. These are
explained as under :
The liquidity coverage ratio (LCR) is introduced with a view to ensure that a bank has
an adequate stock of unencumbered high quality liquid assets that consists of cash
and near cash assets to meet its liquidity needs in next 30 calendar days. This will
help a bank to survive until 30th day of the stress scenario.
The standard norm of net stable funding ratio is also expected to bring discipline
through use of more stable sources of funds to fund long term assets.
(i) The Liquidity Coverage Ratio (LCR) is calculated by using following ratio

Stock of high quality liquid assets

LCR = -------------------------------------------------------------- x 100
Total net cash outflows over the next 30 calendar days

The LCR should be more than or equal to 100 percent at any point of time. This
ratio must be maintained on continuous basis. As per the Basel Committee’s
recommendations banks having business in overseas countries have to maintain this
standard with effect from January 1, 2015. The time frame within which degree of
this standard must be maintained is as follows.

Effective % of LCR
January 1, 2015 60
January 1, 2016 70
January 1, 2017 80
January 1, 2018 90
January 1, 2019 100

With effect from January 1, 2019 the LCR must be minimum of 100 percent or more.
The implementation of LCR in a phased manner over next 4 years will help banks to
maintain this standard without disrupting normal functioning of their business.
During financial crisis banks are supposed to sale high quality liquid assets to meet
liquidity needs and hence liquid assets to meet liquidity need and hence banks can
maintain LCR below 100 percent subject to the approval of national authority. The
assets are considered to be high quality liquid assets if they can be easily and
without loss of time converted into cash with a minimum or no loss of value. Such
assets have distinct characteristics like low credit risk, high marketability, high credit
rating, active secondary market which is less volatile and proper valuation etc. The
Basel committee has divided HQLA into two groups namely level 1 assets and level
2 assets.

Level 1 assets: such assets are comprised of following assets

(a) Coins and bank notes (hard cash both in domestic and foreign currency).

(b) Assets that are created to maintain reserves as stipulated by a central bank of a
country. However a part of these assets which are allowed to be drawn in times of
stress by a central bank are eligible for inclusion in this group. In addition to this,
government securities which are not subjected to reserves but unencumbered that is
free from regulatory or contractual restrictions.

(c) Marketable securities representing claims on or guaranteed by sovereigns,

central banks and international agencies like BIS, IMF, IFC, ADB etc. provided the
following conditions are met.
(i) assigned a zero risk weight under Basel II standardised approach for credit risk.

(ii) traded in large, deep and active repo or cash markets.

(iii) have a proven record as a reliable source of liquidity in the markets.
Level 1 assets are not subjected to any haircut as well as limit.

Level 2 assets

Level 2 assets are limited to the following:

Marketable securities representing claims on or claims guaranteed by sovereigns,

Public Sector Entities (PSEs) or multilateral development banks that are assigned a
20 percent risk weight under the Basel II Standardised Approach for credit risk and
provided that they are not issued by a bank/financial institution/NBFC or any of its
affiliated entities.

Corporate bonds (not issued by a bank/financial institution/NBFC or any of its

affiliated entities) which have been rated AA or above by a recognised credit rating
agency.

The level 2 assets cannot exceed 40 percent of the overall stock of liquid assets fter
haircuts have been applied.

A minimum 15 percent haircut must be applied to the current market value of each
level 2 assets held in the stock.High Quality liquid assets must have following
characteristics

(1) Various risk such as credit risk, legal risk is almost low or negligible. For example
very high credit rating instruments means low credit risk. This makes these assets
as more liquid and marketable.
(2) It is easy to have valuation of such assets without any price manipulation.
(3) Outright and repo markets for such assets are well developed in terms of trading
volumes, settlement system, etc.
(4) The market for such assets is stable or less volatile.

Total Net Cash Outflows

It is defined as the total expected cash outflows less total expected cash inflows in
the specified stress scenario for the subsequent 30 calendar days. Total expected
cash outflows are calculated by multiplying the outstanding balances of various
liabilities and off balance sheet commitments by the rates at which they are expected
to run off or be drawn down. Similarly total expected cash inflows are calculated by
multiplying the outstanding balances of various categories of receivables (assets) by
the rates at which they are expected to flow in under stress scenario up to an
aggregated cap of 75 percent of total expected cash outflows. Based on this
approach, total net cash outflows is calculated as under.
Total net cash outflows in the next 30 calendar days = Total expected cash outflows
in the next 30 calendar days – Total expected cash inflows in the next 30 days.
(Total of net cash inflows should not be more than 75 percent of total expected cash
outflows).
(2) Net Stable Funding ratio (NSFR)
The standard of NSFR is designed with a view to ensure that long term assets are
funded from stable liabilities keeping in view their liquidity risk profiles. It aims at to
reduce over-dependence on short-term wholesale funding during times of buoyant
market liquidity and ensure better assessment of liquidity risk across all on-and off-
balance sheet assets and liabilities. In addition, this Liquidity Standard approach
offsets incentives for banks to fund their stock of liquid assets with short-term funds
that mature just outside the 30-day horizon for meeting LCR.
How NSFR is to be calculated?

Available Stable Funding (ASF) *100 > 100%

Net Stable Funding Ratio = ------------------------------------------------------------
Required Stable Funding (RSF)

“Stable funding” is defined as the portion of those types and amounts of equity and
liability financing expected to be reliable sources of funds over a one-year time
horizon under conditions of extended stress.
Available Stable Funding (ASF)
Available stable funding is comprised of bank’s sources of finance such as
(a) capital (Tire 1 and Tire 2 after deductions); (b) preference share capital (not
included in Tire 1 and Tire 2) with remaining maturity of one year or greater; (c)
liabilities with effective maturities of one year or greater; (d) the portion of demand
deposits/term deposits and wholesale funding with maturities less than one year
which is expected to remain with a bank for an extended period in a bank-specific
stress event. Banks have to undertake behavioural studies and analysis of other
factors to decide which portion of deposits likely to remain with them for at least one
year. The analysis should be discussed in ALCO meeting and documented.
Further, there is a need to undertake periodic reviews of such analysis to verify
whether the existing assumptions are correct or new assumptions need to be made.
B. Required Stable Funding (RSF)
The required amount of stable funding is calculated as the sum of the value of the
assets held and funded by a bank, multiplied by a specific required stable funding
(RSF) factor assigned to each particular asset type, added to the amount of Off-
balance Sheet (OBS) activity (or potential liquidity exposure) multiplied by its
associated RSF factor.