Class Notes

Financial Risk MANAGEMENT

(session-Basel-II, ICAAP, Stress
Testing)

FOR
PGDM
INSTITUTE OF MANAGEMENT
TECHNOLOGY
Why Basel II Norms ?
To understand the need of Basel II norms , Let us know he advantage &
Weaknesses of Basel I as per our previous sessions study.
Advantages of Basel I Accord: -
 Substantial increase in in capital adequacy ratios of internationally active
banks ;
 Relatively simple structure
 Worldwide adoption among internally active banks
 Greater discipline in managing capital
 A bench mark for assessment by market participants
Weaknesses of Basel I Accord: -
 Capital Adequacy depends upon the credit risk, while other risks (e.g. market
and operational) are excluded from the analysis.
 In Credit risk assessment , it was fit for all i.e. there was no difference
between credit quality and rating
 Emphasis was on book value and not on market value
 Inadequate assessment of risks and effects of the use of new financial
instruments, as well as risk mitigation techniques.
Weakness related to market risk were overbridged by the amendment by means of
introducing Capital requirement for market risks.
The above listed weaknesses with few other improvements brought in a new Basel
Capital Accord known as Basel II norms in 2004.
On June 26, 2004 , the BCBS released “ International Convergence of Capital
Measurement and Capital Standards: a revised Framework”. Basel II aims to build
on a solid foundation of prudent capital regulation, supervision and market discipline
to enhance risk management framework and financial stability. It Capitalizes on the
modern risk management techniques and seeks to establish a more risk responsive
linkage between the bank’s operation and their capital requirement.
The Basel II consists of three mutually reinforcing pillars, popularly known as Pillar I,
Pillar II , & Pillar III, A brief description of these pillars is as under :-
Pillar I : It stipulates the Minimum Capital Ratio requirements allocation of regulatory
capital not only for credit risk and market risk but additionally for operational risk
also. Regulators suggested simplified and advance approaches to determining
capital charge for each of these categories of risk .
Pillar II deals with Supervisory Review Process. In fact it covers the entire risk
domain of the banks. Under this requirement , Banks are required to have their own
Internal Capital Adequacy Assessment Process ( ICAAP) which should encompass
 all such risks which are either not fully captured or not captured at all under the Pillar
I. The ICAAP document is subject to supervisory review and if warranted,
supervisors can prescribe the higher capital requirement over and above the
minimum capital ratio envisaged in Pillar I.
Pillar III : It focuses on Market discipline and recoginses the fact that apart from
regulators banks are also monitored by market and the discipline exerted by the
market as powerful as the regulations imposed by regulators. Thus through these
disciplines , depending upon their nature , banks can be penalized or rewarded by
the market forces.
Capital Adequacy Under Basel II
Total CRAR = ( Eligible Capital Funds ) / ( Credit RWA* + Market RWA+ Operational
RWA)
Tier I CRAR = [Eligible Tier I capital funds]/ [Credit RWA* + Market RWA +
Operational RWA]

 *RWA = Risk weighted assets

Basel II has also recommended at least 8% CRAR and 4% Tier 1 CRAR, whereas RBI has given
guidelines for at least 9% CRAR and 6% Tier 1 CRAR.

So calculation of CRAR is dependent on two major factors

1. Eligible Total Capital Funds

2. Risk Weighted Assets
Eligible Total Capital Funds Components

Tier I Tier II
1. Paid up Capital, Statutory Reserves, disclosed 1. Revaluation Reserve (at a discount of 55%)
free reserves
2. Capital Reserve (E.g. Surplus from 2. General Provision & Loss Reserves
sales of assets)
3. Eligible Innovative Perpetual Debt 3. Hybrid Debt Capital Instruments:
Instruments(IPDI)- upto 15% of Tier-I Eg. Perpetual Cumulative Preference
Shares, Redeemable Non-Cumulative
Preference Share, Redeemable Cumulative
Preference Share
4. Preference Shares (PNPS) - 3 & 4 4. Subordinate Debt: fully paid up,
can be max 40% of Tier1 unsecured, subordinated to other
creditors, free of restrictive clauses
5. Remaining IPDI & PNPS from Tier1
Capital
Risk Weighted Assets
Type of Simple to Most Sophisticated & Advanced Approach
Risks
/Approach
Credit Risk Standardized FIRB AIRB
Approach
Market Risk Standarised Duration Internal Model
Approach Approach
Operational Basic Indicator The Standarised Advance
Risk Approach Approach Measurement
Appr0ach

Credit Risk Assessment: Unlike Basel 1, BCBS have devised three

approaches for calculation of credit risk weighted assets:

Standardized Approach to Credit Risk: The standardized approach has

fixed risk weights corresponding to various risk category based on ratings given by
approved external credit rating agencies. The risk weights vary from 0% to 150%
based on the risk category. Unrated loans have 100% risk weights. Standardized
approach has increased risk sensitivity by considering expanded range of collateral,
guarantees and credit derivatives. The risk weights for residential mortgage exposure
were reduced in comparison to Basel 1 Accord.

Foundation Internal Rating Based Approach: In Internal Rating Based

Approach, credit risk is measured on basis of internal ratings given by the banks
rather than external credit rating agencies. The ratings are based on the risk
characteristics of both the borrower and the specific transaction. Expected loss is
calculated based on probability of default (PD) of borrower, loss given default (LGD),
bank’s exposure at default (EAD) and remaining Maturity (M) of exposure

Probability of default (PD) measures the likelihood that the borrower will default
over a given time horizon.

Loss Given Default (LGD) measures the proportion of the exposure that will be
lost if Default occurs.

Exposure at Default (EAD) is estimated amount outstanding in a loan commitment if default

occurs.

Maturity (M) measures the remaining economic maturity of the exposure.

There are two types of losses- Expected and Unexpected.

Expected Loss, which is normal business risk of a bank, is a multiplication of PD, LGD, EAD
and M.

Expected Loss= PD X LGD X EAD X M

Unexpected Loss is that part of credit risk that cannot be priced in the product and hence the
banks have to provide capital for it by risk weighing their assets.

Unexpected Loss is the upward variation in expected loss over a definite time
horizon. Unexpected Loss (UL) may be expressed as under:

UL = E x LGD x Standard Deviation of PD.

In Foundation IRB, PD is calculated by the bank and the remaining are based on
supervisory values set by Basel Committee or RBI (in India)
2.1.2.1.3 Advanced Internal Rating Based Approach: Advanced IRB is advanced
version of foundation IRB. The only difference is that Loss Given Default, Exposure
at Default and Maturity are also estimated by the bank based on the historical data.

Credit Risk Assessment Approaches

Data Input/ Standardized Foundation IRB Advanced IRB

Approach Approach
Probability of RW Provided by Provided by bank based Estimated by Bank based on
Default Regulators on own estimates historical records
Loss Given default Supervisory values set Provided by bank based on
Rated by External by Basel Committee own estimates
Exposure at Agencies Supervisory values set Provided by bank based on
Default by Basel own estimates
Committee
Maturity Supervisory values set Provided by bank based on
 by Basel own estimates
Committee
Data History Historical Data of 7 Historical Data of 5 years
years

Capital Charge for Credit Risk under Standardized Approach

Standardised Approach Risk Weight

Domestic Sovereigns 0%

Foreign Sovereigns 0% to rating Based

Public Sector Entities 20% to 150%

MDBs, BIS and IMF 20%

Banks 20% to 650%

Primary Dealers 20% to 150%

Corporates 20% to 150%

Regulatory Retail Portfolios 75%

Claims secured by Residential Property 50%, 75% & 100%based on LTV

Claims secured by Commercial Real Estate 100%

NPA-Unsecured 50% to 150%

Secured
50% to 100% Depending upon Specific
Provisions

Market Risk Assessment: Market risk is potential for loss resulting from adverse movement in
market risk factors such as interest rates, forex rates, currency valuations, equity prices and
commodity prices. (Bhattcharya, 2008). In Basel 2, risks are divided into two major risks: interest
rate risk and volatility risk. Therefore there is a clear distinction between fixed income and other
products such as equity, commodity and foreign exchange vehicles. The approaches to calculate
market risk in capital charge are:

Standardized Duration Approach: Under the standardized method there are two
principal methods of measuring market risk, a “maturity” method and a “duration”
method. As “duration” method is a more accurate method of measuring interest rate
risk, RBI has adopted standardized duration method to arrive at the capital charge. For
interest rate risk, depending on the time to maturity/ duration of the fixed income
asset, Basel II had recommended banks to hold capital between 0% and 12.5% of an
asset’s value to protect against movements in interest rates. To guard against the volatility risk of
fixed income assets, Basel II recommends risk weightings tied to the
credit risk ratings given to underlying bank assets.

Internal risk management Models Approach: In this methodology banks

are encouraged to develop their own internal models to calculate a stock, currency, or
commodity’s market risk on a case-by-case basis. In this banks have to develop their
measures to calculate “Value of Risk” (VaR) based on 5 years data on position to
position basis. On the basis of Bank’s calculation, capital requirements are predicted.
Similar to other advanced measures RBI will supervise this method.
Operational Risk Assessment:

“Risk of direct or indirect loss resulting from inadequate or failed internal control
processes, people, systems or from external events” Such breakdowns can lead to
financial losses through Error, Fraud, Failure to perform in a timely manner, may
cause the interest of the bank to be compromised like exceeding authority, conducting
business in an unethical or risky manner.
It is the risk of loss arising from the potential that inadequate information system;
technology failures, breaches in internal controls, fraud, unforeseen catastrophes, or
other operational problems may result in unexpected losses or reputation problems
(BIS, 2006).
The Basel II Accord has 3 methods of calculating risk weighted assets with increase
in sophistication and risk sensitivity
(i) the Basic Indicator Approach (BIA); (ii) the Standardized Approach (TSA); and
(iii) Advanced Measurement Approaches (AMA).

Basic Indicator Approach: Under this approach banks must hold capital
for operational risk equal to the average over the previous three years of a fixed
percentage (denoted as alpha) 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.
The Standardized Approach: In this approach, banks’ activities are divided
into eight business lines: corporate finance, trading & sales, retail banking,
commercial banking, payment & settlement, agency services, asset management, and
retail brokerage. The capital charge for each business line is calculated by multiplying
gross income by a factor (denoted beta-β as 12, 15 and 18) assigned to that business

Advanced Measurement Approach: Under the AMA, the regulatory capital requirement will
equal the risk measure generated by the bank’s internal operational
risk measurement system (ORMS). After these criteria have been satisfied, the
operational risk capital charge is computed from the unexpected loss of VaR at the
99.9 percent confidence level over one year horizon provided the expected loss is
accounted for through provisions.
A bank should calculate its regulatory operational risk capital requirement as the sum
of expected loss (EL) and unexpected loss (UL). Expected Loss is covered by
provisions & pricing and Unexpected loss through additional capital.
Calculation of Capital Adequacy Ratio as per Basel II Norms

Please refer Annexure I

Pillar II – Supervisory Review and ICAAP

The Basel II Framework through Pillar 2 has introduced Supervisory Review Process
(SRP). The objective of the SRP is to ensure that the banks have adequate capital to
support all the risks in their business as also to encourage them to develop and use better
risk management techniques for monitoring and managing their risks. This in turn would
require a well-defined internal assessment process within the banks through which they
assure the regulators that adequate capital is indeed held towards the various risks to which they are
exposed.

The main aspects to be addressed under the SRP would include:

(a) the risks that are not fully captured by the minimum capital ratio prescribed
under Pillar 1;
(b) the risks that are not at all taken into account by the Pillar 1; and
(c) the factors external to the bank.

Since the capital adequacy ratio prescribed by the RBI under the Pillar 1 of the Framework is only the
regulatory minimum level, addressing only the three specified risks (viz., credit,
market and operational risks), holding additional capital might be necessary for the banks,
on account of both – the possibility of some under-estimation of risks under the Pillar 1 and
the actual risk exposure of a bank vis-à-vis the quality of its risk management architecture.
Illustratively, some of the risks that the banks are generally exposed to but which are not
captured or not fully captured in the regulatory CRAR would include:

(a) Interest rate risk in the banking book;

(b) Credit concentration risk;
(c) Liquidity risk;
(d) Settlement risk;
(e) Reputational risk;
(f) Strategic risk;
(g) Risk of under-estimation of credit risk under the Standardised approach;
(h) “Model risk” i.e., the risk of under-estimation of credit risk under the IRB approaches;
(i) Risk of weakness in the credit-risk mitigants;
(j) Residual risk of securitisation, etc.

The banks are, therefore, required to prepare a document ,known as Internal Capital Adequacy
Assessment Process ( ICAAP). This assessment should capture bank’s minimum capital requirement
under Pillar –I and also the capital requirement under other various other risks to which it is exposed .

What is an ICAAP document?

The ICAAP Document would be a comprehensive Paper furnishing detailed information on the
ongoing assessment of the bank’s entire spectrum of risks, how the bank intends to mitigate those
risks and how much current and future capital is necessary for the bank, reckoning other mitigating
factors. The purpose of the ICAAP document is to apprise the Board of the bank on these aspects as
also to explain to the regulator the bank’s internal capital adequacy assessment process and the
banks’ approach to capital management.

The key contents of ICAAP Document are:

I Summary of current and projected financial and capital positions

II. Capital Adequacy
III. Key sensitivities and future scenarios
IV. Aggregation and diversification
V. Testing and adoption of the ICAAP
VI. Use of the ICAAP within the bank

The Basel II document of the Basel Committee also lays down the following four key
principles in regard to the SRP envisaged under Pillar 2:

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, as well as their ability to monitor and ensure
their compliance with the regulatory capital ratios. Supervisors should take
appropriate supervisory action if they are not satisfied with the result of this process.
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 required to support the risk

Thus, the ICAAP and SREP are the two important components of Pillar 2 and could be broadly
defined as follows:

The ICAAP comprises a bank’s procedures 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 bank’s risk profile; and
c) Application and further development of suitable risk management systems in
the bank.

Scenario Analysis and Stress Testing

In addition to the assessment of adequacy of capital in normal business conditions,

banks are also required to adopt stress test as a risk management tool.
Stress Test is a measure to assess vulnerability of exceptional but plausible event
which may not occur in normal operations of the Bank. Risk Management is
concerned with what might happen in the future.

There are mainly two types of stress test conducted in a Bank i.e. Sensitivity Tests
and Scenario Tests.

(α) Idiosyncratic Stress Assumption

(β) Market Wide Stress Assumptions

Idiosyncratic Stress Assumption

This stress is due some internal factors and is also known as unsystematic risk.

The premature withdrawal of deposits takes place in the first two buckets (1 day &
2-7 days) in equal proportion.
If the Bank arranges funds by borrowing, it will be available at a rate of the
prevailing repo rate +5% p.a.

The period of stress is 7 days

If funds are arranged by selling the investment in the AFS & HFT categories it is
done at discount of 2.5% of market price.

Market Wide Stress Assumptions

This is systematic risk

The premature withdrawal of deposits (as discussed under various scenarios later in this
section) takes place in the first two buckets (1 day & 2-7 days) in equal proportion.

If bank arranges funds by borrowing, it will be available at abnormally high rates, assumed at
the prevailing repo rate +10% p.a.

The period of stress is 30 days

If funds are arranged by selling the investment in the AFS & HFT categories, it is done at 5%
discount

Pillar III Market Discipline

The aim is 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.

Market discipline can contribute to a safe and sound banking environment. Banks, including should
provide all Pillar 3 disclosures, both qualitative and quantitative, as at end of each financial year along
with the annual financial statements. With a view to enhance the ease of access to the Pillar 3
disclosures, banks may make their annual disclosures both in their annual reports as well as their
respective web sites.

In India , all banks with capital funds of Rs. 500 crore or more, and their significant bank subsidiaries,
must disclose their Tier 1 capital, total capital, total required capital and Tier 1 ratio and total capital
adequacy ratio, on a quarterly basis on their respective websites.

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