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RISK MANAGEMENT

UNIT-4

BASEL COMMITTEE ON BANKING SUPERVISION

BASEL – I, II, and III:

The Basel Committee on Banking Supervision – is an international banking regulatory


committee formed to develop banking supervisory regulations. It was established by the
Governors of the Central Banks of a group of 10 countries (initially) in 1974.

The objective of the BCBS is to gain a better understanding of the challenges faced by
modern banking system in terms of risk and it risk management and to frame supervisory and
regulatory standards and guidelines to help the banking system diminish these risks and
function properly
India is a member of the BCBS along
with Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong
Kong, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, Russia, Saudi
Arabia, Singapore,South Africa, Spain, Sweden, Switzerland, Turkey, U.K. and USA.

Objectives:

1. The set of the agreement by the BCBS (BASEL COMMITTEE ON BANKING


SUPERVISION), which mainly focuses on risks to banks and the financial system are
called Basel accord.
2. The purpose of the accord is to ensure that financial institutions have enough capital
on account to meet the obligations and absorb unexpected losses.
3. India has accepted Basel accords for the banking system.
4. BASEL ACCORD has given us three BASEL NORMS which are BASEL 1,2 and 3.

Tier 1 - The Tier- I Capital is the core capital


Paid up Capital, Statutory Reserves, Other disclosed free reserves, Capital Reserves which
represent surplus arising out of the sale proceeds of the assets, other intangible assets belong
from the category of Tier1 capital.
Tier 2 - Tier-II capital can be said to be subordinate capitals.
Undisclosed reserves, Revaluation Reserves, General Provisions and loss reserves , Hybrid
debt capital instruments such as bonds, Long term unsecured loans, Debt Capital Instruments
etc belong from the category of Tier 2 capital.

Risk Weighted Assets


RWA means assets with different risk profiles; it means that we all know that is much larger
risk in personal loans in comparison to the housing loan, so with different types of loans the
risk percentage on these loans also varies.

BASEL-I

In 1988, The Basel Committee on Banking Supervision (BCBS) introduced capital


measurement system called Basel capital accord, also called as Basel 1.

1. It focused almost entirely on credit risk, It defined capital and structure of risk
weights for banks.
2. The minimum capital requirement was fixed at 8% of risk-weighted assets (RWA).
3. India adopted Basel 1 guidelines in 1999.

Basel I – The First Basel Accord refers to the capital standards imposed on credit institutions
and provided the following –

The definition of capital as composed of core capital and supplementary capital


(representing up to 100% of core capital); -

Determining the risk weights of bank assets, respectively: 0% - zero risk, 20% low risk,
50% medium risk and 100% high risk and also establishing the assets that fall into each risk
category.

the capital adequacy, respectively the minimum level that banks had to maintain between
capital and assets weighted by risk level; the minimum value of this indicator varies
depending on the calculation method, meaning it must be of minimum 8% when it expresses
the total capital ratio (the core capital plus the additional capital) and the assets weighted by
risk level or at least of minimum 4% if it is calculated as the ratio between the core capital
and the assets weighted by risk level.
BASEL-II

In 2004, Basel II guidelines were published by BCBS, which were considered to be the
refined and reformed versions of Basel I accord.

1. The guidelines were based on three parameters which are as follows


2. Banks should maintain a minimum capital adequacy requirement of 8% of risk assets.
3. Banks were needed to develop and use better risk management techniques in
monitoring and managing all the three types of risks that is credit and increased
disclosure requirements.
4. The three types of risk are- operational risk, market risk, capital risk.
5. Banks need to mandatory disclose their risk exposure, etc to the central bank.
6. Basel II norms in India and overseas are yet to be fully implemented.

Basel II - The New Basel Accord The Basel II Accord was based on three mutually
reinforcing pillars:

Minimum requirements of own funds – the capital adequacy ratio must be at least 8%,
calculated as the ratio between the Bank's equity and assets, but this time the assets are
weighted according to three risks:

1. credit risk
2. market risk
3. operational risk

The supervisory process for the bank activity that involves: • internal performance
assessment procedures of its own equity • the supervisory authority is responsible for the
assessment mode conducted by banks • improving the bank-supervisor dialogue • rapid
intervention to prevent the decline in capital

Market discipline which requires more detailed reporting requirements by the Central Bank
and by the public regarding the ownership structure, risk exposures, capital adequacy to the
risk profile. These requirements involve regular publication of information (every six month
by the national banks and quarterly by the internationally active banks).

BASEL-3

The three pillars BASEL-3


Basel III

1. In 2010, Basel III guidelines were released. These guidelines were introduced in
response to the financial crisis of 2008.
2. In 2008, Lehman Brothers collapsed in September 2008, the need for a fundamental
strengthening of the Basel II framework had become apparent.
3. Basel III norms aim at making most banking activities such as their trading book
activities more capital-intensive.
4. The guidelines aim to promote a more resilient banking system by focusing on four
vital banking parameters viz. capital, leverage, funding and liquidity.
5. Presently Indian banking system follows Basel II norms.
6. The Reserve Bank of India has extended the timeline for full implementation of the
Basel III capital regulations by a year to March 31, 2019.

Important Points Regarding Implementation of Basel III

1. The government of India is scaling disinvesting their holdings in PSBs to 52 per cent.
2. The government will soon infuse Rs 6,990 crore in nine public sector banks including
SBI, Bank of Baroda (BoB), Punjab National Bank (PNB) for enhancing their capital
and meeting global risk norms.
3. This is the first tranche of capital infusion for which the government had allocated Rs
11,200 crore in the Budget for 2014-15.
4. The government has infused Rs 58,600 crore between 2011 to 2014 in the state-
owned banks.
5. Finance Minister Arun Jaitley in the Budget speech had said that "to be in line with
Basel-III norms there is a requirement to infuse Rs 2,40,000 crore as equity by 2018
in our banks. To meet this huge capital requirement we need to raise additional
resources to fulfil this obligation.

The Minimum Capital Adequacy Ratio:

This minimum ratio forms the basis for the capital requirements promoted in Basel II. Most
subsequent enhancements to Basel II relate to the composition of this ratio, as the regulators
try to adjust capital requirements to better capture banking institutions’ business models,
product innovation and market evolution.
1. Enhancements to the ratio – when the minimum amount of capital that the bank is
required to hold increases or decreases (for example from 8% in Basel II to 10.5% in
Basel III);
2. Enhancements to the numerator – when the definition of the capital changes (as in
Basel 2.5 where hybrid capital is no longer considered eligible as regulatory capital);
3. » Enhancements to the denominator – when the weighting or the process of assigning
a risk weighting to assets evolves (e.g. in Basel III).

Minimal Capital Adequacy Ratio (CAR) ≤ Capital – Adjustments/ Risk Weighted


Assets

Pillar 1:

Measure and report minimum regulatory capital requirements Under Pillar 1,

Firms must calculate minimum regulatory for credit, capital market and operational risk.

1. Credit risk is the risk associated with bank’s main assets, i.e. that a counterparty fails
to repay the full loan. It is present in all banking book assets and off-balance sheet
products as well as counterparty credit risk for banking and trading book derivatives
and repos.
2. Market risk is the risk of losses (on- and off-balance sheet) due a decrease in the value
of investments. It applies to all trading book products.
3. Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems, or from external events.
RISK MANAGEMENT

UNIT-5

TIME VALUE OF MONEY

Time value of money is the concept that the value of a Rupee to be received in future is less
than the value of a Rupee on hand today. One reason is that money received today can be
invested thus generating more money. Another reason is that when a person opts to receive a
sum of money in future rather than today, he is effectively lending the money and there are
risks involved in lending such as default risk and inflation. Default risk arises when the
borrower does not pay the money back to the lender. Inflation is the rise in general level of
prices.

Time value of money principle also applies when comparing the worth of money to be
received in future and the worth of money to be received in further future. In other words,
TVM principle says that the value of given sum of money to be received on a particular date
is more than same sum of money to be received on a later date.

Few of the basic terms used in time value of money calculations are:

Present Value

When a future payment or series of payments are discounted at the given rate of interest up to
the present date to reflect the time value of money, the resulting value is called present value.
Read further: Present Value of a Single Sum of Money and Present Value of an Annuity

Future Value

Future value is amount that is obtained by enhancing the value of a present payment or a
series of payments at the given rate of interest to reflect the time value of money.
Read further: Future Value of a Single Sum of Money and Future Value of an Annuity

Interest

Interest is charge against use of money paid by the borrower to the lender in addition to the
actual money lent.

Application of Time Value of Money Principle


There are many applications of time value of money principle. For example, we can use it to
compare the worth of cash flows occurring at different times in future, to find the present
worth of a series of payments to be received periodically in future, to find the required
amount of current investment that must be made at a given interest rate to generate a required
future cash flow, etc.

ADVANCED BOND CONCEPTS

A bond is simply a contract between a lender and a borrower by which the borrower promises
to repay a loan with interest. However, bonds can take on many additional features and/or
options that can complicate the way in which prices and yields are calculated. The
classification of a bond depends on its type of issuer, priority, coupon rate, and redemption
features.

1. Bond Issuers

As the major determiner of a bond's credit quality, the issuer is one of the most important
characteristics of a bond. There are significant differences between bonds issued by
corporations and those issued by a state government/municipality or national government. In
general, securities issued by the federal government have the lowest risk of default while
corporate bonds are considered to be riskier ventures.

International bonds (government or corporate) are complicated by different currencies. That


is, these types of bonds are issued within a market that is foreign to the issuer's home market,
but some international bonds are issued in the currency of the foreign market and others are
denominated in another currency.

Here are some types of international bonds:

The definition of the Eurobond market can be confusing because of its name. Although the
euro is the currency used by participating European Union countries, Eurobonds refer neither
to the European currency nor to a European bond market.

A Eurobond instead refers to any bond that is denominated in a currency other than that of
the country in which it is issued. Bonds in the Eurobond market are categorized according to
the currency in which they are denominated. As an example, a Eurobond denominated in
Japanese yen but issued in the U.S. would be classified as a euro yen bond. Foreign bonds
are denominated in the currency of the country in which

A foreign entity issues the bond. An example of such a bond is the samurai bond, which is a
yen-denominated bond issued in Japan by an American company. Other popular foreign
bonds include bulldog and Yankee bonds.

Global bonds are structured so that they can be offered in both foreign and Eurobond
markets. Essentially, global bonds are similar to Eurobonds but can be offered within the
country whose currency is used to denominate the bond.

As an example, a global bond denominated in yen could be sold to Japan or any other
country throughout the Eurobond market.

2) Priority

In addition to the credit quality of the issuer, the priority of the bond is a determiner of the
probability that the issuer will pay you back your money. The priority indicates your place in
line should the company default on payments. If you hold an unsubordinated (senior) security
and the company defaults, you will be first in line to receive payment from the liquidation of
its assets. On the other hand, if you own a subordinated (junior) debt security, you will get
paid out only after the senior debt holders have received their share.

3. Coupon Rate Bond issuers may choose from a variety of types of coupons, or interest
payments.

Straight, plain vanilla or fixed-rate bonds pay an absolute coupon rate over a specified
period of time. Upon maturity, the last coupon payment is made along with the par value of
the bond. Floating rate debt instruments or floaters pay a coupon rate that varies according to
the movement of the underlying benchmark. These types of coupons could, however, be set
to be a fixed percentage above, below, or equal to the benchmark itself. Floaters typically
follow benchmarks such as the three, six or nine-month T-bill rate or LIBOR.

Inverse floaters pay a variable coupon rate that changes in direction opposite to that of short-
term interest rates. An inverse floater subtracts the benchmark from a set coupon rate. For
example, an inverse floater that uses LIBOR as the underlying benchmark might pay a
coupon rate of a certain percentage; say 6%, minus LIBOR.
Zero coupon or accrual bonds do not pay a coupon. Instead, these types of bonds are
issued at a deep discount and pay the full face value at maturity.

Redemption Features

Both investors and issuers are exposed to interest rate risk because they are locked into either
receiving or paying a set coupon rate over a specified period of time. For this reason, some
bonds offer additional benefits to investors or more flexibility for issuers:

Callable, or a redeemable bond features gives a bond issuer the right, but not the
obligation, to redeem his issue of bonds before the bond's maturity. The issuer, however,
must pay the bond holders a premium. There are two subcategories of these types of bonds:
American callable bonds and European callable bonds. American callable bonds can be
called by the issuer any time after the call protection period while European callable bonds
can be called by the issuer only on pre-specified dates. The optimal time for issuers to call
their bonds is when the prevailing interest rate is lower than the coupon rate they are paying
on the bonds. After calling its bonds, the company could refinance its debt by reissuing bonds
at a lower coupon rate.

Convertible bonds give bondholders the right but not the obligation to convert their bonds
into a predetermined number of shares at predetermined dates prior to the bond's maturity. Of
course, this only applies to corporate bonds.

Puttable bonds give bondholders the right but not the obligation to sell their bonds back to
the issuer at a predetermined price and date. These bonds generally protect investors from
interest rate risk. If prevailing bond prices are lower than the exercise par of the bond,
resulting from interest rates being higher than the bond's coupon rate, it is optimal for
investors to sell their bonds back to the issuer and reinvest their money at a higher interest
rate.

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