Risk Management – Basel-I, II & III

The growing sophistication in banking operations, online electronic banking, improvements in information technology etc, have led to increased diversity and complexity of risks being encountered by banks. These risks can be broadly grouped into Credit Risk, Market Risk and Operational Risk. These risks are interdependent and events that affect one area of risk can have ramifications for a range of other risk categories.

Basel-I Accord: It was introduced in the year 2002-03, which covered capital requirements for Credit Risk. The Accord prescribed CRAR of 8%, however, RBI stipulated 9% CRAR. Subsequently, Banks were advised to maintain capital charge for Market Risk also.

Basel-II New Capital Accord: Under this, banks have to maintain capital for Credit Risk, Market Risk and Operational Risk w.e.f 31.03.2007. The New Capital Accord rests on three pillars viz., Minimum Capital Requirements, Supervisory Review Process & Market Discipline. The implementation of the capital charge for various risk categories are Credit Risk, Market Risk and Operational Risk. Analysis of the bank’s CRAR under both Basel-I & Basel-II guidelines should be reported to the Board at quarterly intervals.

Internal Ratings Based (IRB) Approach: Under this approach, banks must categorise the exposures into broad classes of assets as Corporate, Sovereign, Bank, Retail and Equity. The risk components include the measures of the Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (M). There are two variants i.e Foundation IRB (FIRB) and Advanced IRB. Under FIRB, banks have to provide their own estimates of PD and to rely on supervisory estimates for other risk components (like LGD, EAD) while under Advanced IRB; banks have to provide their own estimates of all the risk components. It is based on the measures of Expected Losses (EL) and Unexpected Losses (UL). Expected Losses are to be taken care of by way of pricing and provisioning while the risk weight function produces the capital requirements for Unexpected Losses.

Market Risk: It is a risk pertaining to the interest rate related instruments and equities in the Trading Book i.e AFS (Available For Sale) and HFT (Held for Trading) positions and Foreign Exchange Risk throughout the bank (both banking & trading books). There are two approaches for measuring market risk viz., Standardized Duration Approach & Internal Models Approach.

Operational Risk: Banks have to maintain capital charge for operational risk under the new framework and the approaches suggested for calculation of the same are – Basic Indicator Approach and The Standardized Approach. Under the first approach, banks must hold capital equal to 15% of the previous three years average positive gross annual income as a point of entry for capital calculation. The second approach suggests dividing the bank’s business into eight lines and separate weights are assigned to each segment. The total capital charge is calculated as the three year average of the simple summation of the regulatory capital charges across each of the business lines in each year.

Advanced Measurement Approach (AMA): Under this, the regulatory capital requirement will equal the risk measure generated by the bank’s internal operational risk measurement system using certain quantitative and qualitative criteria. Tracking of internal loss event data is essential for adopting this approach. When a bank first moves to AMA, a three-year historical loss data window is acceptable.

Pillar 2 – Internal Capital Adequacy Assessment Process (ICAAP): Under this, the regulator is cast with the responsibility of ensuring that banks maintain sufficient capital to meet all the risks and operate above the minimum regulatory capital ratios. RBI also has to ensure that the banks maintain adequate capital to withstand the risks such as Interest Rate Risk in Banking Book, Business Cycles Risk, and Credit Concentration Risk etc. For Interest Rate Risk in Banking Book, the regulator may ensure that the banks are holding sufficient capital to withstand a standardized Interest Rate shock of 2%. Banks whose capital funds would decline by 20% when the shock is applied are treated as ‘Outlier Banks’. The assessment is reviewed at quarterly intervals.

Pillar 3 – Disclosure Requirements: It is aimed to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess the key pieces of information on the capital, risk exposures, risk assessment processes and hence the capital adequacy of the institution. Banks may make their annual disclosures both in their Annual Reports as well as their respective websites. Banks with capital funds of Rs.500 crore or more, and their significant bank subsidiaries, must disclose their Tier-I Capital, Total Capital, total required capital and Tier-I ratio and total capital adequacy ratio, on a quarterly basis on their respective websites. The disclosures are broadly classified into Quantitative disclosures and Qualitative disclosures and classified into the following areas:

CapitalCapital structure & Capital adequacy
Risk Exposures & Assessments Qualitative disclosures for Credit, Market, Operational, Banking Book interest rate risk, equity risk etc.
Credit Risk General disclosures for all banks. Disclosures for Standardised & IRB approaches.
Credit Risk Mitigation Disclosures for Standardised and IRB approaches.
Securitisation Disclosures for Standardised and IRB approaches.
Market Risk Disclosures for the Standardised & Internal Models Approaches.
Operational Risk The approach followed for capital assessment.
Equities Disclosures for banking book positions
Interest Rate Risk in the Banking Book (IRRBB) Nature of IRRBB with key assumptions. The increase / decrease in earnings / economic value for upward / downward rate shocks.

Time lines for implementation of Advanced Approaches are set as 31st March 2014. The Basel-II norms are much better than Basel-I since it coveres operational risk. However, risks such as Reputation Risk, Systemic Risk and Strategic Risk (the risk of losses or reduced earnings due to failures in implementing strategy) are not covered and exposing the banks to financial shocks.

As per Basel all corporate loans attracts 8 percent capital allocation where as it is in the range of 1 to 30 percent in case of individuals depending on the estimated risk. Further, group loans attract very low internal capital charge and the bank has a strong incentive to undertake regulatory capital arbitrage to structure the risk position to lower regulatory risk category. Regulatory capital arbitrage acts as a safety valve for attenuating the adverse effects of those regulatory capital requirements that activity’s underlying economic risk. Absence of such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity could cause a bank to exit that relatively low-risk business by preventing the bank from earning an acceptable rate of return on its capital.

Nominally high regulatory capital ratios can be used to mask the true level of insolvency probability. For example – Bank maintains 12% capital as per the norms risk analysis calls for 15% capital. In a regulatory sense the bank is well capitalized but it is to be treated as undercapitalized from risk perspective.

Basel-III is a comprehensive set of reform measures developed to strengthen the regulation, supervision and risk management of the banking sector. The new standards will considerably strengthen the reserve requirements, both by increasing the reserve ratios and by tightening the definition of what constitutes capital. The new norms will be made effective in a phased manner from 1st July 2013 and implemented fully by 31st March 2018. The broad guidelines are:

  • Banks to maintain a minimum 5.5% in common equity (as against 3.6% now) by 31st March 2015.
  • Banks must create a Capital Conservation Buffer of 2.5% by 31st March 2018.
  • Banks should maintain a minimum overall capital adequacy of 11.5% (against the current 9%) by 31st March 2018.
  • Banks must supplement risk based capital ratios by maintaining a leverage ratio of 4.5%

The guidelines will ensure that banks are well capitalized to manage all kinds of risks. The existing norms stipulate that banks should maintain Tier-I Capital and Tier-II Capital that comprises instruments with debt like features. Basel-III rules propose to bring in more clarity and eliminate grey areas in the current rules by clearly defining different kinds of capital.

Tier – I & II capital consists of Paid up Equity Capital + Free Reserves + Balance in Share Premium Account + Capital Reserves (surplus) arising out of sale proceeds of assets but not created by revaluation of assets MINUS Accumulated loss + Book value of Intangible Assets + Equity Investment in Subsidiaries+ Innovative Perpetual Debt instruments. Tier – II consists of Cumulative perpetual preferential shares & other Hybrid debt capital instruments + Revaluation reserves + General Provisions + Loss Reserves (up to maximum 1.25% of weighted risk assets) + Undisclosed Reserves + Subordinated Debt + Upper Tier-II instruments. Subordinated Debts are unsecured and subordinated to the claims of all the creditors. To be eligible for Tier- II capital the instruments should be fully paid, free from restrictive clauses and should not be redeemable at the instance of holder or without the consent of the Bank supervisory authorities. Subordinated debt usually carries a fixed maturity. They will have to be limited to 50% of Tier-I capital.

Economic Capital (EC) is a measure of risk expressed in terms of capital. A bank may, for instance, wonder what level of capital is needed in order to remain solvent at a certain level of confidence and time horizon. In other words, EC may be considered as the amount of risk capital from the banks’ perspective; therefore, it differs from Regulatory Capital (RC) requirement measures. It primarily aims to support business decisions, while RC aims to set minimum capital requirements against all risks in a bank under a range of regulatory rules and guidance. So far, since economic capital is rather a bank-specific or internal measure of available capital, there is no common domestic or global definition of EC. Moreover, there are some elements that many banks have in common when defining EC. EC estimates can be covered by elements of Tier-1, 2 & 3, or definitions used by rating agencies and/or other types of capital, such as planned earning, unrealized profit or implicit government guarantee. EC is highly relevant because it can provide key answers to specific business decisions or for evaluating the different business units of a bank.