Risk Management in banking sector .pptx

Risk management in the Indian banking system

1. Risk Management Shreyas Vyas(Ph.D. in Law) Faculty NISM

2. Introduction The need for banking regulation conceives its roots in the concern towards the socio-economic costs that arise in case of breakdown of the banking system or that of bank failures and systemic crises. So as a result, the major aim of banking industry regulation is to maintain financial stability to ensure a safe and sound banking system to protect the interest of depositors in particular and to promote a healthy investment environment in general. The banking industry is one of the major key areas responsible for the economic growth of a nation, but , with the globalization of the same, there comes a phenomenon of sequential prostration calling for the implementation of minimum global banking regulation standards to avoid cross country impact of banking disruptions or crises.

3. Basel 1 2 and 3 is that Basel 1 is established to specify a minimum ratio of capital to risk-weighted assets for the banks whereas Basel 2 is established to introduce supervisory responsibilities and to further strengthen the minimum capital requirement and Basel 3 to promote the need for liquidity buffers (an additional layer of equity).

4. Basel Committee - 1974 T he central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices. The group of ten countries consist of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, the United Kingdom and the United States, Switzerland was also included as part of the group. Later renamed as the Basel Committee on Banking Supervision(BCBS). The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its mandate is to strengthen the regulation, supervision and practices of banks worldwide with the purpose of enhancing financial stability.

5. Basel Committee on Banking Supervision (BCBS) came into being under the patronage of Bank for International Settlements (BIS), Basel, Switzerland. The Committee formulates guidelines and provides recommendations on banking regulation based on capital risk, market risk and operational risk. Currently there are 27 member nations in the committee. Basel guidelines refer to broad supervisory standards formulated by this group of central banks- called the Basel Committee on Banking Supervision (BCBS). The set of agreement by the BCBS, which mainly focuses on risks to banks and the financial system are called Basel accord. The purpose of the accord is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. India has accepted Basel accords for the banking system.

6. Credit Risk - Credit risk is most simply defined as the potential that a bank’s borrower or counterparty may fail to meet its obligations in accordance with agreed terms. Market Risk - Market risk refers to the risk to a bank resulting from movements in market prices in particular changes in interest rates, foreign exchange rates and equity and commodity prices.

7. BASEL I Risk management (Focused on Credit Risk, No recognition of operational risk) Capital adequacy, sound supervision and regulation Transparency of operations Unquestionably accepted by developed and developing countries Capital requirement 8% of assets (banks were advised to maintain capital equal to a minimum 8% of a basket of assets measured based on the basis of their risk) Tier 1 capital at 4% Tier 2 capital at 4%

8. Capital Adequacy Framework A bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business. Capital is divided into tiers according to the characteristics/qualities of each qualifying instrument. For supervisory purposes capital is split into two categories: Tier I and Tier II.

9. Tier I capital -Share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses. Tier II capital on the other hand consists of certain reserves and certain types of subordinated debt. The loss absorption capacity of Tier II capital is lower than that of Tier I capital.

10. The twin objectives of Basel I were: (a) to ensure an adequate level of capital in the international banking system & (b) to create a more level playing field in the competitive environment . E.g. The accord specified guidelines on how to recognize the effects of multilateral netting (an agreement between two or more banks to settle a number of transactions together as it is cost effective and time-saving as opposed to settling them individually) in April 1995 .

11. BASEL II – The New Capital Farmework In June 1999, the Committee issued a proposal for a new capital adequacy framework to replace the 1988 Accord. This led to the release of the Revised Capital Framework in June 2004. Generally known as ‟Basel II ” , The New Basel Capital Accord focused on, three pillars viz. Pillar I - Minimum capital requirement Pillar II - Supervisory review Pillar III - Market discipline

12. Pillar I - Minimum C apital R equirement The Committee on Banking Supervision recommended the target standard ratio of capital to Risk Weighted Assets should be at least 8% (of which the core capital element would be at least 4%). The minimum capital adequacy ratio of 8% was prescribed taking into account the credit risk. However, in India the Reserve Bank of India has prescribed the minimum capital adequacy ratio of 9% of Risk Weighted Assets.

13. Pillar II - Supervisory R eview The Supervisory review should be carried out in the following manner. Banks should have a process for assessing their overall capital adequacy Supervisors should review banks’ assessments Banks are expected to operate above minimum Supervisor’s intervention if capital is not sufficient

14. Pillar III: Market Discipline Role of the market in evaluating the adequacy of bank capital Streamlined catalogue of disclosure requirements Close coordination with International Accounting Standards Board I n principle, disclosure of data on semiannual basis The new framework was designed with the intention of improving the way regulatory capital requirements reflect underlying risks and to better address the financial innovation that had occurred in recent years. The changes aimed at rewarding and encouraging continued improvements in risk measurement and control.

15. Basel III Accords: The global financial crises of 2008, triggered by the Lehman Brothers’ collapse , set alarm bells ringing for financial institutions. The Basel III framework is designed to make the banking sector more efficient. Basel III is a comprehensive set of reform measures which are designed & developed by the Basel Committee on Banking Supervision with the aim to strengthen the regulation , supervision and risk management of the banking sector (BCBS ). The norms call for improvement of the quantity and quality of capital of banks, stronger supervision, and more stringent risk management and disclosure standards . Therefore, in December 2010, the Basel Committee on Banking Supervision (BCBS) released a comprehensive reform package entitled – “ Basel–III: A Global Regulatory Framework for More Resilient Banks and Banking System” with following two principal objectives: 1 ) To strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. 2) To improve the banking sectors stability to absorb shock arising from financial and economic stress, which, in turn would reduce the risk of a spillover from the financial sector to the real economy.

16. Implementation of Basel III in India The Basel III accords are to be implemented in India in a phase-wise manner from April 1, 2013 to March 31, 2019 in the light of the guidelines issued by Reserve Bank of India in May 2012 with an aim to attain sustainability on micro as well as on macro level. Basel III reforms are aimed at strengthening the regulatory norms at bank-level or we can say the micro prudential regulation, with the intention to raise the resilience of individual banking institutions in periods of stress. In addition to this, the reforms also have a mmacroprudentialfocus as they are likely to address the system wide risks which can build up across the banking sector along with the the pro-cyclical amplification of these risks over time (RBI 2015). The Basel III Capital Regulations guidelines issued by RBI have six constituents: 1) Minimum Capital Requirements 2) Supervisory Review and Evaluation Process 3) Market Discipline 4) Capital Conservation Buffer Framework 5) Leverage Ratio Framework 6) Countercyclical Capital Buffer Framework

17. Moreover, the guidelines on “Liquidity Risk Management by Banks” were issued by RBI circular along with two minimum standards viz.; Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) for funding liquidity were prescribed. Additionally, a set of five tools to be used for monitoring the liquidity risk exposures of banks was also prescribed which are as follows: 1 ) Contractual Maturity Mismatch 2)Concentration of Funding 3 ) Available Unencumbered Assets 4 ) Liquidity Coverage Ratio by Significant Currency 5 ) Market-related Monitoring Tools

18. Basel 1 vs 2 vs 3 Basel 1 Basel 1 was formed with the main objective of enumerating a minimum capital requirement for banks. Basel 2 Basel 2 was established to introduce supervisory responsibilities and to further strengthen the minimum capital requirement. Basel 3 Focus of Basel 3 was to specify an additional buffer of equity to be maintained by banks. Risk Focus Basel 1 Basel 1 has the minimal risk focus out of the 3 accords. Basel 2 Basel 2 introduced a 3 pillar approach to risk management. Basel 3 Assessment of liquidity risk in addition to the risks set out in Basel 2 was introduced by Basel 3.  Risks Considered Basel 1 Only credit risk is considered in Basel 1. Basel 2 Basel 2 includes a wide range of risks including operational, strategic and reputational risks. Basel 3 Basel 3 includes liquidity risks in addition to the risks introduced by Basel 2. Predictability of Future Risks Basel 1 Basel 1 is backward-looking as it only considered the assets in the current portfolio of banks. Basel 2 Basel 2 is forward-looking compared to Basel 1 since the capital calculation is risk-sensitive. Basel 3 Basel 3 is forward looking as macroeconomic environmental factors are considered in addition to the individual bank criteria. Difference between Basel 1 2 and 3

19. Conclusion The difference between Basel 1 2 and 3 accords are mainly due to the differences between their objectives with which they were established to achieve. Even though they are widely different in the standards and requirements they presented, all 3 are navigated in such a way to manage banking risks in light of the swiftly changing international business environments. With the advancements in globalization, banks are interrelated everywhere in the world. If banks take uncalculated risks, disastrous situations can arise due to the massive amount of funds involved and the negative impact can be soon dispersed among many nations. The financial crisis that started on 2008 that caused a substantial economic loss is the timeliest example of this .