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Capital Adequacy and Risk Management in Banks

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CAPITAL ADEQUACY FRAMEWORK AND RISK MANAGEMENT IN BANKS
GUEST LECTURE: MR. R M PATTANAIK
EX GM- INDIAN OVERSEAS BANK

CAPITAL ADEQUACY RATIO (CAR)
Also known as Capital to Risk (Weighted) Assets Ratio (CRAR) is the ratio of a bank’s capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory capital requirements.
It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Two types of capital are measured: tier one capital, which can absorb losses without a bank being required to cease trading, and tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
CAR= Capital funds/ Total risk weighted assets (TRWA)

WHAT IS RISK?
Risk is the possibility of suffering a loss which is UNEXPECTED, UNFORSEEN and UNCERTAIN.
Expected losses can be managed and covered by “Provisions” like Loan loss or NPA provisions, Provision for depreciation and investments etc.
However, unexpected losses can be taken care by maintaining adequate capital. The capital acts as cushion or shock absorber for the bank in times of unforeseen losses.

RISK MANAGEMENT
Whatever activities you undertake there is a certain degree of risk associated with it. This risk however can be managed.
Risk management is the identification (where are the risks), measurement, control, mitigation and monitoring of the risk associated with business activities.
Goals/objectives
* Banks earn their income by managing risk. * The primary goal is to steer risks consciously and actively. * Strike a balance between risk and return (between high risk high return and low risk low return investments)

TYPES OF RISKS
These risks are faced by the bank in general (common for all banks): 1. Credit Risk 2. Market Risk 3. Operational Risk
(In addition to above there are certain bank specific risks as well. 1. CREDIT RISK
Credit risk is the possibility of losses arising from reduction in portfolio value arising from actual or perceived deterioration in credit quality. Losses stem from outright default due to inability or unwillingness to meet commitments such as lending, trading, settlements etc.
The Credit risk affects the “complete asset side” of the balance sheet. However, the degree of risk varies for each component in the asset. 2. MARKET RISK
This is defined as the possibility of loss to the bank caused by changes in the market variables. Credit risk is visible and easy to calculate in contrast to the market risk which is not visible.
This risk is adversely affected by the movements in equity and interest rate markets and currency exchange rate.
The market risk affects both assets as well as the liabilities in the balance sheet. 3. OPERATIONAL RISK
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events (regulators, fraud, natural disasters)
They cover the assets as well as the liabilities side in the balance sheet or even more.

HOW CAN THESE RISKS BE HANDLED?
Basel accords: A set of agreements set by the Basel Committee on Bank Supervision (BCBS), * Basel 1: The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less. * Basel 2: The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements. * Basel 3: Basel III is part of the continuous effort made by the Basel Committee on Banking Supervision to enhance the banking regulatory framework. It builds on the Basel I and Basel II documents, and seeks to improve the banking sector's ability to deal with financial and economic stress, improve risk management and strengthen the banks' transparency.
BASEL-I vs. BASEL-II

THE 3 PILLARS OF BASEL II
Basel – II norms are based on 3 pillars: * MINIMUM CAPITAL – Banks must hold capital against 8% of their assets, after adjusting their assets for risk. Capital for credit risk, market risk and operational risk. * SUPERVISORY REVIEW – It is the process whereby national regulators ensure their home country banks are following the rules. This pillar works on 4 principles: 1. Measurement of own risk and capital adequacy of banks (ICAAP) 2. Supervisory review of internal banking procedures (SREP) 3. Capital above the regulatory minimum 4. Supervisory action: intervention at an early stage to prevent slippage. * MARKET DISCIPLINE – It is based on enhanced disclosure of risk. This pillar compliments Pillar 1 and Pillar 2. 5. Encourages disclosure requirements to enable market participants to assess the capital adequacy of the bank. 6. Disclosure of qualitative and quantitative aspects pertaining to: scope of application of capital adequacy standard, capital, risk exposures. 7. “Market discipline” is relevant where banks use internal methodologies to access capital requirements.

OTHER RISKS
These risks are bank specific. The degree of these risks is dependent upon the business mix and the risk profile of the individual bank. 1. Concentration risk: Giving huge exposures to a particular industry, location or person. 2. Country risk: the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. 3. Settlement risk: the risk that a counterparty does not deliver a security or its value in cash as per agreement 4. Interest rate risk: arises for bond owners from fluctuating interest rates. How much interest rate risk a bond has depends on how sensitive its price is to interest rate changes in the market. 5. Liquidity risk: the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss 6. Equity price risk: the risk that the fair value of equities decreases as a result of changes in the levels of equity indices and the value of individual stocks. 7. Legal risk: the risk of loss to an institution which is primarily caused by:
(a) a defective transaction (c) Failing to take appropriate measures to protect assets
(d) Change in law. 8. Regulatory risk: the risk of a change in regulations and law that might affect an industry or a business. 9. Model risk: the risk of loss resulting from using models to make decisions, initially and frequently referring to valuing financial securities. 10. Outsourcing risk: the risk of outsourcing your services to others outside the company. 11. Business & strategic risk: A possible source of loss that might arise from the pursuit of an unsuccessful business plan. For example, strategic risk might arise from making poor business decisions, from the substandard execution of decisions, from inadequate resource allocation, or from a failure to respond well to changes in the business environment. 12. Reputation risk: a risk of loss resulting from damages to a firm's reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction of shareholder value, consequent to an adverse or potentially criminal event even if the company is not found guilty.
BASEL III: STRENGTHENING THE GLOBAL CAPITAL FRAMEWORK
Basel III (or the Third Basel Accord) is a global, voluntary regulatory framework on bank capital adequacy, stress testing and market liquidity risk. It was agreed upon by the members of the Basel Committee on Banking Supervision in 2010–11, and was scheduled to be introduced from 2013 until 2015; however, changes from 1 April 2013 extended implementation until 31 March 2018 and again extended to 31 March 2019. The third instalment of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the financial crisis of 2007–08. Basel III was supposed to strengthen bank capital requirements by increasing bank liquidity and decreasing bank leverage.
Key principles: * Capital reforms * Liquidity standards * Add-ons(Systemic risk and interconnectedness)

A) CAPITAL REFORMS: * Improving quality of capital base. * Phased increase of core capital fund. * Capital conversation buffer. * Monitor balance sheet leverage ratio

B) LIQUIDITY STANDARDS * Short-term: Liquidity Coverage Ratio(LCR) * Long-term: Net Stable Funding Ratio(NSFR)

C) ADD-ONS(SYSTEMIC RISK AND INTERCONNECTEDNESS) * Countercyclical buffer additional capital * Systematic risk capital structure * Capital incentives for using CCPs * Inter financial exposure higher capital

COMPONENT OF CAPITAL (as per Basel III)
Total regulatory capital will consist of the sum of the following elements: 1) Tier 1 Capital (going-concern capital) a. Common Equity Tier 1 b. Additional Tier 1 2) Tier 2 Capital (gone-concern capital)…...

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