CAIIB BFM Unit 19 - Risk Management and Control

Risk Management and Control

Market risk is controlled by implementing the business policies and setting of market risk limits or controlling through economic measures with the objective of attaining higher RAROC. Risk is managed by the following:

1. Limits and Triggers
2. Risk Monitoring
3. Models of Analyses.

Calculation of Capital Charge of Market Risk
The Basel Committee has two approaches for calculation of Capital Charge on Market Risk as under:

1. Standardized approach
2. Internal Risk Management approach

Under Standardized approach, there are two methods: Maturity method and duration method. RBI has decided to adopt Standardization duration method to arrive at capital charge on the basis of investment rating as under:

Investment rating Capital Required
AAA to AA 0%

A+ to BBB (Residual term to maturity)
Less than 6 M 0.25%
Less than 24M 1.00%
More than 24 M 1.60%
Other Investments 8.00%

How to Calculate RWAs, if Capital Charge is given:
RWAs for Market Risk = Capital Charge / 0.09 (If required CAR is 9%)

Other Risks and Capital Requirement

Other Risks like Liquidity Risks, Interest Rate Risk, Strategic Risk, Reputational Risks and Systemic Risks are not taken care of while calculating Capital Adequacy in banks.

Pillar – II – Supervisory Review Process (SRP)
SRP has two issues:
1. To ensure that bank is having adequate capital.
2. To encourage banks to use better techniques to mitigate risks.

SRP concentrates on 3 main areas:
• Risks not fully captured under Pillar -1 i.e. Interest Rate Risks, Credit concentration Risks, Liquidity Risk, Settlement Risks, Reputational Risks and Strategic Risks.
• Risks not at all taken care of in Pillar -1.
• External Factors.

This pillar ensures that the banks have adequate capital. This process also ensures that the bank managements develop Internal risk capital assessment process and set capital targets commensurate with bank’s risk profile and capital environment. Central Bank also ensures through supervisory measures that each bank maintains required CRAR and components of capital i.e. Tier –I & Tier –II are in accordance with BASEL-II norms. RBIA and other internal inspection processes are the important tools of bank’s supervisory techniques.

Every Bank will prepare ICAAP (Internal Credit Adequacy Assessment Plan) on solo basis which will comprise of functions of measuring and identifying Risks, Maintaining appropriate level of Capital and Developing suitable Risk mitigation techniques.

Pillar – III – Market Discipline

Market discipline is complete disclosure and transparency in the balance sheet and all the financial statements of the bank. The disclosure is required in respect of the following:

• Capital structure.
• Components of Tier –I and Tier –II Capital
• Bank’s approach to assess capital adequacy
• Assessment of Credit Risks, Market Risk and Operational Risk.
• Credit Aspects like Asset Classification, Net NPA ratios, Movement of NPAs and Provisioning.

Frequency of Disclosure
• Banks with Capital funds of Rs. 100 crore or more will make interim Disclosures on Quantitative aspects on standalone basis on their respective websites.
• Larger banks with Capital Funds of Rs. 500 crore or more will disclose Tier-I capital, Total Capital, CAR on Quarterly basis on website.

Risk Weight on NPAs
a) Risk weight on NPAs net of specific provision will be calculated as under:
When provision is less than 20% of NPA o/s ---- 150%
When provision is at least 20% of NPA o/s ---- 100%
When provision is at least 50% of NPA o/s ---- 50%

Category                                 Provision Rate           Risk Weight
Substandard (Secured)            15%                             150%
Substandard (Unsecured)       25%                             100%
Doubtful (DI) (Secured)           25%                             100%
Doubtful (DI) (Un-Secured)     100%                           50%
Doubtful (D2) (Secured)          40%                             100%
Doubtful (D3) (Secured)          100%                           50%
Doubtful (D2)(Un-Secured)     100%                           50%

Off-balance sheet items
Off-balance sheet items have been bifurcated as follows:
i) Non-market related off-balance sheet items
ii) Market related off-balance sheet items

There is two-step process for the purpose of calculating risk weighted assets in respect of off-balance sheet items:
a) The notional amount of the transaction is converted into a credit equivalent factor by multiplying the amount by the specified Credit Conversion Factor (CCF)

b) The resulting credit equivalent amount is then multiplied by the risk weight applicable to the counter party or to the purpose for which the bank has extended finance or the type of asset whichever is higher.

Where the off-balance sheet item is secured by eligible collateral or guarantee, the credit risk mitigation guidelines will be applied.

Non-market related off-balance sheet items:
Off balance sheet items like direct credit substitutes, trade and performance related contingent items and commitments with certain draw downs are classified under Non-market related off-balance sheet items. The credit equivalent amount is determined by multiplying the contracted amount of that particular transaction by the relevant CCF.

Non-market related off-balance sheet items also include undrawn or partially undrawn fund based and non-fund based facilities, which are not unconditionally cancellable. The amount of undrawn commitment is to be included in calculating the off-balance sheet items. Non-market related exposure is the maximum unused portion of the commitment that could be drawn during the remaining period of maturity. In case of term loan with respect to large project to be drawn in stages, undrawn portion shall be calculated with respect of the running stage only.