RISK MANAGEMENT PRESENTATION ON CREDIT RISK AND MARKET RISKByS.D.BARGIR, Joint Director, IIBF

Risk may be defined as “ exposure to uncertainty”

favourable or unfavourable outcomes

aims at mitigating the loss managing risk rather than on

eliminating it

Risk management is a four steps process

Identifying Measuring ( quantifying)Managing controlling, monitoring and

reviewing

Three generic categories of risk

Credit risk

Market risk

Operational risk

Credit Risk

credit risk means default of the borrower or deterioration of borrowers’ credit quality.

Market Risk

arising from movement in market prices

Interest Rate Risk, Exchange Rate Risk, Commodities Price risk Equity Price Risk.

Operational Risk

loss resulting from inadequate or failed

internal processes People systems or external events.

Credit Riskdefaults take various forms

Direct Lending:Loan amount (Principal as well as interest) will not be paid

Guarantees/ Letter of Credit etc.Funds will not be forthcoming upon crystallization of liability

Credit Riskdefaults take various forms Treasury Products payment due from

the counter parties either stops or not forthcoming

Securities Trading Settlement will not be effected

Cross boarder exposure: free transfer of currency is restricted or comes to an end.

credit risk, consists of three risks

Default risk Exposure risk Recovery risk

Default risk is the probability of an event of default depends upon credit standing of the

counter party. default probability cannot be measured

directly. guidance from historical statistics on large

sample over long period of time. bank faces difficulty in obtaining accurate

historical data.

Exposure risk uncertainty associated with future

amounts credit lines- repayment schedule-

exposure risk small other lines of credit -OD, project

financing , guarantees etc- risk cannot be predicted accurately

Recovery risk:

recoveries in the event of default not predictable

depend upon type of default availability of collaterals, third party

guarantees circumstances surrounding the

default.

Expected Losses & Unexpected Losses EL depends upon default

probability(PD), Loss given default (LGD)& exposure at risk (EAD)

EL = PD x LGD x EAD Unexpected losses (UL) is the

uncertainty around EL and it is Standard deviation of EL.

challenges faced by banks in r/o EL aggregation of the risk-related

information to assess the PD, LGD and EAD

implementation of a risk rating system that can correctly model these parameters which is statistically valid.

BASEL

Basel Committee on Banking supervision (BCBS) under the auspices of Bank for International Settlements (BIS)

Established in 1975 by group of 10 countries

Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

Basel II-Implementation in India

with effect from March, 31, 2007 by commercial banks.

90 commercial Banks in India 100 countries

Basel II capital requirements more risk sensitive directly related to the credit rating of

each counter-party instead of counter-party category

capital for credit and market risk but also for operational risk (OR)

where warranted for interest rate risks, credit concentration risks, liquidity risks

SME sector

BASEL II RESTS ON THE THREE PILLARS, Pillar I Minimum Capital

Requirements Pillar 2 Supervisory Review Process Pillar 3 Market Discipline

each pillar is as important as the other one

Pillar 1 – Minimum Capital Requirements

menu of approaches for computing capital adequacy

freedom to choose the approach minimum, the Standardized Approach for

credit risk Basic Indicator Approach for operational

risk standardised Approach or Internal Risk

Measurement Models approach for market risk

Various ApproachesCredit Risk Market Risk Operational

RiskStandardized Approach(SA)

Standardized Approach(SA)

Basic Indicator Approach

Basic-Internal Risk Based(IRB)

Internal Risk Measurement Model

Standardized Approach(SA)

Advanced IRB The internal measurement approach

Pillar 2- Supervisory Review encourage to adopt better risk

management techniques intervene to mandate a higher capital

requirement more inclusive –besides CR,MR,OR credit

concentration risk Interest rate risk in banking book, Liquidity risk, Business risk, Strategic risk and Reputation risk.

Takes into account Business cycle effects too

RISK BASED SUPERVISION (RBS)Business Risk Factors1. Capital, 2. Credit Risk, 3. Market Risk, 4. Earnings risk, 5. Liquidity Risk, 6. Business Strategy

and Environment Risk,

7. Operational Risk 8. Group Risk.

Control Risk Factors1. Internal Controls

Risk, 2. Organisation risk, 3. Management Risk 4. Compliance Risk.

Pillar 3- Market Discipline disclosures to enhance market

discipline Monitoring by markets- other banks,

customers, depositors, subordinated debt instrument holders, analysts & rating agencies

disclosure policy approved by Board financial penalty, for non-compliance

INITIATIVES BY RBI each bank has suitable risk management

framework and the expected level of capital introduced RBS In 23 banks on a pilot basis encouraged all banks to operationalise CAAP expanded the area of disclosures encouraged some banks to migrate from SA

to IRB approaches  

Standardised Approach Different categories of obligors Corporates Sovereign Bank Retail Real Estate Specialized Lending

Issues emerging out of Basel II higher capital requirements improved IT architectures data issues consolidation capacity building external ratings use of national discretion validating the concept of economic

capital

Capital requirements for CORPORATES in Basel II

credit rating

AAA to AA

A+ to A-

BBB+ to BB-

Below BB-

Unrated

RW Basel I

100% 100% 100% 100% 100%

Capital-Basel I

8% 8% 8% 8% 8%

RW Basel II

20% 50% 100% 150% 100%

Capital-Basel II

1.6% 4% 8% 12% 8%

Capital requirements for SOVEREIGN in Basel II

AAA to AA

A+ to A-

BBB+ to BB-

BB to BB-

Below BB-

Unrated

100% 100% 100% 100% 100% 100%

8% 8% 8% 8% 8% 8%

0 20% 50% 100% 150% 100%

0 1.6% 4% 8% 12% 8%

Capital requirements for BANKS in Basel II

AAA to AA

A+ to A-

BBB+ to BB-

BB to BB-

Below BB-

Unrated

100% 100% 100% 100% 100% 100%

8% 8% 8% 8% 8% 8%

20% 50% 100% 100% 150% 100%

1.6% 4% 8% 12% 8% 8%

Capital requirements for BANKS in Basel II

AAA to AA

A+ to A-

BBB+ to BB-

BB to BB-

Below BB-

Unrated

100% 100% 100% 100% 100% 100%

8% 8% 8% 8% 8% 8%

20% 50% 100% 100% 150% 100%

1.6% 4% 8% 12% 8% 8%

Capital requirements for RETAIL in Basel IIRETAIL INDIVIDUAL

OR SMALL BUSINESS

DEFAULT

RW under Basel I

100% 100%

RW under Basel II

75% From 150% to 50%

Capital under Basel II

6% 4% to 12%

Capital requirements for REAL ESTATE in Basel IIRETAILRW BASEL I

RESIDENTIAL50%

COMMERCIAL100%

Capital under Basel I

4% 8%

RW under Basel II

35% 100%

Capital under Basel II

2.7% 8%

SPECIALISED LENDDINGPROJECT FINANCECOMMODITIES,COM. REAL ESTATERW UNDER BASEL I 100%

CAPITAL Basel I 8%

RW UNDER BASEL II 100%

CAPITAL BASEL II 8%

Assessing exposure customer wise and facility wise Probability of Default (PD) - the

probability that a specific customer will default within the next 12 months.

Loss Given Default (LGD) - the percentage of each credit facility that will be lost if the customer defaults.

Exposure at Default (EAD) - the expected exposure for each credit facility in the event of a default.

MARKET RISKMarket risk takes the form of interest rate risk, exchange rate risk, commodity price risk and equity price risk , major risk presently faced by banks in India are interest rate ,exchange rate and liquidity risk.

MARKET RISK-CONTINUED Basel-I focused only on credit risk

excluding the market risk Risk brought vide amendments in 1996 usually measured with a Value-at-Risk

method and on daily basis capital charge should be either the

previous day’s VaR or three times the average of the daily VaR for the preceding 60 working days.

Stipulations of RBI Assign additional risk weight of 2.5% on

the entire investment portfolio Assign risk weight of 100% on the open

position limit on foreign exchange and gold

Build investment fluctuation reserve up to a minimum of 5% of the investment held in ‘Held for Trading’(HFT) and ‘available for sale’(AFS) category in their investment portfolio

Linking risk to capital- single metric Risk measurement focuses on unexpected

losses Different business activities lead to

various unexpected losses These different risks must be measured

individually and aggregated to a single risk metric, both by business line and across the bank as a whole

WINNING FORMULA

Overall risk should always be lower than overall economic capital

.