RISK

MANAGEMENT
& BASEL II & III
 RISK MANAGEMENT
• Risk Management
• Risk Management Function
• Risk Management Structure
• Loan Review Mechanism

• Types of Risks
• Credit Risk
• Market risk
• Operational risk
• BASEL I
• BASEL II
• BASEL III
 RISK MANAGEMENT
FUNCTION
• Organization Structure
• Comprehensive Risk Measurement Approach
• Risk management policies approved by board
• Guidelines & other parameters used to govern risk taking, including
detailed structure of prudential limit
• Strong MIS for reporting, monitoring & controlling risk
• Well laid out procedures, effective control & Comprehensive risk
reporting framework
• Separate Risk Management Organization/framework independent of
operational departments and with clear delineation of level of
responsibility for management of risk
• Periodical review and evaluation
 RISK MANAGEMENT
STRUCTURE
• Setting Risk Limits after assessing its risks & risk Bearing Capacity.
• Independent Risk management team at Organization level.
• Core Functions of Risk Management Team:
• Identify, monitor & measure the risk profile of bank
• Developing Policies and Procedures
• Verifies models that are used for pricing complex products
• Review the risk models and identifying new risks
LOAN REVIEW MECHANISM
(LRM)
• Effective tool for Constant evaluation of quality of loan book &for bringing
about qualitative improvements in credit administration
• Generally used for Large Value Accounts
• Objectives:
• Promptly identify loans which have develop credit weaknesses &
initiate timely action.
• Evaluate portfolio quality and isolate potential problem areas
• Provide information for determining adequacy of loan loss provision
• Asses the adherence to loan policies & procedures, and monitor
compliance
• Provide information on credit administration including credit sanction
process, risk evaluation & post-sanction follow up to top management
 CREDIT RISK
• Definition: The possibility of losses associated with diminutio0n in
the credit quality of borrowers.

• Losses stems from outright default due to inability or unwillingness

of borrower to meet commitments in relation to lending, trading,
settlement and other financial TXN.

• Losses result from reduction in portfolio value arising from actual or

perceived deterioration in credit quality.

• Credit Risk emanates from bank’s dealing with individual, corporate,

bank, financial institutions or sovereign.
 CREDIT RISK
• Credit risk may take following forms:

• Direct Lending

• Guarantees or Letter of Credit

• Treasury Operations

• Securities Trading Businesses

• Cross-border Exposure

• Credit Risk management encompasses identification, measurement,

monitoring and control of the credit risk exposure.
NON PERFORMING ASSETS
(NPA)
• An asset, including a leased asset,
becomes non-performing when it ceases to
generate income for the bank.
• A ‘non-performing asset’ (NPA) was
defined as a credit facility in respect of
which the interest and/ or instalment of
principal has remained ‘past due’ for a
specified period of time.
 NPA CONDITIONS
• Accordingly, with effect from March 31, 2004, a non-
performing asset (NPA) shall be a loan or an advance where;
Interest and/ or instalment of principal remain overdue for
a period of more than 90 days in respect of a term loan,
The account remains ‘out of order’ for a period of more than
90 days, in respect of an Overdraft/Cash Credit (OD/CC),
The bill remains overdue for a period of more than 90 days
in the case of bills purchased and discounted,
Interest and/or instalment of principal remains overdue for
two harvest seasons but for a period not exceeding two half
years in the case of an advance granted for agricultural
purposes
Any amount to be received remains overdue for a period of
more than 90 days in respect of other accounts
• ‘Out of Order’ status
• An account should be treated as 'out of order' if the outstanding
balance remains continuously in excess of the sanctioned
limit/drawing power.
• In cases where the outstanding balance in the principal operating
account is less than the sanctioned limit/drawing power, but
there are no credits continuously for six months as on the date of
Balance Sheet or credits are not enough to cover the interest
debited during the same period, these accounts should be treated
as 'out of order'.
• ‘Overdue’
• Any amount due to the bank under any credit facility is ‘overdue’
if it is not paid on the due date fixed by the bank.
 ASSET CLASSIFICATION
• Categories of NPAs
• Banks are required to classify non-performing
assets further into the following three categories
based on the period for which the asset has
remained non-performing :
 Standard assets
 Sub-standard Assets
 Doubtful Assets
 Loss Assets
 SUB-STANDARD ASSETS
• A substandard asset would be one, which has remained
NPA for a period less than or equal to 12 months.
• In such cases, the current net worth of the borrower/
guarantor or the current market value of the security
charged is not enough to ensure recovery of the dues to
the banks in full.
• In other words, such an asset will have well defined
credit weaknesses that jeopardise the liquidation of the
debt and are characterised by the distinct possibility that
the banks will sustain some loss, if deficiencies are not
corrected.
 DOUBTFUL ASSETS
• An asset would be classified as doubtful if it has
remained in the substandard category for a
period of more than 12 months up to 36 months.
• A loan classified as doubtful has all the
weaknesses inherent in assets that were
classified as sub-standard, with the added
characteristic that the weaknesses make
collection or liquidation in full, – on the basis of
currently known facts, conditions and values –
highly questionable and improbable.
 LOSS ASSETS
• An asset that is an NPA for a period of more than
36 months is treated as a lost asset.
• Such asset has been identified by the bank or
internal or external auditors or by the RBI
inspection but the amount has not been written
off wholly.
• In other words, such an asset is considered
uncollectible.
 MARKET RISK
• Market risk arising from adverse changes in market variables, such as
interest rate, foreign exchange rate, equity price and commodity price.

• Forms of Market risk:

• Liquidity risk

• Interest rate risk

• Foreign exchange rate risk

• Equity price risk

• Commodity price risk.

 OPERATIONAL RISK
• Definition: The risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events.
• The most important type of Operational Risk involves break down in
internal controls and corporate governance.
• Such breakdown can lead to financial loss through error, fraud or
failure to perform in timely manner
• Operational Risk includes Legal risk however excludes Strategic &
Reputational risk.
 BASEL ACCORDS
• Basel is a city in Switzerland which is also the
headquarters of Bureau of International Settlement
(BIS).
• BIS fosters co-operation among central banks with a
common goal of financial stability and common
standards of banking regulations.
• Basel guidelines refer to broad supervisory
standards formulated by this group of central banks-
called the Basel Committee on Banking Supervision
(BCBS).
 Basel Committee on
Banking Supervision: BCBS
• The collapse in 1974 of Bankhaus Herstatt in Germany and of the
Franklin National Bank in the US; prompted the G10 central bank
Governors established a Committee on Banking Regulations and
Supervisory Practices, later renamed as the Basel Committee on Banking
Supervision.
• BCBS formed in the end of 1974 by the central bank governors of the
Group of G10 countries.
• The Committee's members come from Belgium, Canada, France,
Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden,
Switzerland, United Kingdom and United States.
• 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.
 BASEL COMMITTEE ON
BANKING SUPERVISION: BCBS
• 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.
 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%
 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.
 CAPITAL ADEQUACY
FRAMEWORK
• 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.
OBJECTIVES OF BASEL I
• 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.
 BASEL II
THE NEW CAPITAL FRAMEWORK
• 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
 PILLAR I
MINIMUM CAPITAL
REQUIREMENT
• 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.
 PILLAR II
SUPERVISORY REVIEW
• 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 bank’s assessments
• Banks are expected to operate above minimum
• Supervisor’s intervention if capital is not sufficient
 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
• In principle, disclosure of data on semi-annual
basis
 BASEL III
• In 2010, Basel III guidelines were released.
These guidelines were introduced in response to
the financial crisis of 2008.
• A need was felt to further strengthen the system
as banks in the developed economies were
under-capitalized, over-leveraged and had a
greater reliance on short-term funding.
• Also the quantity and quality of capital under
Basel II were deemed insufficient to contain any
further risk.
 OBJECTIVES OF BASEL III
• Improve the banking sector's ability to absorb shocks
arising from financial and economic stress, whatever
the source
• Improve risk management and governance
• Strengthen banks' transparency and disclosures.
• Basel III guidelines are aimed at to improve the ability
of banks to withstand periods of economic and financial
stress as the new guidelines are more stringent than
the earlier requirements for capital and liquidity in the
banking sector.