By S.K.Mishra Asstt. General Manager Central Bank Of India Mumbai

1. OVERVIEW OF BASEL- II By S.K.Mishra Asstt. General Manager Central Bank Of India Mumbai

2. What is risk • Risks are uncertainties resulting in adverse outcome in relation to planned objective or expectations . Impact of such uncertainties could be favourable as well as unfavourable resulting in higher or lower variability in net cash flow effecting the profits.

3. Banking is a Business built on risk • Bank acts as financial intermediary between fund providers & fund users. • While dealing with Depositors’ money & creating financial assets out of that, bank has to undertake various types of risks. • To do business, Bank has to take calculated risk i.e. Risk-Reward Equilibrium by identifying, quantifying, pricing, monitoring & mitigating risks through Risk Management process

4. Valuecreatesshareholder wealth Risk creates opportunity Opportunity creates value Risk Management Philosophy It is more than compliance – it is about building value by optimizing, rather than minimizing risks Risk management is not about avoiding risk. It helps you to be aware of the risks inherent in your business and take advantage of this knowledge to gain competitive advantage and enhance shareholder value 4

5. Why Capital? • Any business entity needs Capital. Capital is the base on which business is expanded and profit is earned. • The Capital belongs to the owners or shareholders as their stakes in the business, who earn profit or dividends proportionate to their capital, subject to the availability of profits for appropriation. • Source of capital is limited & it is costly too. But scope of business growth is unlimited. • Capital has a capacity to absorb unexpected losses. • A banking business is no exception to this.

6. Capital and Loss Absorption • Any business carries RISK of losses, expected or unexpected. • Expected Losses are cushioned through the ‘Risk Based Asset Pricing Process’. • For example, a vegetable seller knows that a small portion of the vegetables may rot or may not get sold at the end of the day and accordingly adjusts his price to cover up this likely loss. As all vegetable sellers do the same, he still remains competitive in the market. • Unexpected losses are to be set off against Capital. • Larger capital base gives a cushion to withstand unexpected losses. • Thus a relationship of risk-weighted assets to capital was put in place & known as ‘Capital to Risk-weighted Asset Ratio (CRAR)’.

7. Role of Capital in Management of Risk • As per Basel accord aggregated risk determines capital needs. • Supply of capital is limited & capital has got its cost. • Whereas there is unlimited scope of business expansion & creation of assets. But supply of capital is limited to support the increasing Risk weighted assets due to business growth. • Solution is in Basel –II. • It has stipulated less requirement of capital for good quality of assets, having lesser risk weight & assets with loss provision.

8. What is Basel • BASEL IS A PLACE IN SWITZERLAND HOUSING THE HEADQUARTERS OF BANK FOR INTERNATIONAL SETTLEMENTS (BIS)

9. BANK FOR INTERNATIONAL SETTLEMENTS, BASEL, SWITZERLAND.

10. What is Bank International for International Settlements (BIS) • Established in 1930 to promote co operation among central banks of member countries. Members consist of central banks of various countries • Recommendations will help countries for convergence towards common approaches & standards • It is widely accepted as international standard of best practices in banking • The committee recommendations do not have any legal binding but are the accepted international best practices’ • The BIS has currently 55 central banks as members including India

11. BASEL - GENESIS • Herstatt Bank, Frankfurt in Germany failed on 26 June 74. Banking license was withdrawn after close of banking hours. Correspondent bank in N.Y. suspended payments in New York. Banks which were to receive $ funds did not get the same. • Settlement risk • Failure of many such banks lead to make regulators think of uniform regulation of banking sector across the globe.

12. Herstatt Bank • The Time Zone difference is 5.00 Hours and US is lagging behind

13. What is BASEL COMMITTEE - • A COMMITTEE ON BANKING REGULATIONS AND SUPERVISORY PRACTICES KNOWN AS BASEL COMMITTEE ESTABLISHED IN 1974 IS KNOWN AS BASEL COMMITTEE • BASEL COMMITTEE IDENTIFIED CAPITAL ADEQUACY AS THE CORE PRINCIPLE FOR EFFECTIVE BANKING SUPERVISION • THE OBJECTIVE OF CAPITAL ADEQUACY REQUIREMENT IS AN INSURANCE AGAINST RISK OF DEFAULT OR UNEXPECTED LOSSES • FIRST ACCORD ON CAPITAL ACCORD WAS ESTABLISHED IN 1988 • CAR at 9% OF CAPITAL

14. Basel I - Dec 1988 • Implemented in India In 1992-93 • Income Recognition • Asset Classification • CRAR • Interest not paid by the borrower not be considered as income • Classification into Sub-standard, Doubtful and Loss Assets • Their provision requirement depending on the age. • CRAR – 9% of the Capital of the Assets of the Balance Sheets • This turned the TNW of almost all Indian Banks into –ve. • Govt. had to infuse Rs.100 millions into Banks to meet • this Ratio.

15. NEED FOR Basel II • Basel I adopted a ‘One Size fits All’ approach and covered only Credit Risk and market Risk. • Risk weights are same for good and bad quality of credit. • NPAs & Standard Assets attract same quantity of capital. • Market Risk was not covered initially and the subsequent proposals treated all investments as similar. • Operational Risk was not addressed at all. • Basel I did not address the issue of supervisory control and review process. • Basel I did not address the issues of Market Discipline by way of adequate and quality disclosures by banks. • Introduction of new financial products

16. Objectives of Basel-II For strong , sound and stability of international banking systems More risk sensitive New paradigm for allocating regulatory capital

17. Features of BASEL-II 1988 Accord - talked about mainly on Credit Risk 1996 BCBS guidelines on Market Risk was introduced 2008/2009 Basel II Accord – Introduces Operational Risk. Basel Committee experts say – Bank’s should have their own capital to cover all the potential losses. It specifies how much cushion/capital a bank should have against the risk involved with the Credit. (Capital Charge calculation) market risk and Operational risk

18. BASEL II IMPLEMENTATION IN INDIA All Commercial banks in India (except Local Area Banks and Regional Rural Banks) shall adopt: Standardized Approach for Credit Risk Basic Indicator Approach for Operational Risk Standardized Duration Approach for Market Risk On or before the following dates – 31.03.2008 - for those Indian banks having overseas presence and all foreign banks operating in India. 31.03.2009 - all other Banks

19. Three pillars of the Basel II framework Minimum Capital Requirements Supervisory Review Process Market Discipline • Credit risk • Operational risk • Market risk • Bank’s own capital strategy • Supervisor’s review • Enhanced disclosure

20. Pillar I – Minimum Capital Requirements The new Accord maintains the current definition of total capital and the minimum 8% requirement* Total capital = Bank’s capital ratio (minimum 9%) Credit risk + Market risk + Operational risk Total capital = Tier 1 + Tier 2 Tier 1: Shareholders’ equity + disclosed reserves Tier 2: Supplementary capital (e.g. undisclosed reserves, provisions) Total Capital Credit Risk The risk of loss arising from default by a creditor or counterparty Market Risk The risk of losses in trading positions when prices move adversely Operational Risk The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events * The revisions affect the denominator of the capital ratio - with more sophisticated measures for credit risk, and introducing an explicit capital charge for operational risk

22. Capital Funds Includes: TIER I CAPITAL: This one can absorb losses without a bank being required to cease operation. This is Core Capital. TIER II CAPITAL: This can absorb losses in the event of a winding up, and also provides lesser degree of protection to depositors.

23. Limit to raise Tier II capital Banks are not allowed to raise Tier II Capital more than Tier I. In other words Tier II capital is capped at 100%of Tier I capital Within Tier II capital banks can raise subordinated debts upto the maximum of 50 % of Tier I capital

24. Capital to Risk Weighted Assets Ratio This is the ratio that the Capital Fund bears with the Total Risk Weighted Assets of the Bank. Capital fund is the sum total of Tier I and Tier II capital. Risk Weighted Assets is calculated by converting the assets on a specified date/ balance sheet date (on which that CRAR has to be calculated) at a prescribed risk weight factors for various categories.

25. BASLE II CLAIMS OF DOMESTIC SOVEREIGNS • Both Fund based & Non-Fund based claims on Govt. - 0% RW • Central Govt. Guaranteed Claims will also attract - 0% RW • Investment in State Govt. Securities - 0% RW • State Govt. Guaranteed Claims - 20% RW • Claims on RBI, DICGC & CGTSME - 0% RW • Claims on ECGC - 20% RW • The above RW will be applicable as long as they are classified as Standard/Performing Assets.

29. Risk Management Risk Identification would mean recognition of all possible risks in the particular business in question & examining its impact on cash flow, then prioritize them to manage at Micro or Macro level. and begins with 1.Risk Identification 2.Risk Measurement 3.Risk Monitoring & Control 4.Risk Mitigation

30. Risk Identification Type of Risk Market OUR FOCUS BASEL I Credit Operational

31. Credit Risk What is a credit risk and when does it arise A credit risk arises on account of default by a borrower in repayment of interest and/or Installments

32. Credit Risk - Framework What are the risk Which, when and how much to accept that results in improving bottom line How can we monitor and control Can we reduce… how?

33. Credit Risk – Organisational structure Board of Directors Risk Management Committee Credit Policy Committee Credit Risk management Department

34. Credit Risk - Types Portfolio Risk - Concentration Risk - Systematic Transaction - Default - Down grade

35. Credit Risk - Measurement Rating Model Quantification

36. Manage Portfolio quality Quantitative ceiling Evaluation of rating wise distribution Industry / sector wise monitoring Target for probable defaults / provisioning Rapid port folio review Discriminatory time schedule for review

37. Credit Risk Management Instruments Appraisal process Risk analysis Credit Audit / Loan review Monitoring Guidelines Approving authority/ Delegation of power Credit appraisal Prudential limits Rating standards and Bench marks Risk pricing

38. Credit Risk Mitigation Securitisation Credit Derivatives Credit default swaps Credit Linked notes Total return swaps

42. RISK MONITORING & CONTROL • Organizational Structure • Comprehensive Risk Management Approach • Policy Adoption at the Corporate level • Guidelines • Strong MIS • Well laid-out Procedures • Periodical reviews and Evaluations • Audit reports

43. Categories of Exposure • Exposures in five categories because of different risk characteristics • DOMESTIC SOVEREIGNS • BANKS • CORPORATES • RETAIL PORTFOLIOS • NPA

44. CLAIMS ON BANKS • Claims on Scheduled Banks, which comply with the minimum CRAR prescription of RBI • 20% • Claims on Non-Scheduled Banks which comply with the minimum CRAR prescription of RBI • 100%

45. BASLE II CLAIMS OF DOMESTIC SOVEREIGNS • Both Fund based & Non-Fund based claims on Govt. - 0% RW • Central Govt. Guaranteed Claims will also attract - 0% RW • Investment in State Govt. Securities - 0% RW • State Govt. Guaranteed Claims - 20% RW • Claims on RBI, DICGC & CGTSME - 0% RW • Claims on ECGC - 20% RW • The above RW will be applicable as long as they are classified as Standard/Performing Assets.

46. Eligible financial collateral Cash EQUIVALENT, CDs, Counter party deposit with lending Bank. Gold – bullion & jewellery (99.99 purity) Central & State Govt. securities , KVP, NSC, LIC policy Debt securities rated by recognized credit rating agency PSEs – at least BB rating Other entities – at least A ST debt instruments – at least P2+/A3/PL3/F3 Mutual Fund units – daily NAV to be available on public domain

47. Retail Portfolio • Retail Category - The maximum aggregated Retail exposure to one counterparty should not exceed the absolute threshold limit of Rs. 5 Crores. (If the turnover is more than 50 Crores it will be classified as Corporate • Regulatory retail should not be confused with our Retail lending schemes • No Rating is required • A flat rate of 75% standard Risk Weight will be applicable. • With following EXCEPTIONS – • Real Estate Exposure • Housing Loan • Consumer Credit, NBFC and IPO Finance • Staff Loans

48. LTV - LOAN TO VALUE RATIO SHOULD NOT EXCEED 75% WHERE LTV =Total Outstanding ( principal + Int.+ Other Charges) ----------------------------------------------------------- Realizable Value of the property mortgaged

49. Corporate Exposure to a party irrespective of constitution if the following conditions are satisfied The total Exposure sanctioned limit or outstanding (whichever is higher ) above 5 Crores Average turnover for three years is more than RS 50 Crores ALL CORPORATE TO BE RATED BY AN EXTERNAL AGENCY IDENTIFIED BY RBI RISK WEIGHT WILL BE AS PER THE RATING

50. CAPITAL CHARGE FOR CREDIT RISK • Standardized Approach - Rating assigned by the eligible • external credit rating agencies will support the measure of credit Risk. • Reserve Bank of India has identified 4 such domestic external Credit • rating Agencies under the revised Framework. These are : • CARE • CRISIL • FITCH • ICRA