Compliance & Risk Management Final

["500 The price volatility makes it imperative for an entity to manage the impact of commodity price fluctuations across its value chain to effectively manage its financial performance and profitability. Commodity futures markets will provide indications of the impending risks. 1.5.3 Operational Risk Operational risk is the risk of loss resulting from inadequate or failed processes or systems or due to external events. Operational risk is inherent in the bank\u2019s activities and can manifest itself in various ways. In essence, operational risk is an \u2018event risk\u2019. There is a wide range of events potentially triggering losses at various levels. a.\tPeople. b.\tProcesses. c.\tTechnical. d.\t Information technology. People risk designates human errors, lack of expertise and fraud, including lack of compliance with existing procedures and policies. Process risk scope includes: a.\t Inadequate procedures and controls for reporting, monitoring and decision-making. b.\t Inadequate procedures on processing information, such as errors in booking transactions and failure to scrutinize legal documentation. c.\t Organizational deficiencies. d.\t Risk surveillance and excess limits: management deficiencies in risk monitoring, such as not providing the right incentives to report risks, or not abiding by the procedures and policies in force. e.\t Errors in the recording process of transactions. f.\t The technical deficiencies of the information system or the risk measures. Technical risks relate to model errors, implementation and the absence of adequate tools for measuring risks. Technology risks relate to deficiencies of the information system and system failure. These events could result in financial losses, litigation, and regulatory penalties as well as damage to the firms. Operational risk can particularly aggravate due to the malfunctioning of internal process and monitoring mechanism. The risk is two pronged. At the technical level, it exists due to","501 deficiency or malfunctioning of information system. At the operational, organizational level, lacunae in monitoring and absence of rules and regulations are the reasons for operational risk. As such, operational risk is the result of various human and technical failures \/ errors. Robust supervision and control system, training of personnel, regular internal and independent audits, development of personnel policies with ethical codes, etc. are the strategies adopted to address operational risk at operational level.At the technology level, arrangement of password and other security measures, creation of succession for technology staff, formulation and testing of disaster recovery plans prove to be useful risk mitigant measures. The risks covered under the first pillar of Basel II Capital Accord include \u2018minimum capital adequacy ratio of 8 percent, that covers range of risks, more importantly the credit risk, market risk, and operational risk. Nevertheless, pillar 2 demands that banks have sufficient capital to cover all types of risks. Other types of risks include. 1.5.4 Model Risk The use of models invariably presents model risk, which is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Model risk can lead to financial loss, poor business and strategic decision making, or damage to a bank\u2019s reputation. Banks rely heavily on quantitative analysis and models in most aspects of financial decision making. They routinely use models for a broad range of activities, including underwriting credits; valuing exposures, instruments, and positions; measuring risk; managing and safeguarding client assets; determining capital and reserve adequacy; and many other activities. Any mathematical models developed on the basis of algorithms may inherently contain some risks in using them and taking decisions based on their outcome. Hence, the risk managers have to be mindful about such risks and make corrections to make it more appropriate. Model risk occurs primarily for two reasons: a.\t The model may have fundamental errors and may produce inaccurate outputs when viewed against the design objective and intended business uses. b.\t The model may be used incorrectly or inappropriately. Even a fundamentally sound model producing accurate outputs consistent with the design objective of the model may exhibit high model risk if it is misapplied or misused. 1.5.5 Liquidity Risk Liquidity risk is the risk to earnings or capital arising from a bank\u2019s inability to meet its cash and collateral obligations when they come due, without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources.","502 Liquidity risk also arises from the bank\u2019s failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value. It arises from the maturity transformation function of converting short term liability into a long- term asset. The demand for liquid fund arises from the following sources: a.\t To make payment of withdrawals of deposits, borrowing and other liabilities, b.\t To finance new loans and advances, c.\t To settle claims against the bank, d.\t To honour contingent liabilities that devolve The liquidity requirement of a bank changes constantly and therefore the volume of liquid assets required for maintaining operational efficiency also changes on a dynamic basis. The management of liquidity risk is often tailored to the bank\u2019s asset and liability structure, back- up funding plan and stress scenarios to measure the liquidity position under stressed situation. Too little liquidity can threaten a bank\u2019s operation in the short term and too much liquid assets may adversely impact long term profitability. It is noteworthy to mention that liquid assets are typically less profitable. 1.5.6 Legal Risks Legal risk is the risk of financial loss that arises from the uncertainty of outcomes of legal suits filed by the bank in a court of law or legal actions taken against it by the third parties. Legal risk arises due to errors in the application or interpretation of laws or omissions to perform obligations under the laws. Banking transactions involve contracts between banks and customers, which can become unenforceable due to deficient documentation or invalid charges on collaterals. The customer can accuse banks of negligence in handling their business or in taking unilateral actions that have been detrimental to his business. With rise in legal awareness in the community, banks may get exposed to various kinds of protracted legal litigations involving cost and time. Banks should consciously keep legal provisions in mind while conducting banking businesses. Legal risk arises in cross border transactions when applicable laws of other countries are unknown or unclear or when jurisdictional ambiguities arise in the identification of responsibilities of different national authorities. Regulatory risk refers to the adverse impact of the existing or new rules or statutes. Generally, the loss is considered as potential and not actual due to a variety of possible regulatory actions. 1.5.7 Reputation Risk Reputation risk is the risk to earnings or capital arising from negative public opinion. This affects the institution\u2019s ability to establish new relationships or services or continue servicing existing relationships. This risk can expose the institution to litigation, financial loss, or damage its reputation. Reputation risk exposure is present throughout the organization and","503 that is why banks have the responsibility to exercise abundant caution in dealing with their customers and community. This risk is present in activities such as asset management and agency transactions. The speed and scope of internet communications magnify the risks or enhance the benefits of a reputation risk. It may result from or create credit, liquidity, market, and legal risk. Bad customer service, inappropriate behavior of the staff, and delay in decisions create a bad image of the bank among the public and hamper development of business. The management\u2019s failure to be cognizant of the events that damage the bank\u2019s reputation and to take remedial actions in time may lead to erosion of its standing in the market. 1.5.8 Solvency Risk Solvency risk is the risk of being unable to absorb losses, generated by all types of risks, with the available capital. Solvency risk is equivalent to the default risk of the bank. Solvency is a joint outcome of available capital and total risk exposures. The basic principle of \u2018capital adequacy\u2019, promoted by regulators, is to maintain the minimum level of capital which allows a bank to sustain the potential losses arising from its operation. The implementation of this principle requires: a.\t Assessing all material risks to make them comparable to the capital base of a bank b.\t Adjusting capital to a level to match the risk profile 1.5.9 Compliance Risk Compliance risk is the risk to earnings or capital arising from violations of, or non- conformance with, laws, rules, regulations, prescribed practices, or ethical standards. It also arises in situations where the laws or rules governing certain bank products or activities of the bank\u2019s clients may be ambiguous or untested. It also exposes the institution to fines, civil money penalties, payment of damages, and the voiding of contracts. This risk can lead to a diminished reputation, reduced franchise value, limited business opportunities, lessened expansion potential, and lack of contract enforceability. Compliance risk is often overlooked as it blends into operational risk and transaction processing. A portion of this risk is sometimes referred to as legal risk. This is not limited solely to the risk from failure to comply with consumer protection laws; it encompasses all laws as well as prudent ethical standards and contractual obligations. It also includes exposure to litigation from all aspects of banking, traditional and non- traditional. 1.5.10 Climate-Related Risk Climate risk refers to the risk of financial loss associated with consequences, likelihoods and responses to the impacts of climate change. Banks and the banking system are exposed to climate change through macro- and microeconomic transmission channels that arise from two distinct types of climate risk drivers.","504 First, they may suffer from the economic costs and financial losses resulting from the increasing severity and frequency of physical climate risk drivers. Second, as economies seek to reduce carbon dioxide emissions, which make up the vast majority of greenhouse gas (GHG) emissions, these efforts generate transition risk drivers. These arise through changes in government policies, technological developments, or investor and consumer sentiment. They may also generate significant costs and losses for banks and the banking system. The impact of these drivers on banks can be reflected in traditional risk categories. For example, credit risk increases if climate risk drivers reduce borrowers\u2019 ability to repay and service debt (income effect) or banks\u2019 ability to fully recover the value of a loan in the event of default (wealth effect). 1.5.11 Payment and Settlement Risk Safe, secure and efficient payment systems are critical to the effective functioning of the financial systems. Payment systems are at the centre of both the domestic and international financial infrastructure. They are the means by which financial institutions transfer funds among themselves on their own behalf or on behalf of their customers. While they operate virtually unnoticed, they are essential to the smooth functioning of a modern market-based economy If these critical functions break down, it gives rise to multiple risks associated with and dependent on the payments systems: Credit risk: the risk that a participant in the system will be unable to fully meet its financial obligations within the system when due or at any time in the future. Liquidity risk: the risk that a participant in the system will have insufficient funds to meet financial obligations within the system when due, although it may be able to do so at some time in the future. Legal risk: the risk that a poor legal frame-work or legal uncertainties will cause or exacerbate credit or liquidity risks. Operational risk: the risk that operational factors such as technical malfunctions or operational mistakes will cause or exacerbate credit or liquidity risks. Systemic risk: These risks can have systemic consequences. That is, the inability of a system participant to meet its obligations when due, or a disruption in the system itself, could result","505 in the inability of other participants or of financial institutions in other parts of the financial system to meet their obligations when due. Such a failure could cause widespread liquidity or credit problems, which could threaten the stability of the financial system. 1.6 NON-FINANCIAL RISKS Non-financial risks which banks are exposed to are: business risk and strategic risk. The description of each of them is given below: 1.6.1 Business Risk Business risk refers to any event or circumstance that has the potential to prevent a bank from achieving its business goals or objectives. Business risk can be internal (such as your strategy) or external (such as global economy). These are the risks that the bank willingly assumes to create a competitive advantage and add value to shareholders. Business or operating risk pertains to the product market in which the bank operates, and includes technological innovations, marketing and product design. Products designed by the bank may be made superfluous by technological advancement.An example would be door-to- door deposit marketing that could prove very costly in comparison with internet driven banking. A bank with a pulse on the market and driven by technology as well as a high degree of customer focus, could be relatively protected against this risk. 1.6.2 Strategic Risk Strategic risk is the risk to earnings or capital arising from adverse business decisions or improper implementation of those decisions. This risk is a function of the compatibility of an organization\u2019s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. The resources needed to carry out business strategies are both tangible and intangible. They include communication channels, operating systems, delivery networks, and managerial capacities and capabilities. Strategic risk focuses on more than an analysis of the written strategic plan. It focuses on how plans, systems, and implementation affect the bank\u2019s franchise value. It also incorporates how management analyses external factors that impact the strategic direction of the company. Since this kind of risk impacts the whole organization, one should be aware of its risk implications in taking decisions. Let us sum up \uf0ae\t Risk is the product of likelihood and impact. Financial risk is the possibility of actual return deviating from expected return \uf0ae\t Although various risks arise independently, there is interdependency among various types of risks","506 \uf0ae\t Globally, there has been phenomenal rise in the risks associated with banking activities due to increased market volatility, globalization of financial market, innovative products, technological development, etc. \uf0ae\t In India, the financial reforms in 1991 and subsequent developments contributed to extraordinary growth and competition among banks. Deregulation of interest rate and exchange rate made the financial market highly volatile. \uf0ae\t RBI and GOI have taken a number of initiatives which have opened new opportunities as well as new challenges. \uf0ae\t Financial markets and banking system have been evolving continuously, and the new risks are emerging in the system causing financial turbulence. The global interconnectedness has exacerbated the risks for the financial system including banks against which the bank\u2019s risk management policies should be able to protect. Check your Progress 1.\t Financial and macroeconomic connectedness makes economies, corporations and banks are vulnerable to what type of risk. a.\t Model risk b.\t Compliance risk c. \t Country risk d.\t Contagion risk 2.\t Migration is a part of a.\t Market risk b.\t Strategic risk c.\t Credit risk d.\t Business risk 3.\t Settlement risk arises a.\t when the transactions do not take place simultaneously b.\t when the transactions take place between institutions c.\t when transactions are of very high value d.\t When the clearing system collapses 4.\t Counterparty risk is a.\tUnilateral","507 b.\tBilateral c.\tMultilateral d.\tTrilateral 5.\t Strategic risk comes under a.\t Financial risk b.\t Non-Financial risk c.\t Credit risk d.\t Market risk Answers to check your progress 1. d 2. c 3. a 4. b 5. b","508 1.\t Transition from Basel I to Basel III 2.\t Basel Committee on Banking Supervision 3.\t The Concordat 1. TRANSITION FROM BASEL I TO BASEL III 1.1 GLOBAL BANKING REGULATION For a long time, banking regulation was national. That is, governments and their regulatory agencies used to frame rules and banking supervisory guidelines specific to their country\u2019s needs. Regulatory rules differed significantly between countries. Not until 1988, when the Basel I Accord was released, did international banking regulations take shape. The Basel Accords also outlined regulatory guidelines for internationally active banks, their operations and risk management. 1.1.1\t Bank of International Settlement (BIS) The Bank for International Settlements (BIS), established in Basel, Switzerland, in 1930, is the principal center of international central bank cooperation. The central banks of different countries are its shareholders. The BIS acts as: i.\t A forum to promote discussion and policy analysis among central banks and within the international financial community ii.\t A center for economic and monetary research iii.\t A prime counterparty for central banks in their financial transactions iv.\t An agent or trustee in connection with international financial operations 2.BASEL COMMITTEE ON BANKING SUPERVISION The Basel Committee on Banking Supervision (BCBS), initially named as the Committee on Banking Regulations and Supervisory Practices, was set up by the central-bank Governors of the Group of Ten (G-10) countries at the end of 1974 in the aftermath of serious disturbances in international currency and banking markets following Herstatt Bank crisis. The Committee, headquartered at the Bank for International Settlements in Basel has central banks and banking supervisors as its members (45 members from 28 jurisdictions). The Committee was set up with an objective to enhance financial stability by improving the quality of banking supervision worldwide. It was also meant to serve as a forum for regular cooperation between its member countries on banking supervisory matters. Being a platform to discuss matters of supervisory concern, BCBS, initially, focused on modalities to close gaps in the supervisory net. But its wider objective had been to improve supervisory understanding and the quality of banking supervision worldwide. It seeks to do this in three principal ways:","509 i.\t by exchanging information on national supervisory arrangements; ii.\t by improving the effectiveness of techniques for supervising international banking business; and iii.\t by setting minimum supervisory standards in areas where they are considered desirable. However, it is important to bear in mind that BCBS is not a global supervisory authority. Both the reports and recommendations issued by the committee do not have legal force. Instead, the committee formulates broad banking supervisory standards (such as the Basel Accords), develops guidelines for both banks and regulators, and recommends statements of best practice. It seeks to instill guiding regulatory principles without attempting to micromanage member countries\u2019 supervisory approaches. It was expected that individual authorities will take steps to implement them. through detailed arrangements \u2013 statutory or otherwise \u2013 which are best suited to their own national interest. Why setting of international standards is important? By establishing minimum prudential requirements, international standards play a key role in promoting stability and efficiency of global financial markets. i.\t Disregard to international standards may start a race to the bottom. In a competitive environment, jurisdictions may opt to underbid each other in lowering prudential requirements, hoping to become more attractive to foreign financial firms. ii.\t This process can become acute in modern financial markets if individual authorities do not adequately consider spillovers and contagion effects that negatively impact other countries. iii.\t A fragmented global regulatory framework might hinder trust in the global financial system and the ability of countries to rely on each other\u2019s systems. This would create inefficiencies by fragmenting pools of capital and liquidity and impacting cross- border flows. iv.\t The net result would be inefficient financing and higher risks to national economies. This rationale underpins the multilateral approach to financial regulation and the creation of international standards setting bodies such as the BCBS. 3. THE CONCORDAT In 1975, Basel Committee set out certain principles known as \u201cConcordat\u201d which laid down the ground rules which should govern the supervision of banks\u2019 foreign establishments by parent and host authorities. The report dealt exclusively with the responsibilities of banking supervisory authorities for monitoring the prudential conduct and soundness of the business of banks\u2019 foreign establishments. The primary reason for the foundation of the BCBS was the implications for the monetary authorities of the growing globalization of financial intermediation. Whereas financial","510 markets and intermediation became international, (monetary) control and regulatory systems remained national. Large scale expansion of off- shore branches, subsidiaries, and joint ventures gave rise to huge unregulated off- shore financial network which was neither controlled and supervised by the host country nor by the destination country. For example, when an American bank opened a branch in London, the rules meant for domestic branches located in US was no more applicable to this London based branch. Similarly, the regulatory authority of the UK also did not have the power to supervise this branch as it was owned and operated by its US based parent bank. Therefore, one important task before the Committee was to close gaps in international supervisory coverage so that (i)\t no banking establishment would escape supervision; and (ii)\t supervision would be adequate and consistent across member jurisdictions. A first step in this direction was the paper issued in 1975 that came to be known as the \u201cConcordat\u201d The Concordat set out principles for sharing supervisory responsibility for banks\u2019 foreign branches, subsidiaries and joint ventures between host and parent (or home) supervisory authorities. The report dealt exclusively with the responsibilities of banking supervisory authorities for monitoring the prudential conduct and soundness of the business of banks\u2019 foreign establishments This report set out certain principles which the Committee believes should govern the supervision of banks\u2019 foreign establishments by parent and host authorities. In May 1983, the Concordat was revised and re-issued as Principles for the supervision of banks\u2019 foreign establishments. Adequate supervision of banks\u2019 foreign establishments calls not only for an appropriate allocation of responsibilities between parent and host supervisory authorities but also for contact and cooperation between them. In April 1990, a supplement to the 1983 Concordat was issued. This supplement, \u2018Exchange of information between supervisors of participants in the financial markets\u2019, aimed to improve the cross-border flow of prudential information between banking supervisors. In July 1992, certain principles of the Concordat were reformulated and published as the Minimum standards for the supervision of international banking groups and their cross- border establishments. In October 1996, the Committee released a report on the supervision of cross borders, drawn up by a joint working group that included supervisors from non-G10 jurisdictions and offshore centres. The document presented proposals for overcoming the impediments to effective consolidated supervision of the cross-border operations of international banks. Subsequently endorsed by supervisors from 140 countries, the report helped to forge relationships between supervisors in home and host countries.","511 Herstatt Bank Crisis The collapse of Herstatt Bank (in German, Bankhaus Herstatt) and its effects on the international financial markets\u2014particularly on the foreign exchange market\u2014highlighted the close interdependence among international banks around the world. Herstatt Bank was a midsized West German bank active in the foreign exchange market. For a long time, the foreign exchange market was a relatively small and stable market, but it changed dramatically after 1973. In 1974, Herstatt Bank collapsed after German supervisors withdrew its banking license. Unfortunately, the supervisors did not wait for the close of business to shut down the bank but acted at lunchtime in Germany. Their timing had international ramifications. Herstatt was engaged in foreign exchange trading, where it was buying and selling foreign currency, mainly German marks. In accordance with customs, Herstatt Bank\u2019s counterparties had paid the bank in the morning local time, roughly six hours ahead of New York, for the foreign exchange transactions that Herstatt was engaged in. When the regulators closed the bank in Germany at lunchtime. New York banks were not yet open. The counterparties who made the payments to Herstatt Bank in Frankfurt during the morning, expected that they would receive funds in exchange for their foreign currency in their New York accounts in the afternoon. Herstatt Bank was closed at lunchtime Frankfurt time. U.S. banks became aware that Herstatt had been shut down. They subsequently suspended all dollar payments on the parent bank\u2019s behalf. When the New York markets opened later in the day, Herstatt\u2019s clients were unable to access their exchanged funds. There followed a chain reaction that severely impacted the global payments and settlements system. In the three days following Herstatt\u2019s closure, the gross amount of funds transferred among banks for the purpose of payments and settlements fell by approximately 60%. Since then, settlement risk has commonly been called \u201cHerstatt risk.\u201d 4. BASEL-I ACCORD With the end of the petrodollar boom and the ensuing banking crises of the early 1980s, this desire for a common banking capitalization standard came to the forefront of the agendas of the Basel Committee\u2019s member states. Six years of deliberations followed; in July of 1988, the G-10 (plus Spain) came to a final agreement and issued the first set of regulatory guidelines. The Basel Capital Accord, known informally as \u201cBasel-I\u201d came into being. First time, capital came to be recognized as the necessary buffer to withstand onset of risk in the banking system and since then it gained more prominence as risk management tool known as Capital Adequacy Ratio (CAR). Later on, quality of capital Tier- I, Tier -II and AT \u2013 I occupied space after Basel -III accord came up in 2010- 2013.","512 The main features of 1988 Basel accord was to prevent international banks from building business volumes without adequate capital backing, the cornerstone of risk management. Other features were; i.\t The focus was on credit risk. ii.\t Set minimum capital standards for banks. iii.\t Became effective at the end of 1992. The focus was to create a level playing fields for internationally active banks. Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans. 4.1 Capital Linked to Credit Risk Basel-I was hailed for incorporating risk into the calculation of capital requirement, particularly the credit risk. The capital measurement system provided for the implementation of a common framework for capital assessment as a function of the riskiness of fund based and non-fund based exposures. Since all assets in the balance sheet of a bank do not provide the same riskiness to banks. Hence differentiated degree of riskiness was brought about through risk weights \u2013 a measure of how much risk a type of asset could pose. 4.2 Risk Weighting To derive a balance sheet weighted by risk factors, each instrument, loan, or debt is grouped into four broad categories depending on its perceived credit risk. This resulted in a broad consensus on a weighted approach to the measurement of risk, both on and off banks\u2019 balance sheets. 0% Risk Weight i.\tCash, ii.\t Claims on central governments and central banks denominated in national currency and funded in that currency iii.\t Other claims on OECD countries, central governments and central banks iv.\t Claims collateralized by cash of OECD government securities or guaranteed by OECD Governments 20% Risk Weight i.\t Claims on multilateral development banks and claims guaranteed or collateralized by securities issued by such banks ii.\t Claims on, or guaranteed by, banks incorporated in the OECD","513 iii.\t Claims on, or guaranteed by, banks incorporated in countries outside the OECD with residual maturity of up to one year iv.\t Claims on non-domestic OECD public-sector entities, excluding central government, and claims on guaranteed securities issued by such entities v.\t Cash items in the process of collection 50% Risk Weight i.\t Loans fully securitized by mortgage on residential property that is or will be occupied by the borrower or that is rented. 100% Risk Weight i.\t Claims on the private sector ii.\t Claims on banks incorporated outside the OECD with residual maturity of over one year iii.\t Claims on central governments outside the OECD (unless denominated and funded in national currency) iv.\t Claims on commercial companies owned by the public sector v.\t Premises, plant and equipment, and other fixed assets vi.\t Real estate and other investments vii.\t Capital instruments issued by other banks (unless deducted from capital) viii.\t All other assets At National Discretion (0,10,20 or 50%) i.\t Claims on domestic public sector entities, excluding central governments, and loans guaranteed by securities issued by such entities 4.3 Cooke Ratio ATarget Standard Ratio, popularly known as Cooke Ratio named after Mr. Peter Cooke (Bank of England), Chairman of the Basel Committee was prescribed Cooke Ratio = Capital \/ Risk Weighted Assets \u2265 8% Where, Capital = Core Capital + Supplementary Capital \u2013 Deductions Risk WeightedAsset = Exposure \u00d7 Risk Weight (Prescribed by Basel Committee)","514 To calculate required capital, a bank would multiply the assets in each risk category by the category\u2019s risk weight and then multiply the result by 8%. Thus, a ` 100 commercial loan would be multiplied by 100% and then by 8%, resulting in a capital requirement of ` 8. Components of Capital i.\t Core Capital (Tier I Capital) a.\t Paid Up Capital b.\t Disclosed Reserves (General and Legal Reserves) ii.\t Supplementary Capital (Tier II Capital) a.\t General Loan-loss Provisions b.\t Undisclosed Reserves (other provisions against probable losses) c.\t Asset Revaluation Reserves d.\t Subordinated Term Debt (5+ years maturity) e.\t Hybrid (debt\/equity) instruments Deductions i.\t Investments in unconsolidated banking and financial subsidiary companies and investments in the capital of other banks & financial institutions ii.\tGoodwill Example Simple Bank has the following Balance Sheet (`mln) Equity 1000 Cash 50 Disclosed reserve 500 Government Bonds 450 Sub ordinated Debts 700 Interbank Loan 100 Deposits 12500 Mortgage loan 8000 Loan Loss Reserves 300 Loans to corporates 6400 Total 15000 Total 15000 From the above information: Tier-I Capital = 1000 + 500 = `1500 cr Tier II Capital = 700 + 300 = 1000 cr Total Capital = `2500 cr Risk Weighted Assets = (50 \u00d7 0) + (450 \u00d7 0) + (100 \u00d7 0.2) + (8000 \u00d7 0.5) + (6400 \u00d7 1) = 10420 Basel 1 risk asset ratio = 2500\/10420 = 24%","515 4. Implementation Basel I\u2019s adaptation and implementation occurred rather smoothly in the Basel Committee states. All Basel Committee members implemented Basel I\u2019s recommendations\u2014including the 8% capital adequacy target\u2014by the end of 1992. Although they were not intended to be included in the Basel I framework, other emerging market economies also adopted its recommendations. The Adoption of Basel I standards was seen as a sign of regulatory strength and financial stability in emerging markets. By 1999, nearly all countries\u2014at least on paper\u2014implemented the Basel Accord. In line with the international regulatory standard, Reserve Bank of India adopted Basel 1 Accord by making announcement in its Mid-term Review of Monetary and Credit Policy for 1998-99 to raise CRAR from 8 per cent to 9 per cent. 4.5\t Criticisms of Basel-I Accord Basel-I Accord was criticized for taking too simplistic an approach to setting credit risk weights. i.\t Risk weights were based on what members of the Accord negotiated rather than on the actual risk of each asset. Risk weights did not flow from any particular insolvency probability standard, and were for the most part, arbitrary. ii.\t Due to the wide breadth and absoluteness of Basel I\u2019s risk weightings, banks have found ways to \u201cwiggle\u201d around Basel I\u2019s standards to put more risk on their loan books than what was intended by the framers of the Basel Accord. One of the methods used by banks is to securitize their corporate loans and sell off the least risky securitized asset. This method\u2014called \u201ccherry picking\u201d\u2014creates banks that, on paper, are properly protecting themselves against credit risk, but in reality, are taking on quantities of risk far greater than what Basel I intended. iii.\t The requirements did not explicitly account for operating and other forms of risk that may also be important. The capital standards did not account for hedging, diversification, and differences in risk management techniques. 1.9 BASEL COMMITTEE AMENDMENT 1996 The Basel Committee began to address the treatment of market risks in a 1993 consultative document, and the outcome was the January 1996 Amendment to the Capital Accord to incorporate market risks (or Market Risk Amendment), to take effect at the end of 1997. Market risk is the risk that changes in market prices will cause losses in trading positions, both on- and off-balance sheets. The different forms of market risk recognised in the amendment included: equity price risk (market and specific), interest rate risk associated with fixed income instruments currency risk and commodities price risk.","516 In the numerator of the Basel ratio, a third type of capital, tier 3 capital, was permitted to be used by banks but only when computing the capital charge related to market risk, and subject to the approval of the national regulator. Tier 3 capital was defined as short-term subordinated debt (with a maturity of less than 2 years), which met a number of conditions stipulated in the agreement, including a requirement that neither the interest nor principal can be repaid if it results in the bank falling below its minimum capital requirement. Under the Amendment, one of two approaches to market risk can be adopted, internal rating based models or standardized model. An important aspect of the Market Risk Amendment was that banks were, for the first time, allowed to use internal models (value-at-risk models) as a basis for measuring their market risk capital requirements, subject to strict quantitative and qualitative standards. Much of the preparatory work for the market risk package was undertaken jointly with securities regulator. Baring Bank Failure At the time of its collapse, Baring Brothers was the oldest merchant bank in London. In addition to Baring Brothers & Company (BB&C), the two main operating companies of the Barings group were Barings Asset Management and Barings Securities Limited. BB&C was an authorised bank, based in London with branches in Singapore and Hong Kong. Barings Securities Limited (BSL) was incorporated in the Cayman Islands although its head office was in London. BSL had a number of subsidiaries one of which was Barings Futures Singapore (BFS) where the problem arose. Barings is another example of how fraud can lead to bank failure. This combined with market risk and weak management systems made it possible for the large trading positions accumulated by this individual to go undetected for a long period. The Barings crisis was attributable to fraud committed by the head trader at BFS, Nick Leeson. In his autobiography Rogue Trader, Nick Leeson said the ethos at Barings was simple: \u2018We were all driven to make profits, profits, and more profits ... I was the rising star.\u2019 Leeson did make Barings vast sums. In 1993, he made \u00a310m - 10% of the bank\u2019s profits for that year. But in 1995, the discovery of a secret file - Error Account 88888 - showed that Leeson had gambled away \u00a3827m in Barings\u2019s name. As long as the profits rolled in, Barings\u2019 old- money merchant bankers tolerated the new breed of securities traders, though oversight was lax. Barings\u2019 culture meant that 28-year-old Nick Leeson in the Singapore office could trade securities without direct supervision. He was in charge of both buying and selling ( \u201ctrading\u201d and \u201csettlement\u201d), which meant that he was uniquely placed to commandeer huge sums of cash from London, to make use of this cash as he wished, and to report the results to his best advantage.","517 He claimed to be arbitraging between derivatives markets in Singapore and Osaka. As Leeson controlled both the trading and the documentation of these trades he was able to disguise the growing position he was taking by having an important account excluded from daily management reports and by fixing, through fraudulent entries, this account to be zero on month-ends. He also falsified reports to SIMEX in order to reduce the required margin calls. The management structure at BFS was both complicated and at times uncoordinated. Different strands of management believed that each other were in charge of, and monitoring, Leeson\u2019s activities. There was a failure of internal controls to detect these problems and, as such, the fraud continued and multiplied as Leeson took increasingly risky positions in an attempt to cover up losses made on previous transactions. In February 1995, Leeson\u2019s activities were discovered. Although it became clear almost immediately that the losses ran into hundreds of millions of dollars, it was not possible to tell just how large these losses were. On the afternoon of Friday 24 February, Barings\u2019 senior management notified the BOE that its securities subsidiary in Singapore had made large losses on Japanese Government Bond and equity markets and held large uncovered options positions in the Japanese stock market (Nikkei index). As stock markets took fright from the biggest financial scandal in years, Leeson fled the firm\u2019s Singapore office leaving a note saying \u2018I\u2019m sorry\u2019 Barings requested the BOE\u2019s support to assist with the winding down of these activities. Without a private buyer or the possibility of allowing Barings to trade the next day, Barings Bank virtually folded up. Ultimately, it become part of ING, the Dutch bank paying \u00a31.00 for it in 1995. Many of Leeson\u2019s former colleagues lost their jobs. The failure of Barings highlighted a number of important lessons for senior bank managers including the importance of internal controls and audit processes The failure of Barings was attributable to a combination of fraud, market risk and inadequate internal controls. 1. BASEL II ACCORD During the early 1990s, there were two important compelling trends which persuaded Basel Committee to review Basel I provisions. i.\t One development was the rapid increase in securitizations of mortgages and other loans, banks in the decade following negotiation of Basel I. Many securitizations were undertaken primarily for nonregulatory reasons, such as reducing interest rate exposure. However, even these securitizations can have a regulatory arbitrage effect as the assets","518 retained by the bank bear a higher risk of loss than the securitized portfolio of loans as a whole. Once the Basel I rule were operative, banks recognized that the innovative securitization techniques originally devised for business reasons also provided a major arbitrage opportunity. \t These developments required banks and other institutions to make important improvements in risk measurement and risk management. As market participants innovate and use more sophisticated products, bank regulators and supervisors must ensure that they do not fall behind. ii.\t The second development was a series of advances in the internal risk management techniques of large banks. Most important among these was the increasing use of credit risk models for risk assessment purposes. As the proliferation of new instruments made the credit profile of banks more complex, the industry was devising new methodologies to manage this risk. The use of these new methods underscored the degree to which a risk weight assigned to an asset or asset equivalent under Basel I could diverge from the bank\u2019s best estimate of the actual risk created by that exposure. The effect was both to facilitate regulatory arbitrage and to erode confidence that Basel I was an effective regulatory tool. \t In response the Committee attempted to review and revise the 1988 with a view to develop a framework that would further strengthen the soundness and stability of the international banking system. The other challenges before the Basel II committee before Basel Committee were to i.\t Eliminate regulatory arbitrage by getting risk weights right such that capital allocation reflects level of risk. ii.\t Align regulation with best practices in risk management. iii.\t Provide banks with incentives to enhance risk measurement and management capabilities. iv.\t Recognition of operational risk as an additional element for determining capital allocation in addition to the credit and market risk. The BCBS released the \u201cInternational Convergence of Capital Measurement and Capital Standards: ARevised Framework\u201d on June 26, 2004. The Revised Framework was updated in November 2005 to include trading activities and the treatment of double default effect, and a comprehensive version of the framework was issued in June 2006 incorporating the constituents of capital and the 1996 amendment to the Capital Accord to incorporate Market Risk. The Revised Framework sought to arrive at significantly more risk-sensitive approaches to capital requirements. In India Basel II guidelines were implemented on April 27, 2007 when RBI issued the circular for for implementation of Basel II guidelines by banks in India.","519 Description of all the Events Basel Time Event Date Announcements Period 1. Basel I October 30, The announcement by RBI in its Mid-term Review of 1998 Monetary and Credit Policy for 1998-99 to raise CRAR from 8 per cent to 9 per cent. 2. Basel II April 27, 2007 RBI announced final guidelines for implementation of Basel II. 3. Basel III December 30, RBI issued draft guidelines for implementation of the 4. Basel III 5. Basel III 2011 proposed Basel III capital regulations. May 02, 2012 RBI announcement to adopt stricter measures of Basel III framework governing improved risk management systems in banks. March 27, RBI revised Basel-III capital regulation-timeline from 2014 Mar 31, 2018 to Mar 31, 2019. 6. Basel III March 01, RBI allowed banks to expand the capital base to meet 3. Basel III 2016 Basel-III norms by including certain items such as 4. Basel III the value of the property and foreign exchange in the 5. Basel III calculation of its Tier-I capital for capital adequacy ratios. December 30, RBI issued draft guidelines for implementation of the 2011 proposed Basel III capital regulations. May 02, 2012 RBI announcement to adopt stricter measures of Basel III framework governing improved risk management systems in banks. March 27, RBI revised Basel-III capital regulation-timeline from 6. Basel III 2014 Mar 31, 2018 to Mar 31, 2019. March 01, RBI allowed banks to expand the capital base to meet 2016 Basel-III norms by including certain items such as the value of the property and foreign exchange in the calculation of its Tier-I capital for capital adequacy ratios. Source: RBI. Basel II is a comprehensive framework for improving bank safety and soundness by more closely linking regulatory capital requirements with bank risk, by improving the ability","520 of supervisors and financial markets to assess capital adequacy, and by giving banking organizations stronger incentives to improve risk measurement and management. The Committee believed that the revised Framework would promote the adoption of stronger risk management practices by the banking industry. The Committee retained key elements of the 1988 capital adequacy framework, including the general requirement for banks to hold total capital equivalent to at least 8% of their risk-weighted assets; the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk; and the definition of eligible capital. The framework encompasses three elements: risk-focused regulatory capital requirements, supervisory review, and market discipline. These are the so-called three pillars of Basel II. 1.1 Pillar 1: Minimum Capital Requirement Pillar 1. Sets minimum capital requirements designed to improve upon the standardized rules set forth in the 1988 Accord. These minimum regulatory capital requirements should reflect the three major types of risk that a bank faces: credit risk, market risk, and operational risk. The framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and their financial market infrastructure. Capital requirement for Market risk continued as per the provisions of Amended Basel I Accord. The Revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and financial markets. Credit Risk Operational Risk Market Risk Standardised approach Foundation IRB Approach Basic Indicator Approach Standardized approach Advanced Approach Standardised Approach Internal Model Advanced Measurement Approach Fig. 23.1 Pillar 1 Approaches The capital requirement for credit risk, market risk and operational risk will be discussed in more detail in the next chapter. But in order to provide sufficient capital to bear the different kinds of risks, measurement of risks becomes a most important and challenging task which can be understood in subsequent chapters. 1.2 Pillar II Supervisory Review Process This pillar identifies the role of the national supervisors under Basel 2. Basel has identified four principles of supervisory review: a.\t Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.","521 b.\t Principle 2: Supervisors should review and evaluate banks\u2019 internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process. c.\t Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum. d.\t Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored. We will discuss this pillar in more detail in the unit dealing ICAAP. Fig. 23.2 Three Pillars of Basel Guidelines 1.3 Pillar 3 Market Discipline The third pillar is intended to strengthen incentives for prudent risk management. Greater transparency in banks\u2019 financial reporting should allow marketplace participants to better reward well-managed banks and penalize poorly managed ones. Participating banks are expected to disclose: i.\t Risk exposure. ii.\t Capital adequacy. iii.\t Methods for computing capital requirements. iv.\t All material information, that is, information which, if omitted or mis-stated, could affect the decision-making of the agent using the information. v.\t Disclosure should take place on a semi-annual basis; quarterly in the case of risk exposure, especially if the bank engages in global activities.","522 2. BASEL III CAPITAL REGULATION Basel III reforms attempt to strengthen the bank-level i.e., micro prudential regulation, with the intention to raise the resilience of individual banking institutions in periods of stress. Besides, the reforms have a macro prudential dimension also, addressing system wide risks, which can build up across the banking sector, as well as the procyclical amplification of these risks over time. These new global regulatory and supervisory standards mainly seek to raise the quality and level of capital to ensure banks are better able to absorb losses on both a going concern and a gone concern basis, increase the risk coverage of the capital framework, introduce leverage ratio to serve as a backstop to the risk-based capital measure, raise the standards for the supervisory review process (Pillar 2) and public disclosures (Pillar 3) etc. However, The Basel III regulatory standards continue to be based on three-mutually reinforcing Pillars, viz. minimum capital requirements, supervisory review of capital adequacy, and market discipline of the Basel II capital adequacy framework. They are Pillar 1-Minimum Capital Requirements establishes the minimum amount of capital that a bank should have against its credit, market and operational risks. It provides the guidelines for calculating the risk exposures in the assets of a bank\u2019s balance sheet (the \u201crisk-weighted assets\u201d) and sets the minimum capital requirements. Pillar 2-Supervisory Review and Evaluation Process involves both banks and regulators taking a view on whether a firm should hold additional capital against risks not covered in Pillar 1. An important part of Pillar 2 requirement is the preparation of \u201cInternal Capital Adequacy Assessment Process\u201d (ICAAP), which is bank\u2019s self-assessment of its risk profile and capital requirement. Pillar3, called \u201cMarket Discipline\u201d, aims to encourage market discipline by requiring banks to","523 disclosure specific, prescribed details of their risks, capital, and risk management practices. Under Pillar 1, the Basel III framework continued to offer a basket of options for computing capital requirement against their credit, market, and operational risks. 2.1 Capital Charge for Credit Risk Credit risk is the risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments. Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk: i.\t Standardized Approach (SA) - The standardized approach assigns standardized risk weights to exposures. Risk weighted assets are calculated as the product of the standardized risk weights and the exposure amount. Exposures are risk-weighted net of specific provisions (including partial write-offs). \t In addition, to determine the risk weights in the standardized approach for certain exposure classes, regulators allow the use of external ratings for risk weighting purposes. Assessments of rating made by external credit assessment institutions can be used for assessment of capital for credit risk purposes ii.\t Internal Rating Based Approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types: a.\t Foundation IRB (FIRB): The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure at Default (EAD). b.\t Advanced IRB (AIRB): In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the outset and on an ongoing basis such as those relating to the design of the rating system, operations, controls, corporate governance, and estimation and validation of credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the minimum, PD data for five years and LGD and EAD data for seven years. However, in India, keeping in view the need for consistency and harmony with international standards, RBI decided in 2007 that all commercial banks in India (excluding Local Area","524 Banks and Regional Rural Banks) should adopt Standardized Approach for credit risk, Accordingly, banks were advised to undertake an internal assessment of their preparedness for migration to advanced approaches and take a decision with the approval of their Boards, whether they would like to migrate to any of the advanced approaches. However, banks were advised to obtain prior approval of the RBI for adopting any of the advanced approaches. 2.2 Capital Adequacy Standard Capital adequacy ratios are a measure of the amount of a bank\u2019s capital expressed as a percentage of its risk weighted credit exposures. Reserve Bank issued necessary guidelines on capital adequacy based on the Basel III recommendation on May 2, 2012, which became operable in India from April 1, 2013. The most challenging part of Basel-III Capital accord is providing capital conservation buffer of 2.5 percent of risk weighted assets. 2.3 Composition of Regulatory Capital Banks in India are required to maintain a minimum Pillar 1 Capital to Risk-weightedAssets Ratio (CRAR) of 9% on an on-going basis (other than capital conservation buffer and countercyclical capital buffer etc.). The Reserve Bank would consider the relevant risk profile of each bank and their internal capital adequacy assessments (ICAAP) to ensure that the capital held by a bank is commensurate with the bank\u2019s overall risk profile. This would include, among others, the effectiveness of the bank\u2019s risk management systems in identifying, assessing \/ measuring, monitoring, and managing various risks including interest rate risk in the banking book, liquidity risk, concentration risk and residual risk. Accordingly, the Reserve Bank may consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and their risk management systems. A bank should compute Basel III capital ratios in the following manner:","525 Common Equity Tier 1 capital Common Equity Tier 1 Capital ratio = Credit Risk RWA + Market Risk RWA + Operational Risk RWA Eligible Tier 1 Capital Tier 1 Capital Ratio = Credit Risk RWA + Market Risk RWA + Operational Risk RWA Eligible Total Capital Total Capital = Credit Risk RWA + Market Risk RWA + Operational Risk RWA Example From the following information extracted from the Balance Sheet dated March 31, 2021 of ABC Bank, compute the various Capital Ratios Common Equity Capital `10000 cr Credit risk RWA `75000 cr Additional Tier 1 Capital `1500 cr Market risk RWA `13000 cr Tier 2 Capital `2000 cr Operational risk RWA `12000 cr Solution (`in Crore) 1st Step Compute Eligible capital Outstanding Eligible Capital 2nd Step CET 1 Capital 10000 10000 Additional Tier 1 Capital (Max 1.5% of Total 1500 1500 RWA) Tier 1 Capital 11500 11500 Tier 2 capital (Max 2.0% of Total RWA) 2000 2000 Total Capital 13500 13500 Compute Total Risk Weighted Assets Credit RWA 75000 Market RWA 13000 Operational RWA 12000 Total RWA 100000","526 3rd Step Compute required ratios 10000\/100000 10.0% CET 1 Ratio 11500\/100000 11.5% Tier 1 Ratio 13500\/100000 13.5% CRAR 2.4 Components of Capital Two types of capital are taken into account for computing capital adequacy ratio\u2013(i) tier one capital which can absorb losses without a bank being required to cease operation, e.g. ordinary share capital, and (ii) tier two capital which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors, e.g. subordinated debt. Tier one capital is important because it safeguards both the survival of the bank and the stability of the financial system. Tier two capital is capital which generally absorbs losses only in the event of a winding-up of a bank, and so provides a lower level of protection for depositors and other creditors. It comes into play in absorbing losses after tier one capital has been used by the bank. Total regulatory capital will consist of the sum of the following categories: i.\t Tier 1 Capital (going-concern capital) a.\t Common Equity Tier 1 b.\t Additional Tier 1 ii.\t Tier 2 Capital (gone-concern capital) Going Concern Capital vs Gone Concern Capital From regulatory capital perspective, going-concern capital is the capital which can absorb losses without triggering bankruptcy of the bank. Gone-concern capital is the capital which will absorb losses only in a situation of liquidation of the bank. 2.5 Maximum and Minimum Capital Requirement i.\t As a matter of prudence, RBI has prescribed that that scheduled commercial banks operating in India shall maintain a minimum total capital (MTC) of 9% of total risk weighted assets (RWAs) i.e., capital to risk weighted assets (CRAR). ii.\t Common Equity Tier 1 (CET1) capital must be at least 5.5% of total risk-weighted assets (RWAs) i.e., for (credit risk + market risk + operational risk) on an ongoing basis.","527 iii.\t Tier 1 capital must be at least 7% of RWAs on an ongoing basis. Thus, within the minimum Tier 1 capital, Additional Tier 1 capital can be admitted maximum at 1.5% of RWAs. iv.\t Total Capital (Tier 1 Capital plus Tier 2 Capital) must be at least 9% of RWAs on an ongoing basis. Thus, within the minimum CRAR of 9%, Tier 2 capital can be admitted maximum up to 2%. v.\t If a bank has complied with the minimum Common Equity Tier 1 and Tier 1 capital ratios, then the excess Additional Tier 1 capital can be admitted for compliance with the minimum CRAR of 9% of RWAs. vi.\t In addition to the minimum Common Equity Tier 1 capital of 5.5% of RWAs, banks are also required to maintain a capital conservation buffer (CCB) of 2.5% of RWAs in the form of Common Equity Tier 1 capital. Details of operational aspects of CCB will be discussed later. Regulatory Capital As % of Total RWAs (i) Minimum Common Equity Tier 1 Ratio 5.5% (ii) Capital Conservation Buffer (Composed of CET 1 Capital) 2.5% (iii) Minimum Common EquityTier 1 Ratio plus Capital Conservation 8.0% Buffer (iv) Additional Tier 1 Capital 1.5% (v) Minimum Tier 1 Capital 7.0% (vi) Tier 2 capital 2.0% (vii) Minimum Total Capital Ratio 9.0% (viii) Minimum Total Capital Ratio plus Capital Conservation Buffer 11.5% Example From the following extracts from the Balance Sheet of ABC Bank as on 31.03.2021 find out whether the bank has complied capital adequacy requirement. Common Equity Capital `8000 cr Credit risk RWA `75000 cr Additional Tier 1 Capital `2000 cr Market risk RWA `13000 cr Tier II Capital `1500 cr Operational risk RWA `12000 cr Solution 1st Step Compute Eligible Capital","528 Outstanding Amt `in crores Eligible Amt `in crores CET 1 Capital 8000 8000 Additional Tier 1 Capital (Max 1.5% of Total RWA) 2000 1500 Tier 1 Capital 9500 Tier 2 capital (Max 2.0% of Total RWA) 1500 1500 Total Eligible Capital 9500 + 1500 + 500 (the excess 11500 Additional Tier 1 capital if CET 1 Ratio and Tier 1 Ratios are complied) 2nd Step Compute Total Risk Weighted Assets 3rd Step Credit RWA 75000 Market RWA 13000 Operational RWA 12000 8.0% Total RWA 100000 9.5% Compute Required Ratios 11.5% CET 1 Ratio 8000\/100000 Tier 1 Ratio 9500\/100000 CRAR 11500\/100000 Note: Since CET Tier 1 Capital ratio and Tier 1 Capital ratios are complied, additional Tier 1 capital can be admitted for compliance with the minimum CRAR. 2.6 Elements of Common Equity Tier 1 Capital > 5.5% Common Equity Tier 1 capital is the highest quality of capital, and must \u2013 i.\t provide a permanent and unrestricted commitment of funds; and ii.\t be freely available to absorb losses; and iii.\t not impose any unavoidable servicing charge against earning Common Equity Tier 1 Capital Common Equity Tier 1 Capital Ratio =\t Total Risk Weighted Assets\t Elements of Common Equity component of Tier 1 capital will comprise the following: i.\t Common shares (paid-up equity capital) issued by the bank which meet the criteria for","529 classification as common shares for regulatory purposes; ii.\t Stock surplus (share premium) resulting from the issue of common shares; iii.\t Statutory reserves; iv.\t Capital reserves representing surplus arising out of sale proceeds of assets; v.\t Other disclosed free reserves, if any; vi.\t Balance in Profit & Loss Account at the end of the previous financial year; vii.\t Revaluation reserves arising out of change in the carrying amount of a bank\u2019s property consequent upon its revaluation may, at the discretion of banks, be reckoned as CET1 capital at a discount of 55% instead of as Tier 2 capital subject to meeting the following conditions: \u25cf\t bank is able to sell the property readily at its own will and there is no legal impediment in selling the property; \u25cf\t the revaluation reserves are shown under Schedule 2: Reserves & Surplus in the Balance Sheet of the bank; \u25cf\t revaluations are realistic, in accordance with Indian Accounting Standards. \u25cf\t valuations are obtained, from two independent valuers, at least once in every 3 years; where the value of the property has been substantially impaired by any event, these are to be immediately revalued and appropriately factored into capital adequacy computations; \u25cf\t the external auditors of the bank have not expressed a qualified opinion on the revaluation of the property; \u25cf\t the instructions on valuation of properties and other specific requirements as mentioned in the circular DBOD.BP.BC.No.50\/21.04.018\/2006-07 January 4, 2007 on \u2018Valuation of Properties- Empanelment of Valuers\u2019 are strictly adhered to \t Banks may, at their discretion, reckon foreign currency translation reserve arising due to translation of financial statements of their foreign operations in terms of Accounting Standard (AS) 11 as CET1 capital at a discount of 25% subject to meeting the following conditions: \u00b7 the FCTR are shown under Schedule 2: Reserves & Surplus in the Balance Sheet of the bank; \u00b7 the external auditors of the bank have not expressed a qualified opinion on the FCTR viii.\t Banks may reckon the profits in current financial year for CRAR calculation on a quarterly basis provided the incremental provisions made for non-performing assets at the end of any of the four quarters of the previous financial year have not deviated more than 25% from the average of the four quarters. The amount which can be reckoned","530 would be arrived at by using the following formula: EPt = {NPt \u2013 0.25*D*t} Where; EPt = Eligible profit up to the quarter \u2018t\u2019of the current financial year; t varies from 1 to 4 NPt = Net profit up to the quarter \u2018t\u2019 D = average annual dividend paid during last three years ix.\t While calculating capital adequacy at the consolidated level, common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e., minority interest) which meet the criteria for inclusion in Common Equity Tier 1 capital; and x.\tLess: Regulatory adjustments \/ deductions applied in the calculation of Common Equity Tier 1 capital [i.e., to be deducted from the sum of items (i) to (viii)]. Definitions Common Shares (or common stock) Common shares represent the basic ownership interest. It is the residual corporate interest that bears the ultimate risk of loss, as it is subordinate to all other instruments issued by the bank. Share Premium Stock surplus or share premium is the excess amount paid by an investor over the par value of a stock issue. Statutory Reserve All scheduled commercial banks operating in India (including foreign banks) are required to transfer not less than 25 per cent of the net profit (before appropriations) to the Reserve Fund. Reserve Fund under Section 17(1) of BR Act 1949. Capital Reserve That portion of a company\u2019s profits is not paid out as dividends to shareholders. They are also known as undistributable reserves and are ploughed back into the business. Balance in Profit and Loss Account The balance in Profit and Loss account or retained earnings represents the earned capital of the bank. Earned capital is the capital that develops and builds up over time from profitable operations. It consists of all undistributed income that remains invested in the bank. Revaluation Reserve","531 These reserves arise from revaluation of assets that are undervalued on the bank\u2019s books, typically bank premises and marketable securities. The extent to which the revaluation reserves can be relied upon as a cushion for unexpected losses depends mainly upon the level of certainty that can be placed on estimates of the market values of the relevant assets and the subsequent deterioration in values under difficult market conditions or in a forced sale. For Classification as Common Shares (Paid-up Equity Capital) for Regulatory Purposes it is strongly recommended to go through RBI Master Circular on Basel III Capital Regulation https:\/\/rbidocs.rbi.org.in\/rdocs\/notification PDFs\/12MCBASELIIICAPITALREGULATIONSED3EF388F75E48198FF8328B36F43670. PDF dated April 2022. 2.7 Elements of Additional Tier 1 Capital Additional Tier 1 capital comprises high-quality capital and must\u2013 a.\t provide a permanent and unrestricted commitment of funds; and b.\t be freely available to absorb losses; and c.\t provide for fully discretionary capital distributions. Additional Tier 1 capital will consist of the sum of the following elements: i.\t Perpetual Non-Cumulative Preference Shares (PNCPS), which comply with the regulatory requirements; ii.\t Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital; iii.\t Debt capital instruments eligible for inclusion in Additional Tier 1 capital, which comply with the regulatory requirements; iv.\t Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Additional Tier 1 capital; v.\t While calculating capital adequacy at the consolidated level, Additional Tier 1 instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Additional Tier 1 capital and vi.\tLess: Regulatory adjustments \/ deductions applied in the calculation of Additional Tier 1 capital [i.e., to be deducted from the sum of items (i) to (v)].","532 Eligible Additional Capital = Max 1.5% of Total RWA > 7.0% CET 1 Capital + Eligible Additional Tier 1 capital Tier 1 Ratio = Credit Risk RWA + Market Risk RWA + Operational Risk RWA\t \t Under Basel III, the criteria for instruments to be included in Additional Tier 1 capital have been modified to improve their loss absorbency. The only limitation of concept of AT- I capital is its cost. Since it is equal to perpetual funds with long term redemption clause, its cost of raising funds for banks goes up. What is Loss Absorbency requirement of Additional Tier 1 Instruments? Additional Tier 1 instruments should invariably meet loss absorbency criteria in order to become eligible for capital adequacy purpose. This criterion refers to the ability of the instrument for principal loss absorption through either i.\t conversion to common shares at an objective pre-specified trigger point or ii.\t a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects: a.\t Reduce the claim of the instrument in liquidation; b.\t Reduce the amount re-paid when a call is exercised; and c.\t Partially or fully reduce dividend payments on the instrument. Various criteria for loss absorption through conversion \/ write-down \/ write-off on breach of pre- specified trigger and at the point of non-viability have been provided in RBI guidelines. For criteria for inclusion of Perpetual Debt Instrument (PDI) in Additional Tier 1 Capital details it is strongly recommended to go through RBI Master Circular on Basel III Capital Regulation No RBI\/2015- 16\/58 DBR No BP.BC.1\/21.06.201\/2015-16 dt July 1,2015)","533 Annexure 4. 2.8 Elements of Tier 2 Capital Tier 2 capital comprises certain types of reserves and subordinated debt instruments that do not qualify as CET1 or AT1 Capital but are available to absorb losses ahead of more senior creditors of the banking group in a winding up. i.\t General Provisions and Loss Reserves \t Provisions or loan-loss reserves held against future, presently unidentified losses, which are freely available to meet losses which subsequently materialize, will qualify for inclusion within Tier 2 capital. Accordingly, General Provisions on Standard Assets, Floating Provisions, incremental provisions in respect of unhedged foreign currency exposures, Provisions held for Country Exposures, Investment ReserveAccount, excess provisions which arise on account of sale of NPAs and \u2018countercyclical provisioning buffer' will qualify for inclusion in Tier 2 capital. However, these items together will be admitted as Tier 2 capital up to a maximum of 1.25% of the total credit risk-weighted assets under the standardized approach. Under Internal Ratings Based (IRB) approach, where the total expected loss amount is less than total eligible provisions, banks may recognise the difference as Tier 2 capital up to a maximum of 0.6% of credit-risk weighted assets calculated under the IRB approach; ii.\t Provisions ascribed to identified deterioration of particular assets or loan liabilities, whether individual or grouped should be excluded. Accordingly, for instance, specific provisions on NPAs, both at individual account or at portfolio level, provisions in lieu of diminution in the fair value of assets in the case of restructured advances, provisions against depreciation in the value of investments will be excluded; iii.\t Debt Capital Instruments issued by the banks; iv.\t Preference Share Capital Instruments [Perpetual Cumulative Preference Shares (PCPS) \/ Redeemable Non-Cumulative Preference Shares (RNCPS) \/ Redeemable Cumulative Preference Shares (RCPS)] issued by the banks; v.\t Stock surplus (share premium) resulting from the issue of instruments included in Tier 2 capital; vi.\t While calculating capital adequacy at the consolidated level, Tier 2 capital instruments issued by consolidated subsidiaries of the bank and held by third parties which meet the criteria for inclusion in Tier 2 capital; vii.\t Revaluation reserves at a discount of 55% viii.\t Any other type of instrument generally notified by the Reserve Bank from time to time for inclusion in Tier 2 capital; and","534 ix.\t Less: Regulatory adjustments \/ deductions applied in the calculation of Tier 2 capital [i.e., to be deducted from the sum of items (i) to (vii)]. Under Basel III, the criteria for instrumentsto be included in Tier 2 capital have been modified to improve their loss absorbency Eligible Tier 1 Capital = Max 1.5% of Total RWA CET 1 Capital + Eligible Additional Tier 1 Capital + Eligible Tier 2 Capital Tier 1 Ratio =\t Credit Risk RWA + Market Risk RWA + Operational Risk RWA\t > 9.0% Discount applicable to Tier 2 Debt Capital Instrument The debt instruments shall be subjected to a progressive discount for capital adequacy purposes. As they approach maturity these instruments should be subjected to progressive discount as indicated in the table below for being eligible for inclusion in Tier 2 capital. Remaining Maturity of Instruments Rate of Discount(%) Less than 1 year 100 Oneyear and more but less than two years 80 Two years and more but less than three years 60 Three years and more but less than four years 40 Four years and more but less than five years 20 Five years and above 0 General Provision and Loss Reserve General provisions or general loan-loss reserves are created against the possibility of future losses. Where they are not ascribed to particular assets and do not reflect a reduction in the valuation of particular assets, these reserves qualify for inclusion in capital. Investment Fluctuations Reserve With a view to building up of adequate reserves to guard against any possible reversal of interest rate environment in future due to unexpected developments, banks were advised to build up Investment Fluctuation Reserve (IFR) of a minimum 5 per cent of the investment portfolio within a period of 5 years.","535 General Provision on Standard Assets As a countercyclical measure Banks are required to make general provision for standard assets at the following rates for the funded outstanding on global loan portfolio basis a.\t Farm Credit to agricultural activities and Small and Micro Enterprises (SMEs) sectors at 0.25 per cent; b.\t advances to Commercial Real Estate (CRE) Sector at 1.00 per cent; c.\t advances to Commercial Real Estate \u2013 Residential Housing Sector (CRE - RH) at 0.75 per cent; d.\t housing loans at 0.25%; e.\t all other loans and advances not included in (a) (b) and (c) above at 0.40 per cent. For classification as Debt Capital Instrument and RNCPS under Tier 2 Capital it is strongly recommended to go through RBI Master Circular on Basel III Capital Regulation https:\/\/rbidocs.rbi. org.in\/rdocs\/notification\/ P D F s \/ 1 2 M C B A S E L I I I C A P I TA L R E G U L AT I O N S E D 3 E F 3 8 8 F 7 5 E 4 8 1 9 8 F F 8328B36F43670.PDF dt April 2022) Annexure 4 and Annexure 6.","536 2.9 Regulatory Adjustments \/ Deductions The following paragraphs deal with the regulatory adjustments \/ deductions which will be applied to regulatory capital both at solo and consolidated level. i.\t Goodwill and all Other Intangible Assets \t Goodwill and all other intangible assets should be deducted from Common Equity Tier 1 capital including any goodwill included in the valuation of significant investments in the capital of banking, financial and insurance entities which are outside the scope of regulatory consolidation. In terms of AS 23 \u2013 Accounting for investments in associates, goodwill\/capital reserve arising on the acquisition of an associate by an investor should be included in the carrying amount of investment in the associate but should be disclosed separately. Therefore, if the acquisition of equity interest in any associate involves payment which can be attributable to goodwill, this should be deducted from the Common Equity Tier 1 of the bank. Goodwill Goodwill is an intangible asset that is commonly recognized as a result of a business combination. Goodwill represents the excess of the cost of a company over the sum of the fair values of the tangible and identifiable intangible assets acquired less the fair value of liabilities assumed in a business combination. ii.\t Deferred Tax Assets (DTAs) \t The DTAs computed as under should be deducted from Common Equity Tier 1 capital: a.\t DTA associated with accumulated losses; and b.\t The DTA(excluding DTAassociated with accumulated losses), net of DTL. Where the DTL is in excess of the DTA (excluding DTA associated with accumulated losses), the excess shall neither be adjusted against item (a) nor added to Common Equity Tier 1 capital. DTAs may be netted with associated deferred tax liabilities (DTLs) only if the DTAs and DTLs relate to taxes levied by the same taxation authority and offsetting is permitted by the relevant taxation authority. The DTLs permitted to be netted against DTAs must exclude amounts that have been netted against the deduction of goodwill, intangibles and defined benefit pension assets.","537 Deferred Tax Assets Unabsorbed depreciation and carry forward of losses which can be set-off against future taxable income which is considered as timing differences result in deferred tax assets. The deferred Tax Assets are accounted as per the Accounting Standard 22. Deferred Tax Liabilities Deferred tax liabilities have an effect of increasing future year\u2019s income tax payments, which indicates that they are accrued income taxes and meet definition of liabilities. iii.\t Cash Flow Hedge Reserve \t The amount of the cash flow hedge reserve which relates to the hedging of items that are not fair valued on the balance sheet (including projected cash flows) should be derecognized in the calculation of Common Equity Tier 1. This means that positive amounts should be deducted, and negative amounts should be added back. This treatment specifically identifies the element of the cash flow hedge reserve that is to be derecognized for prudential purposes. It removes the element that gives rise to artificial volatility in Common Equity, as in this case the reserve only reflects one half of the picture (the fair value of the derivative, but not the changes in fair value of the hedged future cash flow). Cash Flow Hedge Cash flow hedge is a hedging process in which the risk associated with the future probable cash flows are managed. The cash flow hedge is done mainly in the case of foreign currency transactions because in that case the risk of exchange rate going up or coming down will affect the profit\/ loss of the investor. To safeguard them from any expected loss in the future, an entity can enter into a cash flow hedging. A separate cash flow hedge reserve account is created to adjust all hedging transactions. iv.\t Shortfall of the Stock of Provisions to Expected Losses \t The deduction from capital in respect of a shortfall of the stock of provisions to expected losses under the Internal Ratings Based (IRB) approach should be made in the calculation of Common Equity Tier 1. The full amount is to be deducted and should not be reduced by any tax effects that could be expected to occur if provisions were to rise to the level of expected losses. v.\t Gain-on-Sale Related to Securitisation Transactions \t As per Basel III rule text, banks are required to derecognise in the calculation of Common Equity Tier 1 capital, any increase in equity capital resulting from a securitisation","538 transaction, such as that associated with expected future margin income (FMI) resulting in a gain-on-sale. However, as per existing guidelines on securitization of standard assets issued by RBI, banks are not permitted to recognise the gain-on-sale in the P&L account including cash profits. Therefore, there is no need for any deduction on account of gain-on-sale on securitization. Banks are allowed to amortise the profit including cash profit over the period of the securities issued by the SPV. vi.\t Cumulative Gains and Losses due to Changes in Own Credit Risk on Fair Valued Financial Liabilities \t Banks are required to derecognise in the calculation of Common Equity Tier 1 capital all unrealised gains and losses which have resulted from changes in the fair value of liabilities that are due to changes in the bank\u2019s own credit risk. In addition, with regard to derivative liabilities, derecognise all accounting valuation adjustments arising from the bank\u2019s own credit risk. vii.\t Defined Benefit Pension Fund Assets and Liabilities \t Defined benefit pension fund liabilities, as included on the balance sheet, must be fully recognised in the calculation of Common Equity Tier 1 capital (i.e., Common Equity Tier 1 capital cannot be increased through derecognising these liabilities). For each defined benefit pension fund that is an asset on the balance sheet, the asset should be deducted in the calculation of Common Equity Tier 1 net of any associated deferred tax liability which would be extinguished if the asset should become impaired or derecognised under the relevant accounting standards. viii.\t Investment in own shares (Treasury Stock) \t Investment in a bank\u2019s own shares is tantamount to repayment of capital and therefore, it is necessary to knock off such investment from the bank\u2019s capital with a view to improving the bank\u2019s quality of capital. This deduction would remove the double counting of equity capital which arises from direct holdings, indirect holdings via index funds and potential future holdings as a result of contractual obligations to purchase own shares. ix.\t Treatment of a Bank\u2019s Investments in the Capital Instruments Issued by Banking, Financial and Insurance Entities within Limits \t The investment of banks in the regulatory capital instruments of other financial entities contributes to the interconnectedness amongst the financial institutions. In addition, these investments also amount to double the counting of capital in the financial system. Therefore, these investments have been subjected to stringent treatment in terms of deduction from respective tiers of regulatory capital. \t If the total of all holdings listed in paragraph above, in aggregate exceed 10% of the","539 bank\u2019s Common Equity (after applying all other regulatory adjustments in full listed prior to this one), then the amount above 10% is required to be deducted, applying a corresponding deduction approach. Example From the following extracts from the Balance Sheet of ABC Bank as on 31.03.2021compute the various regulatory capital adequacy ratios: Sl Particulars Position as on No 31.12.2019(` cr) 1 PNCPS 3 000 2 RNCPS (Residual maturity 2 yrs) 1 000 3 Perpetual Debt Instrument 2 000 4 Paid up Capital 6 000 5 Basel compliant dated securities for Tier II (Residual period 9 1 500 months) 6 Revaluation reserve 2 000 7 Statutory Reserve 5 000 8 Capital reserve 1 000 9 Credit balance in P\/L account 2 500 10 General provision and loss reserve 1 500 11 Goodwill 1 000 12 Credit Risk Weighted Assets 1 50 000 13 Market Risk Weighted Assets 25 000 14 Operational Risk Weighted Assets 10 000 Solution 1St Step: Calculation of Eligible Common Equity Capital `in crore `in crore 4 Paid up Capital 6 000 7 Statutory Reserve 5 000 9 Balance in Profit & Loss A\/c 2 500 8 Capital Reserve 1 000 6 Revaluation Reserve (0.45 of 2000) 900 Total CET 1 Capital 15 400","540 11 Less: Goodwill 1 000 Total eligible CET 1 Capital after adjustment 14 400 2nd Step: Calculation of Eligible Additional Tier 1 Capital 17175 1 PNCPS 3 000 19 075 3 PDI 2 000 185000 7.78% Max. eligible Additional Tier 1 capital = 1.5% of 2 775 9.28% 10.31% 185000 = 2775 Total eligible Tier 1 capital 14400+2775 3rd Step: Calculation of Eligible Tier 2 capital RNCPS 1000 cr 400 2 Less Discount 60% for Residual Maturity being 2 Yrs 10 General Provisions and Loss Reserves 1 500 5 Tier 2 Debt Capital Instruments ` 1500 cr Nil Less Discount 100% for Residual Mat being 9 months Total eligible Tier 2 capital 1900 Total Eligible Capital 17175+1900 4th Step: Compute total risk weighted assets RWA for Credit Risk 150 000 RWA for Market Risk 25 000 RWA for Operational Risk 10 000 Total risk weighted assets 5th Step: Compute required ratio CET 1 Ratio 14400\/185000 Tier 1 Ratio 17175\/185000 CRAR 19075\/185000","541 Let us sum up \uf0ae\t At a global level, the banking regulation standard is set by Basel Committee on Banking Supervision. The Basel Committee on Banking Supervision (BCBS), initially named as the Committee on Banking Regulations and Supervisory Practices, was set up by the central-bank Governors of the Group of Ten (G-10) countries at the end of 1974. \uf0ae\t In 1975 BCBS issued the first guideline called \u201cConcordat\u201d. The Concordat set out principles for sharing supervisory responsibility for banks\u2019foreign branches, subsidiaries and joint ventures between host and parent (or home) supervisory authorities. \uf0ae\t It was followed by the release of Basel 1 accord which was released in 1988, asking banks to maintain minimum capital adequacy of 8% against credit risk. It prescribed risk weight that was applied to various types of exposures. \uf0ae\t However, Basel 1 accord was criticized because it was not sufficiently risk sensitive. In 2004, Basel 2 was introduced which required banks to maintain capital against credit risk, market risk and operational risk. \uf0ae\t Further, it advocated for three pillar approaches which consisted of Minimum Capital Requirement, Supervisory Review Process and market discipline. \uf0ae\t Basel \u2013 II formed the basis for identification, measurement, and monitoring of risks in the banking system that can be improved upon by fine tuning their models. \uf0ae\t Basel 3 recommended strengthening the quality and quantity of regulatory capital along with adequate liquidity cover in order to improve the resiliency of banks. Basel 2 has (No change in Basel 3) provided two options for measurement of capital charge for credit risk namely Standardized Approach and Internal Rating Based Approach. \uf0ae\t In the case of Internal Rating Based Approach, the required capital is calculated from PD, LGD and EAD with the help of prescribed formula provided by Basel Committee. \uf0ae\t From the required capital, Bank can calculate notional credit RWA by multiplying the required capital by 12.5. \uf0ae\t Basel \u2013 III Capital accord propounds maintenance of quality capital so that the regulated entities are well in a position to absorb any kind of risks. Check your Progress 1.\t Basel Committee set out certain principles known as \u201cConcordat\u201d which laid down the ground rules which should govern the supervision of a.\t Domestic branches by the national regulator b.\t Foreign branches by host and destination countries","542 c.\t Money laundering and terrorist financing d.\t Risk management system in banks 2\t Under Basel 3 guidelines, Credit Conversion Factor for a LC bill drawn under a LC issued by a well- capitalized bank and discounted on behalf of a \u2018A\u2019 rated company is a.\t 20% b.\t 50% c.\t 100% d.\t 150% 3.\t Exposure to an account guaranteed by State Government carries a risk weight of a.\t 0% b.\t 20% c.\t 50% d.\t 75% 4.\t Maximum amount of General Provisions and Loss Reserve that is admissible under Tier 2 capital is a.\t 1.5% of total RWAs b.\t 1.25% of total RWAs c.\t 2% of total RWAs d.\t 1.25% of credit RWAs 5.\t Which of the following is gone concern capital? a.\t Common Equity Tier 1 Capital b.\t Additional Tier 1 Capital c.\t Tier 1 capital d.\t Tier 2 capital Answers to check your progress 1. b 2. a 3. b 4. d 5. d","543 1.\t Organisational structure & Risk Management Committee 2.\t Risk Identification, Measurement, Mitigation, Monitoring & Control 3. \t Risk Management Models Organisational Structure & Risk Management Committee 1.ORGANISATIONAL STRUCTURE The risk management organization delineates the tasks at three levels, namely Board of Directors, Executive Management and Operating management. Also, there are specific duties performed by audit functionaries from within the bank or outside. These are discussed in the following paragraphs. 1.1 Board of Directors The board of directors is the supreme decision-making body of a bank. It decides on the course of action the bank should follow. It provides the required leadership and the guidance to the organization for achieving its objectives. The board of directors has the ultimate responsibility for the management and performance of a company and is responsible for its governance i.\t In the area of risk management, Board sets common goals, direction, strategies and above all development of required capability to manage various types of risks. Each bank has a unique business profile in terms of its composition, strengths and weaknesses, the market it serves and the business focus. Based on this information, the board decides on the blend of optimal return and minimum risk given bank\u2019s risk profile and its risk bearing capacity. ii.\t The board of directors will be at the top of the risk management organizational structure and will have the primary responsibility to understand the nature and materiality of risks the bank faces and put in place appropriate tools and techniques to manage those risks. However, the board members do not take part in day to day operations or activities. The board needs regular inputs for facilitating decision making. iii.\t But it is necessary to ensure that the board members are qualified for their position and are free of influences from people within or outside the organization. Risk management is a very specialized and sensitive function, and it is essential that board members understand their role, recommend sound practices, establish \u201cchecks and balances,\u201d and prevent conflicts of interest. iv.\t For assuming the responsibility, with inputs from senior management, the Board would take up the following steps: a.\t Set the overall strategic direction of the bank, including fixing risk tolerance limits.","544 b.\t oversee, guide, and review the performance of senior management; and set senior management compensation. c.\t Monitor the performance of the bank, review risk reports. d.\t Meet regularly with senior management and internal auditors to review and approve policies. The risk management architecture should be properly vetted by the appropriate experts. e.\t Review performance and responsibilities of the bank\u2019s senior management and consider accountability. f.\t Evaluate the methods used for risk assessment as also the organizational structure proposed for the function. g.\t Encourage the consultative decision-making process. 1.2 Executive Management The next layer of responsibility is on an independent Risk Management Committee or Executive Committee of the top Executives which reports directly to the Board of Directors. The Risk Management Committee \/ Executive Committee of the top executives is responsible for evaluating overall risks faced by the bank and determining the level of risks which will be in the best interest of the bank. Some of their functions include: v.\t the overall business strategy and the key policies of the institution within the applicable legal and regulatory framework, taking into account the institution\u2019s long- term financial interests in view; vi.\t the overall risk strategy, including the institution\u2019s risk appetite and its risk management framework; vii.\t an adequate and effective internal governance and internal control framework that includes a clear demarcation of responsibilities, well-functioning independent internal risk management, compliance and audit functions that have sufficient authority, stature and resources to perform their functions; viii.\tthe amounts, types and allocation of both internal capital and regulatory capital to adequately cover all the material risks faced by the institution; ix.\t targets for the liquidity management of the institution; x.\t a remuneration policy that is in line with the remuneration principles; xi.\t a risk culture which addresses the institution\u2019s risk awareness and risk-taking behaviour; xii.\t arrangements aimed at ensuring the integrity of the accounting and financial reporting systems, including financial and operational controls and compliance with the law and relevant standards.","545 1.3 Risk Management Committees Credit, market, and operational risks arise from different sources and different banking activities although sometimes they arise concurrently. The organizational structure should therefore have provisions for specialized committees, which deal with each of these business risks. These committees will consist of the executive directors and the business line heads of the functional departments since links exist between different types of risks. They primarily perform the following activities: xiii.\t advice and support the executive committee in its supervisory function regarding the monitoring of the institution\u2019s overall risk appetite and strategy, taking into account all types of risks, to ensure that they are in line with the business strategy, objectives, corporate culture and values of the institution; xiv.\t assist the executive committee in its supervisory function in overseeing the implementation of the institution\u2019s risk strategy and the corresponding limits; xv.\t oversee the implementation of the strategies for capital and liquidity management as well as for all other relevant risks of an institution, such as market, credit, operational (including legal and IT risks); xvi.\t recommend necessary adjustments to the risk strategy resulting from, inter alia, changes in the business model of the institution, market developments or recommendations made by the risk management function; xvii.\treview a number of possible scenarios, including stressed scenarios, to assess how the institution\u2019s risk profile would react to external and internal events; xviii.\tThe risk committee should assess the risks associated with the offered financial products and services and take into account the alignment between the prices assigned to and the profits gained from those products and services; and xix.\t assess the recommendations of internal or external auditors and follow up on the appropriate implementation of measures taken. The higher-and the lower-level committees will require the backup of full-fledged departments and other supporting staff and thus, the organizational structure will have credit, market, and operational risk management committees and departments, besides a separate risk management department that will work as the secretariat of the committees. The reporting system is to be put in place for both periodical, and exception reporting. The formats, frequency, the recipients thereof have to be detailed. It would entail the reporting of approvals, escalation mechanism for exceptions and excesses over discretion and procedures for recording these exceptions. This task is again for the senior management to undertake.","546 1.4 Line Functionaries The operating management includes people who actually do business and implement the risk management policy on a day-to-day basis. The operating management needs to address and implement various risk management procedures such as: xx.\t Operating within relevant levels of authority, prescribed ceilings and laid down procedures while committing the bank to various transactions. xxi.\t Obtaining adequate information about the customer, counter party before entering into transaction. xxii.\tGathering sufficient details of the market situation to make decisions on pricing. xxiii.\tConsidering the counter party\u2019s expertise in undertaking transactions with comparable complexity. xxiv.\tAssessing funding requirements and making arrangements to meet them. xxv.\tEnsuring that adequate and effective control mechanisms are in place. xxvi.\tAdhering strictly to approved risk management policies and procedures. 1.5 Internal Audit Functionaries While the board, executive and operating managements are engaged in developing the risk management organization and policies and procedures and following them, the internal audit function looks into the monitoring aspect with a dispassionate outlook. This includes primarily the review of critical control systems and risk management processes. Since it is a part of third line of defence in risk management, its efficacy will hold the key to control risks. Every bank will put in place the processes for assessment of risk across the bank in all operations where risk exposure is taken and appropriate control mechanism to manage risk. Internal audit function undertakes an effectiveness review of risk assessments and the internal controls. An audit of this kind provides valuable feedback to improve the assessment processes as well as internal control. a.\t The bank needs an outside or independent agency to challenge the basis of management\u2019s risk assessments and evaluate the adequacy and effectiveness of risk treatment strategies. The unbiased view of external agencies will help in rectifying any lose ends in the controls; b.\t monitor the effectiveness of the institution\u2019s internal quality control and risk management systems:","547 c.\t monitor the financial reporting process and submit recommendations aimed at ensuring its integrity; d.\t Banks design the control system needed for risk management. Hedging or other risk mitigation strategies are developed as part of this exercise. Internal auditors review these systems as well as the risk mitigation strategies. As the outcome of such a review, providing advice in the design and improvement of control systems and risk mitigation strategies becomes the responsibility of the auditors. As stated earlier, imbibing the concept of risk in the long and short-term planning exercises is the task of the senior management. Even such planning exercises can be subjected to a review and audit by the internal auditors. Implementing a risk-based approach to planning and executing the internal audit process remains a part of the internal audit. Assessment of business risks, its quantification and measurement will also ensure that the capital is in sync with the risks. 1.6 Credit Risk Management Committee (CRMC) Each bank may, depending on the size of the organization or loan\/ investment book, constitute a high- level Credit Risk Management Committee (CRMC).The Committee should be headed by the Chairman\/ CEO\/ED, and should comprise of heads of Credit Department, Treasury, Credit Risk Management Department (CRMD) and the Chief Economist. The functions of the Credit Risk Management Committee should be as under: a.\t Be responsible for the implementation of the credit risk policy\/ strategy approved by the Board. b.\t Monitor credit risk on a bank wide basis and ensure compliance with limits approved by the Board. c.\t Recommend to the Board, for its approval, clear policies on standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, d.\t Decide delegation of credit approving powers, prudential limits on large credit exposures, standards for loan collateral, portfolio management, loan review mechanism, risk concentrations, risk monitoring and evaluation, pricing of loans, provisioning, regulatory\/legal compliance, etc. 1.7 Credit Risk Management Department (CRMD) Credit Risk Management Department should be constituted independent of the Credit Administration Department. The functions of CRMD include:","548 a.\t Measure, control and manage credit risk on a bank-wide basis within the limits set by the Board\/ CRMC b.\t Enforce compliance with the risk parameters and prudential limits set by the Board\/ CRMC. c.\t Lay down risk assessment systems, develop MIS, monitor quality of loan\/ investment portfolio, identify problems, correct deficiencies and undertake loan review\/audit. Large banks could consider separate set up for loan review\/audit d.\t Be accountable for protecting the quality of the entire loan\/ investment portfolio. The Department should undertake portfolio evaluations and conduct comprehensive studies on the environment to test the resilience of the loan portfolio. Concurrently, each bank should also set up Credit Risk Operations\/Systems. Banks should have in place appropriate credit administration, credit risk measurement and monitoring processes. The credit administration process typically involves the following phases: a.\t Relationship management phase i.e., business development. b.\t The transaction management phase covers risk assessment, loan pricing, structuring the facilities, internal approvals, documentation, loan administration, ongoing monitoring and risk measurement. Portfolio management phase entails monitoring of the portfolio at a macro level and the management of problem loans. Credit risk mitigation is possible only if all the inputs are organised keeping the industry risk profile in view. The client relationship can be maintained only if the credit decisions and risk taking ability sync with market needs. 1.8 ORGANIZATIONAL STRUCTURE TO MANAGE MARKET RISK Successful implementation of any risk management process has to emanate from the top management in the bank and its strong commitment to integrate basic operations and strategic decision making with risk management. Ideally, the organization set up for market risk management should be as under:- a.\t The Board of Directors b.\t The Risk Management Committee c.\t The Asset-Liability Management Committee (ALCO) d.\t The ALM support group\/ Market Risk Group The Board of Directors should have the overall responsibility for management of risks. The Board should decide the risk management policy of the bank and set limits for liquidity, interest rate, foreign exchange and equity price risks.","549 The Asset-Liability Management Committee, popularly known as ALCO should be responsible for ensuring adherence to the limits set by the Board as well as for deciding the business strategy of the bank in line with bank\u2019s budget and risk management objectives. The ALCO is a decision-making unit responsible for balance sheet planning from a risk-return perspective including strategic management of interest rate and liquidity risks. The role of the ALCO should include, inter alia, the following:- a.\t product pricing for deposits and advances b.\t deciding on desired maturity profile and mix of incremental assets and liabilities c.\t articulating interest rate view of the bank and deciding on the future business strategy d.\t reviewing and articulating funding policy e.\t reviewing economic and political impact on the balance sheet The ALM Support Groups consisting of operating staff should be responsible for analysing, monitoring and reporting the risk profiles to the ALCO. The Risk management group should prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to the balance sheet and recommend the action needed to adhere to the bank\u2019s internal limits, etc. 1.9 ORGANIZATIONAL STRUCTURE FOR TRADING ACTIVITY The Middle Office The Middle Office is responsible for the critical functions of independent market risk monitoring, measurement, analysis and reporting for the bank\u2019s ALCO. Mid office in treasury keeps a close eye on risk appetite and compliance of risk management policies while they are implemented. Ideally this is a full-time function reporting to, or encompassing the responsibility for, acting as ALCO\u2019s secretariat. An effective Middle Office provides the independent risk assessment which is critical to ALCO\u2019s key-function of controlling and managing market risks in accordance with the mandate established by the Board\/Risk Management Committee. It is a highly specialized function and must include trained and competent staff, expert in market risk concepts. The methodology of analysis and reporting will vary from bank to bank depending on their degree of sophistication and exposure to market risks. The same criteria will govern the reporting requirements demanded of the Middle Office, which may vary from simple gap analysis to computerized VaR modelling. Middle Office staff may prepare forecasts (simulations) showing the effects of various possible changes in market conditions related to risk exposures. Segregation of duties principles must be evident in this function which must report to ALCO independently of the treasury function."]