Risk Management Consists of Identification Assessment Acceptance or mitigation of adverse consequences of events and circumstances

It is a general management function that seeks to identify assess and address the causes and effects of uncertainty and risk in an organization. Risk Management focuses on Increasing expected losses and mitigating expected losses.

Exploring and managing the universe of unexpected losses and gains

Prior to the year 1997, quite a relax criteria was applied to the domestic banks as they were required to maintain the aggregate value of their paid up capital and unencumbered general reserves at 7.5 % of the demand and Time Liabilities as at the close of the last working day in December, 1972. While for foreign banks the aggregate value of their paid up capital and reserves in Pakistan at the close of any day was required to be not less than 50 Lakhs rupees or 7.5 % of their total demand and time liabilities at the close of the last working day of the previous calendar year, whichever is higher.

However, section 13 of the BCO, 1962 was modified in 1997 and new instructions on capital were issued vide BPRD Circular No. 36 of 1997 for implementation from 31-121997 onward. Effective from 31-12-1997, all banks were required to maintain a minimum paid up capital of Rs. 500Mn by 31-12-1997, whereas shortfall if any, was to be met by 31-12-1998. While capital and unencumbered general reserves maintained by the bank should not be less than 8 % of the Risk Weighted Assets

Few fixed risk classes defined by the supervisor: 0%, 20%, 50%, 100% Limited or no Credit Risks Mitigation Techniques Limited risk sensitivity for credit risk implies opportunities for regulatory arbitrage (behavior that defeats the regulatory requirement) No Operational Risk Limited recognition of collateral and guarantees/ risk mitigation technique ( New credit risk mitigation techniques are not recognized e.g. credit derivatives, on-balance sheet netting)
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Only credit and market risk explicitly covered, no separation of Operational Risk Increasing divergence between economic and regulatory capital (Regulatory capital should come closer to the real risk profile of a bank economic capital) No recognition of granularity and diversification effects Portfolio effects are not considered (life assurances receivable not accepted)

Regulatory Capital

Defined by the regulator Inclusive of Tier 1 & Supplementary Capital (Tier 2 and Tier 3 Capital) Meant to assure that bank is able to cover major losses without crises

Regulatory Capital Management helps to ensure the soundness and stability of the banking sector and stability of the banking sector & protect depositors

Economic Capital Management helps to identify value creating business activities to satis Information needs and, with Basel II, to fulfill regulatory requirements

Economic Capital

Anything that can absorb economic losses without affecting debt-holders Not just capital but also intangibles and hidden charges Necessary to absorb potential losses associated with any of the risk already assumed or to be assumed
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Quantification of Risks Market Risk Credit Risk Ops Risk Others

Risk Aggregation Overall Risk Overall Economic Capital Tolerance for risk

Overall Risk- Taking Capacity Tier 1 Capital & reserves Intangibles, expected net gains & others

For each business line/ product, all relevant risks must be measured individually and aggregated to a single metric. Banks capital must be enough to ensure viability of the institution. Risks are well priced if the

price realized is equal to or better than the market price & costs.

(RWA (credit risk) + 12.5 * Capital required for Market Risk)

> 9

Total Capital______________

Current Accord
Capital ratio of 9 %

Proposed New Accord

Unchanged

Numerator the amount of a bank capital i.e. definition of regulatory capital

Unchanged

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Current Accord

Proposed New Accord

Denominator- the measure the risk faced by the bank referred to as RWA. It explicitly covers only two major risks - credit risk & market risk other risk are presumed to be covered implicitly through the treatment of these two major risks.

Substantial change in the treatment of RWA and explicit treatment of operational risk to be included in the denominator. Introduction of three distinct options for the calculation of credit risk& three others for operational risk.
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 Basel II is a world wide regulation that helps banks to determine whether their existing equity is adequate as compared to the risks that bank faces in the form of credit, market, liquidity and operational risks. Examples include: Credit risk the risk of borrower defaulting in loan repayment Market risk the risk of fluctuation in interest rates, etc. e.g. effective markup rates differing from pool rates Liquidity risk the risk that banks liquidity position is not adequate enough to meet its cash requirements Operational risk the risk of bank breaching any regulation and incurring losses in the form of penalties or cashier making excess payments
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First Pillar

Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management

Second Pillar

Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process, including supervisory power to require banks to hold more capital than required under the First Pillar

Third Pillar

Market Discipline: New public disclosure requirements to compel improved bank risk management

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 Correlating banking risks and their management with capital requirement. Improve safety and soundness in the financial system by placing emphasis on banks internal control, risk management processes and models, the supervisory review process and market discipline. Calculating capital requirements under Basel II requires banks to implement a comprehensive risk management framework across the institution. Better Risk Management = Lower Capital Requirement & lower costs / higher profits

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Credit Risk i) Advances IRB approach ii) Foundation IRB approach iii) Standardized approach

Operational Risk

Market Risk

i) Advanced i) Internal Models Measurement approach ii) Alternate Standardized approach iii) Basic Indicator approach ii) Standardized approach

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Sovereign Portfolio

Central government, provincial government or the central bank of any country

Bank Portfolio
Retail Portfolio

Commercial banks and DFIs

Exposure to individual, small business in the form of revolving credits and lines of credit (including credit cards and overdrafts), personal term loans and leases (e.g. instalment loans, auto loans and leases, student and educational loans, personal finance) and small business facilities. To be eligible the total exposure to a single person should not be more than Rs 10 million in case of consumer loans and small business loans.

Mortgage loans are not included in this category.

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Public Sector Entities

Owned or controlled by central or provincial government or any entity categorized as PSE by SBP

Corporate Portfolio

Proprietorship, partnership or limited company, insurance companies that is neither a PSE, bank, DFI, nor included in retail exposures.

Consumer loans and small business loans above Rs 10 million will be a part of corporate portfolio and will not remain in retail.

Mortgages

Loans to individuals for the purchase or construction of residential house / apartment or making improvements in house / apartment / land irrespective of the amount of finance

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Basel II analysis Credit Risk via four parameters

Probability of Default
Probability of default of the borrowers in each risk grade (rating) on a one year time horizon

Loss Given Default (LGD)

Loss after the event of a default

Exposure at Default (EAD)

Outstanding amount at time of default

Maturity (M)
Remaining effective maturity of the EAD

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 The new regulations require

Bank should be able to determine the amount of loan committed by the bank to be disbursed The amount of such committed exposure not yet disbursed by the bank at any cut off date Example may include

Running finance line approved for Rs 10 million but current outstanding is Rs 4 million and therefore Rs 6 million is banks commitment not yet disbursed by the bank.

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 Measure credit risk pursuant to fixed risk weights based on

Standardised

external credit assessments (ratings) Least sophisticated capital calculations; generally highest capital burden determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). More risk sensitive capital requirements determined inputs of PD, LGD, EAD and M Most risk-sensitive (although not always lowest) capital requirements Transition to Advanced IRB status only with robust internal risk management systems and data

Measure credit risk using sophisticated formulas using internally

Foundation IRB

Measure credit risk using sophisticated formulas and internally

Advanced IRB

Under Basel II, banks have strong incentive to move to IRB status and reduce capital charges by improving risk management systems

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Approaches for Credit Risk as per Basel II

Standardized Approach (a Foundation Internal Rating Based (FIRB) Advanced Internal Rating Based (AIRB)

modified version of existing accord)

Parallel run start from July- 2006 Actual Implementation 2008

Parallel run start from Jan- 2008 Actual Implementati on 2010

Increasing Risk Management Sophistication

Parallel run can be started from Jan- 2010 No date for Actual Implementati on

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INCENTIVES OF ADVANCED CREDIT APPROACHES

Capital adequacy requirements

Basel I

Basel II Standardized Approach

Basel II FIRB

Basel II AIRB

Risk Management Sophistication

The core of Basel II is not to increase capital but in better risk management through systematically assessment & quantification of risks and optimal use of resources. Banks with a better compliance /good risk management and control system have longer supervisory cycle/ lesser supervisory intervention including directions, sanctions and penalties.
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 The most unsophisticated approach for measuring risk, this approach is likely to be used by the majority of smaller, regional banks The minimum capital requirement calculation is similar to the first Basel Accord, however Credit Risk is now to be determined by reference to the public rating of the borrower:
Min. Capital Requirement = 8% x Loan amount x credit risk weighting

Risk weightings are non-linear between rating levels, e.g.:

AA rated corporate risk weighting = 20% CCC rated corporate risk weighting = 150% Unrated corporate risk weighting = 100%

Defining the required Regulatory Capital is objective based solely on the criteria within the Accord
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The IRB Approaches are more sophisticated, but harder to execute

Capital is measured as a complicated function of PD:

Capital = LGD x f(PD) x EAD

The Foundation IRB Approach only allows the bank to determine PD, other variables are provided by the regulator The Advanced IRB Approach allows the bank to determine each variable

PD = Probability of Default EAD = Exposure At Default LGD = Loss Given Default

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