Risk Based Capital

Management for Banks

Compiled By

Janata Bank Staff College

Dhaka.
Risk Related to Banking Activities
 Risk is nothing but possibility of losing assets through some
activity i.e., in case of banking credit activity, market activity,
operational activity etc.

 Risk inherent with banking activities are

 Credit risk
 Market Risk
 Operational risk
 Supervisory risk
Why is Capital so Important?
 Bank is a highly leveraged institution
 Capital performs several unique and indispensable jobs in
banks
- Cushion against bank’s business loss.
- Promote public confidence
- Organization’s growth
- Sets limit to risk exposure
- A measure of soundness and stability
Capital Adequacy Rule

 The capital adequacy rules is to ensure that the institution

has enough capital in relation to the risks with their entity’s
activities.
 Enough capital means the amount of capital sufficient to
meet any unforeseen loss.
 Capital Adequacy is defined as the level of capital which is
required to protect a bank from portfolio losses.
 The Basel Committee, designed Capital Regulation, which is
known as the Basel Accord.
Objectives of Basel Accord

 To strengthen the soundness and stability of the international

banking system and

 To obtain a high degree of consistency in its application to

banks in different countries with a view to diminishing an
existing source of competitive inequality among international
banks.
What is the Basel Committee

 A Committee of central banks and bank supervisor and

regulators from the major industrialized countries (Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg,
Netherlands, Sweden, Switzerland, U.K and U.S.A) that
meets every three months at the BIS in Basel.
Basel-I Capital Requirement
 Adopted in 1988
 Capital is linked with risk assets/credit risk.
 Banks should calculate Risk Weighted Assets (RWA) and
this to be calculated dividing assets into four risk group i.e.
0%, 20%, 50% & 100%.
 Capital is divided between:
 Tier-1 or Core Capital
 Tier-2 or Supplementary Capital

Tier-2 cannot exceed 100% of Tier-1

Minimum capital requirement is 8% of RWA
Basel-I Capital Standered
 Focus only on Credit or Default Risk

 Market Risk exposure (Changing interest rates, exchange

rates) added later.
 Limitations:
 Same Set of risk weights
 Same required Minimum CAR for all banks.

 Operational Risk, gradually turning critical, ignored.

 Need for Revised Capital Standard

 BASEL-II
Capital Adequacy:
Bangladesh Scenario
 Before 1991 – No Capital Adequacy Standard
 Bank Company Act-1991 – Cap. Adequacy Linked to
Liabilities (6% of total demand and time liabilities)
 However, disregards the asset quality of bank
 January, 1996: Capital Adequacy Linked to RWA (8%) in line
with BASEL-I
 Risk to OBS item also considered
Criticism of Basel-I Accord
 Exclusive focus on credit risk.
 Inadequate differentiation of credit risk/one size fits all
approach is not appropriate.
 No recognition for risks related to term structure of credit
portfolio.
 Dose not recognize portfolio diversification effect of credit
risk
 Dose not recognize credit risk mitigation techniques and role
of collateral.
 Dose not levy any capital charge for operational risk.
Risk Based Capital Basel-II
 This framework was finalized in 2004.
 Basel-II states that bank should maintain capital not only
covering credit risk but also covering market & operational
risk.
 RWA should be calculated covering Market & Operational
risk along with credit risk,
 In addition to calculation MCR (Pillar-1) banks should have a
robust review process on risk and capital planning as stated
in pillar-2 of Basel-II.
 Again in addition to pillar-1 & pillar-2 banks should disclose
their performance as explained in pillar-3 for the sake of
establishing Market Discipline. So, that all the stakeholders
of banks will be able to know the position of banks success.
 Pillar-I Pillar-II Pillar-III
Supervisory Market
Minimum Capital Requirement
Review Discipline

Operational
Credit Risk Market Risk
Risk
Internal Capital
Adequacy
Assessment
Basic Process
Standardized (ICAAP)
Indicator
Approach Standardized Core and
Approach
Approach Supervisory
Disclosure
Standardized
Foundation
Approach
IRB Approach
Supervisory
Advanced Evaluation
Advanced Process
Internal Model Measuremen
IRB Approach
Approach t Approach
The Guideline is Structured
Around Following Three aspects:
 Minimum Capital Requirements to be maintained by a bank
against credit, market and operational risk.

 Assessing Overall Capital Adequacy in relation to bank’s risk

profile and a strategy for maintaining capital at an adequate
level.

 Disclosure of Information on Bank’s Risk Profile, Capital

Adequacy and Risk Management.
Capital Base
 Tier-1 or Core Capital
 Paid up capital
 Non-repayable share premium account
 Statutory Reserve
 General Reserve
 Retained Earnings
 Minority Interest in subsidiaries
 Non-Cumulative irredeemable Preference Share
 Dividend Equalization Accounts

 Tier-2 or Supplementary Capital

 General Provision
 Revaluation Reserves
 Revaluation Reserve for fixed assets
 Revaluation Reserve for securities
 Revaluation Reserve for equity instrument
 All other Preference Share
 Subordinated debt

 Tier-3 or Additional Supplementary Capital

 Short-term subordinated debt (Maturity max. 5 yr. –min 2 yr.)
Condition for Maintaining Regulatory
Capital
 The amount of T-2 capital will be limited to 100% of the amount of T-1
capital.
 50% of revaluation reserves for fixed assets and securities shall be
eligible for T-2 capital.
 10% of revaluation reserves for equity instruments shall be eligible for
T-2 capital.
 Subordinated debt (T-2) shall be limited to a maximum of 30% of the
amount of T-1 capital.
 A minimum of about 28.5% of market risk needs to be supported by T-1
capital. Supporting of market risk from T-3 capital shall be limited up to
maximum of 250% of T-1 after meeting credit risk.
Minimum Capital Requirement
  No schedule bank in Bangladesh shall commence and carry
on business unless it has minimum paid up capital / capital
deposited with BB as fixed by BB.

 CAR = ≥ 10%

With T-1 at least 5%

 Total Eligible Regulatory Capital = (Eligible T-1 Capital +

Eligible T-2 Capital + Eligible T-3 Capital )

 Total RWA = RWA for CR + 10 x (Capital charges for market

risk and operational risk)
Minimum Capital Requirement (MCR)
(Credit + Market + Operational Risk)
Risk weighted Amount Cr. Tk.
For Credit Risk = ……….
For Market Risk ………… x 10 = ………
For Operational Risk ………… x 10 = ………
Total : RWA …………
Minimum Capital Requirement 10% of RWA
(MCR) = ……… x 10%
= ………
Basel-III: Global Capital Framework
for Resilient Banking System
 To strengthen global capital and liquidity rules with the goal
of promoting a more resilient banking sector, BCBS issued
“Basel-III : A Global Regulatory Framework for Resilient
Banks and Banking System” in December 2010.

 The Objective of the reforms was to improve the banking

sector’s ability to absorb shocks arising from financial and
economic stress, whatever the source, thus reducing the risk
of spillover from the financial sector to the real economy.

 Though its reform package, BCBS also aim to improve risk

management and governance as well as strengthen bank’s
transparency and disclosures.
Basel-III: Introduction
 Gradual erosion of the level and quality of the capital was
observed in the last financial crisis.

 At the same time, many banks were holding insufficient

liquidity buffers. The banking system therefore was not able
to absorb the resulting systemic trading and credit losses.

 During the most severe episode of the crisis, the market lost
confidence in the solvency and liquidity of many banking
institution.

 The weakness in the banking sector were rapidly transmitted

to the rest of the financial system and the real economy,
resulting in a massive contraction of liquidity and credit
availability.
The Basel Committee Introduced a
Number of Fundamental Reforms
 Strengthening the Capital Framework

 Supplementing the Risk Based Capital Requirement with a

Leverage Ratio.

 Reducing Procyclicality and Promoting Countercyclical

Buffers.

 Addressing Systemic Risk and Interconnectedness.

 Introducing Global Liquidity Standard.

What Basel-III is mainly about?

Risk Management not the Crisis

Management.

Risk Based Capital Management

(Quality, Quantity and Liquidity)
Key Features of Basel-III

To improve risk
To improve banking management and
sector’s ability to Reducing the risk of governance as well
absorb shocks spillover from the as strengthen
arising from financial sector to bank’s transparency
financial and the real economy. and disclosures
economic stress instead of crisis
management.
Roadmap of Basel-III by BB
 Issuance of Guideline by December 2014
 Draft Guideline Issued : 19 august 2014
 Final Guideline Issues : Through BRPD Circular # 18, dated 21.12.2014

 Capacity Building of Bank & BB Officials :

January 2015 to December 2019.

 Commencement of Basel-III Implementation process : January

2015

 Initiation of Full Implementation of Basel-III : January 2020

 Basel-II and Basel-III: Status of
Three Pillars
Basel-II Basel-III
Pillar-I Pillar-II Pillar-III Pillar-I Pillar-II Pillar-III
Minimum Supervisory Disclosure & Enhanced Enhanced Enhanced
Capital Review Market Minimum Supervisory Risk
Requirements Process Discipline Capital & Review Disclosure &
Liquidity process for Market
Requirements Firm wide Discipline
Risk
Management
and Capital
planning
Phase-in Arrangements for Basel-III
Implementation in Bangladesh
Particulars 2015 2016 2017 2018 2019
Minimum Common Equity Tier-1 (CET) Capital Ratio 4.50% 4.50% 4.50% 4.50% 4.50%

Capital Conservation Buffer - 0.625% 1.25% 1.875% 2.50%

Minimum CET-1 Plus Capital Conservation Buffer 4.50% 5.125% 5.75% 6.375% 7.00%

Minimum T-1 Capital Ratio 5.50% 5.50% 6.00% 6.00% 6.00%

Minimum Total Capital Ratio 10.00% 10.00% 10.00% 10.00% 10.00%

Minimum Total Capital plus Capital Conservation 10.00% 10.625% 11.25% 11.875% 12.50%
Buffer
Phase-in deductions from CET-1

Excess Investment over 10% of a bank’s equity in the 20% 40% 60% 80% 100%
equity banking, financial and insurance entities/
Phase-in deductions from Tier-2 Revaluation Reserve
(RR)
RR from Fixed Assets, Securities and Equity 20% 40% 60% 80% 100%
Securities
Leverage Ratio 3.00% 3.00% 3% Migration to pillar 1
Readjustment

Liquidity Coverage Ratio ≥ 100% ≥ 100% ≥ 100% ≥ 100% ≥ 100%

(From sep)
Net Stable Funding Ratio ≥ 100% ≥ 100% ≥ 100% ≥ 100% ≥ 100%
(From Sep)
Basel-III: Changes in Capital
Framework
Particulars Basel-III Basel-II
Components of Capital
Going Concern Capital : Core Capital
Tier-1 Capital  Common Equity Tier-1
 Additional Tier-1
Tier-2 Capital Gone Concern Capital Supplementary Capital

Tier-3 Capital Abolished in Basel-III Additional Supplementary

Capital

Components of Tier-1 a) Paid up Capital a) Paid up Capital

Capital/Common Equity b) Non-repayable share premium b) Non-repayable share
Account premium Account
Tier-1
c) Statutory reserve c) Statutory reserve
d) General reserve d) General reserve
e) Retain earnings e) Retain earnings
f) Minority Interest in subsidiaries f) Minority Interest in
g) Dividend Equalization account subsidiaries
g) Non-cumulative
irredeemable preference
shares
h) Dividend Equalization
account
Basel-III: Changes in Capital
Framework
Particulars Basel-III Basel-II
a) Intangible asset e.g., book
Deduction/ a) Shortfall in provisions required
value of goodwill and value of
against classified assets.
regulatory b) Goodwill and all other intangible
any contingent assets.
b) Shortfall in provisions required
adjustments Assets against classified assets.
from Tier-1 c) Deferred tax assets (DTA) c) Shortfall in provisions required
against investment in share.
Capital d) Defined benefit pension fund assets. d) Remaining deficit on account
e) Gain on sale related to securitization of revaluation of investments
transactions in securities after netting off
any other surplus on the
f) Investment in own shares securities
g) Investments in the capital of e) Reciprocal/crossholdings of
banking, Financial and Insurance bank’s capital/subordinated
Entities. debt artificially intended to
inflate the capital position of
banks.
f) Holding of equity shares in
any form exceeding the
approved limit under section
26(2) of Bank Company Act,
1991. The
additional/unauthorized
amount of holdings will be
deducted at 50% from Tier-
1capital and 50% from Tier-2
capital.
g) Investment in subsidiaries
which are not consolidated.
Basel-III: Changes in Capital
Framework
Particulars Basel-III Basel-II

Additional Tier-1 a) Instrument issued by banks that

meet the qualifying criteria for AT1
No such capital was in Basel-II

Capital as specified.
b) Minority Interest i.e. AT1 issued by
consolidated subsidiaries to third
parties (for consolidated reporting
only)

Deduction/ a) Shortfall in provisions required

against classified assets.
No such capital deduction was in
Basel-II previously.
regulatory b) Goodwill and all other intangible
adjustments from Assets
c) Deferred tax assets (DTA)
Additional Tier-1 d) Defined benefit pension fund
Capital assets.
e) Gain on sale related to
securitization transactions
f) Investment in own shares
g) Investments in the capital of
banking, Financial and Insurance
Entities.
Basel-III: Changes in Capital
Framework
Particulars Basel-III Basel-II
Components of Tier-2 a) General Provisions
b) Subordinated debt/
a) General Provisions
b) Revaluation
Capital Instruments issued by the Revaluation reserve for fixed assets.
banks that meet the Revaluation reserve for securities.
qualifying criteria for Tier-2 Revaluation reserve for equity
instrument.
capital.
c) Minority Interest i.e. Tier-2 c) All Other preference shares
issued by consolidated d) Subordinate debt
subsidiaries to third parties

Deduction/ As applicable of the areas as

specified in deduction for AT-1
No such deduction was
applicable.
regulatory above.
adjustments from
Tier-2 Capital

Components of Tier-3 Abolished in Basel-III Consisting of short-term

subordinated Debt (maturity less
Capital than or equal to five years, solely
for the purpose of meeting a
portion of the capital
requirements for market risk.
Basel-III: Changes in Capital
Framework
Particulars Basel-III Basel-II
Capital Conservation Banks are required to maintain a
capital conservation buffer of
No such concept was in Basel-II

Buffer (CCB) 2.5%, comprised of common

equity Tier 1 capital, above the
regulatory minimum capital
requirement of 10%

Constraint Constraint on capital distributions

when a bank’s CET 1 level falls
No such concept was in Basel-II

between 4.5% and 7% of its

RWAs.
If a bank does not have positive
earnings and has a common
Equity Tier 1 ratio less than 7%,
it should not make positive net
distributions.
Limits of Capital Framework
 Common Equity Tier 1 of at least 4.5% of the total RWA

 Tier 1 capital will be at least 6.0% of the total RWA.

 Minimum CRAR of 10% of the total RWA.
 Additional Tier 1 capital can be admitted maximum up to
1.5% of the total RWA or 33.33% of CET1, whichever is
higher.
 Tier 2 capital can be admitted maximum up to 4.0% of the
total RWA or 88.89% of CET1, whichever is higher.
 In addition to minimum CRAR , Capital Conservation Buffer
(CCB) of 2.5% of the total RWA is being introduced which will
be maintained in the form of CET1.
Basel-III: Leverage Ratio
Particulars Basel-III Basel-II
Leverage Ratio Newly added in Basel-III No such concept
was in Basel-II

Issues In order to avoid building up excessive on and off- No such concept

balance sheet leverage in the banking system, a simple, was in Basel-II
Covered transparent, non-risk based leverage ratio has been
introduced. The leverage ratio is intended to achieve the
following objectives:
a) Constrain the build-up of leverage in the banking
sector which can be damage the broader financial
system and the economy, and
b) Reinforce the risk based requirements with an easy to
understand and a non-risk based measure.

Formula Tier 1 Capital (after related deduction) / Total Exposure

(after related deduction)
No such concept
was in Basel-II

Reporting The parallel run period for leverage ratio will commence
from January, 2015 and run until December 2016.
Bank level disclosure of the leverage ratio and its
components will start from January 1, 2015. However,
banks should report their Tier 1 leverage ratio to the BB
along with CRAR report from the quarter ending March,
2015.
Basel-III: Liquidity Coverage Ratio
Particulars Basel-III Basel-II

Liquidity Coverage Newly added in Basel-III No such concept was in Basel-II

Ratio (LCR)

Issues Covered Developed to promote short-term

resilience of a bank’s liquidity risk
No such concept was in Basel-II

profile by ensuring that it has sufficient

high-quality liquid assets to survive a
significant stress scenario lasting for
one Month (30 days)

Formula (Stock of HQLAs/ Net cash outflow

over the next 30 calendar days) ≥
No such concept was in Basel-II

100%
Basel-III: Supervisory Review Process
Particulars Basel-III Basel-II
ICAAP Reporting Yearly reporting mandatory No such instruction was in Basel-II

Risks Covered Basel-III Covers 10(ten) risks: Basel- II Covers 11(eleven) risks:
 Residual risk  Residual risk
 Concentration risk  Securitization risk
 Interest rate risk in the banking book  Credit Concentration risk
 Liquidity risk  Interest rate risk in the banking
 Reputation risk book
 Strategic risk  Liquidity risk
 Settlement risk  Reputation risk
 Appraisal of core risk management  Strategic risk
practice  Settlement risk
 Environmental and climate change  Evaluation of core risk
risk management
 Other material risks  Environmental risk
 Other material risks

Measures to Increased emphasis on firm wide

support and a number of specific risk
The process was run as adhoc basis
where some of the technical issues
supplement the management topics, including risk were not specified and justified in
supervisory review concentrations. terms of banking practices in the
respective areas.
process
 Basel-III: Market Discipline
Particulars Basel-III Basel-II
Web page title of “Disclosures on Risk Based Capital (Basel-III)” “Disclosures on Risk Based Capital (Basel-II)”

Market
Disclosure
Disclosure Within the Qualitative & Quantitative
disclosures, the following issues have been
 Qualitative Information
 Quantitative Information
requirements to included: (As per Central Bank provided formats)
improve market  Reconciliation of regulatory capital with
audited financial statement.
discipline  Information on regulatory adjustments
 Description of limits and minimum
requirements identifying all elements of
capital to which these apply.
 Description of the main features of capital
instruments issued
 Comprehensive explanation of how the
ratios are calculated when banks publish
ratios that include components of regulatory
capital
Basel-III: Positive Impacts
 Fewer bank failures, fewer taxpayer bailouts- banks hold
more and better quality capital to withstand future shocks.

 Stronger banking system in the long run.

 Greater confidence in the stability of the financial system

once implementation commences.

 Longer implementation period :

 Would aid the current fledging recovery worldwide.
 Allow banks to adapt by retaining earning, issuing equity.

 Profits rise as bad loans decline.

 Bank share prices improve as they engage in acquisitions

Basel-III: Negative Impacts
 Reduction in credit
Decreased availability and increased borrowing cost
Fewer borrowers have access to funding
Significantly more onerous conditions

 Banks not meeting the ratio requirements cannot pay out

dividends, bonuses, share buybacks
Raise investor concerns over dividends

 Banks may have to come up sizeable amounts of :

 New equity
 Retained earnings, or
 Dispose of assets to meet the new capital ratios.
Preparatory Course of Action
Common Equity / Core Capital has to be increased
by earning expected profit

Asset-Liability Management should make stronger to

ensure liquidity coverage

Investment monitoring systems should be structured

and effective to ensure asset quality

Assessment of capital under revised directions

should be performed to determined bank’s status in
the respective compliance areas

Improvement of human resources quality should be

ensure to cope up Basel-III norms, etc.
THANK YOU